Homework 10

Flotation costs incurred to raise new external capital reduce the firm's cost of capital.

False

A firm's capital structure is comprised of the total of short-term and long-term financing.

False A firm's capital structure is comprised of long-term financing only.

A firm's financial structure is comprised of the total of long-term financing only.

False A firm's financial structure includes both short and long-term financing.

A firm's financial structure is comprised of the total of short-term and long-term financing.

True

Target weights used in calculating a firm's cost of capital are weights the firm has estimated will maximize the value of the firm.

True

The minimum rate of return on all long-term capital budgeting projects should be the firm's risk-adjusted cost of capital.

True

Because of the tax effect, the cost of equity capital is generally lower than the cost of debt capital.

False Because of the tax effect, the cost of debt capital is generally lower than the cost of equity capital. Interest is deductible pre-tax, while dividends are paid after-tax.

Book value weights used in calculating a firm's cost of capital are preferred to marginal value weights because they represent current costs.

False Marginal weights represent current costs.

Target weights used in calculating a firm's cost of capital are weights the firm has estimated will provide the maximum cost of capital for the firm.

False Target weights used in calculating a firm's cost of capital are weights the firm has estimated will provide the minimum cost of capital for the firm.

Retained earnings has a cost of capital which is higher than that of the cost of capital for new issues of common stock because it includes a required return for the lack of dividend payments.

False The cost of retained earnings capital is identical to that for new issues of common stock less flotation costs.

The minimum rate of return on all long-term capital budgeting projects should be the cost of capital used to finance the project.

False The return on all long-term capital budgeting projects should be the risk-adjusted cost of capital.

The cost of long-term bond financing is also defined as the bond's yield to maturity.

False The yield to maturity is the return required by investors, the cost of capital for the bonds is determined by finding the after-tax equivalent of the pre-tax yield to maturity adjusted for flotation costs.

Flotation costs are generally higher for common stock than for debt financing.

True

Flotation costs incurred to raise new external capital increase the firm's cost of capital.

True

Marginal value weights used in calculating a firm's cost of capital are preferred to book value weights because they represent current costs.

True

Target weights used in calculating a firm's cost of capital are weights the firm has estimated will provide the minimum cost of capital for the firm.

True

The cost of capital may also be called a hurdle rate or minimum required rate of return on long-term capital investments.

True

When the cost of capital is adjusted to a higher minimum required rate of return to account for possible error in forecasting related to capital budgeting projects and the determination of the costs of capital, the new rate and all other adjusted-for-risk rates are called hurdle rates.

True

Because of the tax effect, the cost of debt capital is generally lower than the cost of equity capital.

True Interest is deductible pre-tax, while dividends are paid after-tax

Which statement is correct, all else held constant? a. Beta is used to compute the return on equity and the standard deviation is used to compute the return on preferred. b. A decrease in a firm's WACC will increase the attractiveness of the firm's investment options. c. The aftertax cost of debt increases when the market price of a bond increases. d. If you have both the dividend growth and the security market line's costs of equity, you should use the higher of the two estimates when computing WACC. e. WACC is applicable only to firms that issue both common and preferred stock

b. A decrease in a firm's WACC will increase the attractiveness of the firm's investment options.

Which one of the following will decrease the aftertax cost of debt for a firm? a. Decrease in the firm's beta b. Increase in tax rates c. Increase in the risk-free rate of return d. Decrease in the market price of the debt e. Increase in a bond's yield to maturity

b. Increase in tax rates

The weighted average cost of capital is defined as the weighted average of a firm's: a. return on all of its investments. b. cost of equity, cost of preferred, and its aftertax cost of debt. c. pretax cost of debt and its preferred and common equity securities. d. bond coupon rates. e. common and preferred stock

b. cost of equity, cost of preferred, and its aftertax cost of debt.

Assume a firm has a beta of 1.2. All else held constant, the cost of equity for this firm will increase if a. market risk premium decreases. b. risk-free rate decreases. c. market rate of return decreases. d. beta decreases. e. either the risk-free rate or the market rate of return decreases.

b. risk-free rate decreases.

An increase in a levered firm's tax rate will: a. decrease the cost of preferred stock. b. increase both the cost of preferred stock and debt. c. decrease the firm's cost of capital. d. decrease the cost of equity capital. e. increase the firm's WACC

c. decrease the firm's cost of capital.

A firm has a cost of equity of 13 percent, a cost of preferred of 11 percent, an aftertax cost of debt of 5.2 percent, and a tax rate of 35 percent. Given this, which one of the following will increase the firm's weighted average cost of capital? a. Increasing the firm's tax rate b. Issuing new bonds at par c. Redeeming shares of common stock d. Increasing the firm's beta e. Increasing the debt-equity ratio

d. Increasing the firm's beta

Ted is trying to decide what cost of capital he should assign to a project. Which one of the following should be his primary consideration in this decision? a. Amount of debt used to finance the project b. Use, or lack, of preferred stock as a financing option c. Mix of funds used to finance the project d. Risk level of the project e. Length of the project's life

d. Risk level of the project

Which one of the following represents the minimum rate of return a firm must earn on its assets if it is to maintain the current value of its securities? a. Cost of equity b. Pretax cost of debt c. Aftertax cost of debt d. Weighted average cost of capital e. Weighted average cost of preferred and common stock

d. Weighted average cost of capital

The results of the dividend growth model: a. vary directly with the market rate of return. b. can only be applied to projects that have a growth rate equal to that of the current firm. c. are highly dependent upon the beta used in the model. d. are sensitive to the rate of dividend growth. e. are most reliable when the growth rate exceeds 10 percent.

d. are sensitive to the rate of dividend growth.