Financial Management & Policy - Chapter 14

The aftertax cost of debt generally increases when: I. a firm's bond rating increases. II. the market rate of interest increases. III. tax rates decrease. IV. bond prices rise.

**II and III only -I and III only -I, II, and III only -II, III, and IV only -I, II, III, and IV

The capital asset price model approach to equity valuation:

**assumes the reward-to-risk ratio is constant -is dependent upon the unsystematic risk of a security -assumes the reward-to-risk ratio increases as beta increases -can only be applied to dividend-paying firms -assumes a firm's future risks will be higher than its current risks

A company's current cost of capital is based on:

**both the returns currently required by its debtholders and stockholders -only the return required by the company's current shareholders -the current market rate of return on equity shares -the weighted costs of all future funding sources -the company's original debt-equity ratio

If a company uses its WACC as the discount rate for all of the projects it undertakes then the company will tend to:

**increase the average risk level of the company over time -accept all positive NPV projects -reject all high-risk projects -reject all negative NPV projects -favor low-risk projects over high-risk projects

When a manager develops a cost of capital for a specific project based on the cost of capital for another firm which has a similar line of business as the project, the manager is utilizing the _____ approach.

**pure play -subjective risk -divisional cost of capital -capital adjustment -security market line

Flotation costs for a levered firm should be:

**weighted and included in the initial cash flow -ignored when analyzing a project because they are a sunk cost -spread over the life of a project thereby reducing the cash flows for each year of the project -considered only when two projects are mutually exclusive -totally ignored when internal equity funding is utilized

If a firm uses its WACC as the discount rate for all of the projects it undertakes then the firm will tend to:I. reject some positive net present value projects.II. accept some negative net present value projects.III. favor high risk projects over low risk projects.IV. increase its overall level of risk over time.

**I, II, III, and IV -I and III only -III and IV only -I, II, and III only -I, II, and IV only

Which one of these will increase a company's aftertax cost of debt?

**a decrease in the company's tax rate -a decrease in the company's debt-equity ratio -an increase in the credit rating of the company's bonds -an increase in the company's beta -a decrease in the market rate of interest

Which one of the following statements is correct?

**a project that is unacceptable today might be acceptable tomorrow given a change in market returns -firms should accept low-risk projects prior to funding high-risk projects -making subjective adjustments to a company's WACC when determining project discount rates unfairly punishes low-risk divisions within the company -the pure play method is most frequently used for projects involving the expansion of a company's current operations -companies that elect to use the pure play method for determining a discount rate for a project cannot subjectively adjust the pure play rate

The capital structure weights used in computing a company's weighted average cost of capital:

**are based on the market values of the outstanding securities -are based on the book values of debt and equity -depend upon the financing obtained to fund each specific project -remain constant over time unless new securities are issued or outstanding securities are redeemed -are restricted to debt and common stock

Preston Industries has two separate divisions. Each division is in a separate line of business. Division A is the largest division and represents 65 percent of the company's overall sales. Division A is also the riskier of the two divisions. When management is deciding which of the various divisional projects should be accepted, the managers should:

**assign appropriate, but differing, discount rates to each project and then select the projects with the highest net present values -allocate more funds to Division A since it is the larger of the two divisions -fund all of Division B's projects first since they tend to be less risky and then allocate the remaining funds to the Division A projects that have the highest net present values -allocate the company's funds to the projects with the highest net present values based on the company's weighted average cost of capital -fund the highest net present value projects from each division based on an allocation of 65 percent of the funds to Division A and 35 percent of the funds to Division B

Scholastic Toys is considering developing and distributing a new board game for children. The project is similar in risk to the firm's current operations. The firm maintains a debt-equity ratio of 0.40 and retains all profits to fund the firm's rapid growth. How should the firm determine its cost of equity?

**by using the capital asset pricing model -by adding the market risk premium to the aftertax cost of debt -by multiplying the market risk premium by (1 - 0.40) -by using the dividend growth model -by averaging the costs based on the dividend growth model and the capital asset pricing model

Textile Mills borrows money at a rate of 13.5 percent. This interest rate is referred to as the:

**cost of debt -cost of capital -compound rate -capital gains yield -current yield

A group of individuals got together and purchased all of the outstanding shares of common stock of DL Smith, Inc. What is the return that these individuals require on this investment called?

**cost of equity -cost of capital -dividend yield -income return -capital gains yield

A firm's cost of capital:

**depends upon how the funds raised are going to be spent -will decrease as the risk level of the firm increases -is independent of the firm's capital structure -should be applied as the discount rate for any project considered by the firm -for a specific project is primarily dependent upon the source of the funds used for the project

The cost of capital for a new project:

**depends upon how the funds raised for that project are going to be spent -is determined by the overall risk level of the firm -is dependent upon the source of the funds obtained to fund that project -is dependent upon the firm's overall capital structure -should be applied as the discount rate for all other projects considered by the firm

A firm's overall cost of equity is:

**highly dependent upon the growth rate and risk level of the firm -is generally less than the firm's WACC given a leveraged firm -unaffected by changes in the market risk premium -generally less than the firm's aftertax cost of debt -inversely related to changes in the firm's tax rate

When a firm has flotation costs equal to 7% of the funding need, project analysts should:

**increase the initial project cost by dividing that cost by (1 - 0.07) -add 7 percent to the firm's WACC to get the discount rate for the project -increase the project's discount rate to offset these expenses by multiplying the firm's WACC by 1.07 -increase the initial project cost by multiplying that cost by 1.07 -increase the project's discount rate to offset these expenses by dividing the firm's WACC by (1 - 0.07)

When a firm has flotation costs equal to 8.3 percent of the funding need, project analysts should:

**increase the initial project cost by dividing that cost by (1 − .083) -increase the project's discount rate to offset these expenses by multiplying the company's WACC by 1.083 -increase the project's discount rate to offset these expenses by dividing the company's WACC by (1 − .083) -add 8.3 percent to the company's firm's WACC to determine the discount rate for the project -increase the initial project cost by multiplying that cost by 1.083

The cost of equity for a company with a debt-equity ratio of 0.41:

**is affected by either a change in the company's beta or its projected rate of growth -tends to remain static even as the company's level of risk increases -increases as the unsystematic risk of the company's stock increases -equals the risk-free rate plus the market risk premium -equals the company's pretax weighted average cost of capital

A company's pretax cost of debt:

**is based on the current yield to maturity of the company's outstanding bonds -is equal to the coupon rate on the latest bonds issued by the company -is equivalent to the average current yield on all of a company's outstanding bonds -is based on the original yield to maturity on the latest bonds issued by a company -has to be estimated as it cannot be directly observed in the market

The dividend growth model:

**is only as reliable as the estimated rate of growth -can only be used if historical dividend information is available -considers the risk that future dividends may vary from their estimated values -applies only when a company is currently paying dividends -is based solely on historical dividend information

The weighted average cost of capital for a wholesaler:

**is the return investors require on the total assets of the firm -is equivalent to the aftertax cost of the firm's liabilities -should be used as the required return when analyzing a potential acquisition of a retail outlet -remains constant when the debt-equity ratio changes -is unaffected by changes in corporate tax rates

Deep Mining and Precious Metals are separate firms that are both considering a silver mining project. Deep Mining is in the actual mining business and has an aftertax cost of capital of 16.2 percent. Precious Metals is in the precious gem retail business and has an aftertax cost of capital of 13.4 percent. The project under consideration has initial costs of $950,000 and anticipated annual cash inflows of $165,000 a year for 12 years. Which firm(s), if either, should accept this project?

**neither Deep Mining nor Precious Metals (NPV = −$950,000 + $165,000{[1 − (1/1.16212)]/.162}NPV = −$99,553. Neither company should accept this project as the applicable discount rate for both firms is 16.2 percent and the NPV is negative at this rate.) -Deep Mining only -Precious Metals only -Both Deep Mining and Precious Metals -cannot be determined without further information

Which one of the following statements is correct? v2

**overall, a firm makes better decisions when it uses the subjective approach than when it uses its WACC as the discount rate for all projects -mandatory projects should only be accepted if they produce a positive NPV when the firm's WACC is used as the discount rate -firms will correctly accept or reject every project if they adopt the subjective approach -the pure play approach should only be used with low-risk projects -the subjective approach assesses the risks of each project and assigns an adjustment factor that is unique just for that project

Jenner's is a multi-division firm that uses its overall WACC as the discount rate for all proposed projects. Each division is in a separate line of business and each presents risks unique to those lines. Given this, a division within the firm will tend to:

**prefer higher risk projects over lower risk projects -receive less project funding if its line of business is riskier than that of the other divisions -avoid risky projects so it can receive more project funding -become less risky over time based on the projects that are accepted -have an equal probability with all the other divisions of receiving funding

The weighted average cost of capital for a firm with debt is the:

**rate of return a company must earn on its existing assets to maintain the current value of its stock -discount rate that the firm should apply to all of the projects it undertakes -coupon rate the firm should expect to pay on its next bond issue -minimum discount rate the firm should require on any new project -rate of return debtholders should expect to earn on their investment in this firm

The flotation cost for a firm is computed as:

**the weighted average of the flotation costs associated with each form of financing -the arithmetic average of the flotation costs of both debt and equity -a weighted average based on the book values of the firm's debt and equity -one-half of the flotation cost of debt plus one-half of the flotation cost of equity -the geometric average of the flotation costs associated with each form of financing