Chapter 11: Determining Cost of Capital

For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure. a. re > rs > WACC > rd. b. WACC > re > rs > rd. c. rd > re > rs > WACC. d. WACC > rd > rs > re. e. rs > re > rd > WACC.

a

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting? a. Accounts payable. b. Common stock "raised" by reinvesting earnings. c. Common stock raised by new issues. d. Preferred stock. e. Long-term debt.

a

Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely a. become less risky over time, and this will maximize its intrinsic value. b. accept too many low-risk projects and too few high-risk projects. c. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. d. continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital. e. become riskier over time, but its intrinsic value will be maximized.

c

Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth. a. If a firm's managers want to maximize the value of their firm's stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project's expected future cash flows. b. If a firm evaluates all projects using the same cost of capital, and the CAPM is used to help determine that cost, then its risk as measured by beta will probably decline over time. c. Projects with above-average risk typically have higher than average expected returns. Therefore, to maximize a firm's intrinsic value, its managers should favor high-beta projects over those with lower betas. d. Project A has a standard deviation of expected returns of 20%, while Project B's standard deviation is only 10%. A's returns are negatively correlated with both the firm's other assets and the returns on most stocks in the economy, while B's returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital. e. If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms' assets.

d

When working with the CAPM, which of the following factors can be determined with the most precision? a. The beta coefficient, bi, of a relatively safe stock. b. The most appropriate risk-free rate, rRF. c. the expected rate of return on the market, rM. d. The beta coefficient of "the market," which is the same as the beta of an average stock. e. The market risk premium (RPM).

d both the market and an average stock have betas of 1.0. Since we know this to be the case, we can obviously determine beta for the market or an average stock with precision.

Burnham Brothers Inc. has no retained earnings since it has always paid out all of its earnings as dividends. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, and its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC? a. The flotation costs associated with issuing new common stock increase. b. The company's beta increases. c. Expected inflation increases. d. The flotation costs associated with issuing preferred stock increase. e. The market risk premium declines.

e

For capital budgeting and cost of capital purposes, the firm should always consider reinvested earnings as the first source of capital⎯i.e., use these funds first⎯because reinvested earnings have no cost to the firm.

false

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost.

false

The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC.

false

The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

false

The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.

false

The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

false

The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and reinvested earnings, whose cost is the average return on the assets that are acquired.

false

The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant.

false

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the dividend growth method, and the bond-yield-plus-risk-premium method. However, only the dividend growth method is widely used in practice.

false

If expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Therefore, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt.

false increased inflation results in a parallel upward shift in the SML, which means equal percentage increases in the required return on debt and equity

"Capital" is sometimes defined as funds supplied to a firm by investors.

true

Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets. They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.

true

If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the dividend growth model, and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method. All this makes it especially difficult to estimate the cost of equity for a private company.

true

If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.

true

If the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock (re) is equal to the cost of equity capital from retaining earnings (rs) divided by one minus the percentage flotation cost required to sell the new stock, (1 − F). If the expected growth rate is not zero, then the cost of external equity must be found using a different formula.

true

The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

true

The cost of capital used in capital budgeting should reflect the average after-tax cost of providing required returns to investors.

true

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

true

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

true

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, is not deductible by the issuing firm.

true

The reason why reinvested earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm's common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should distribute those earnings to its investors. Thus, the cost of reinvested earnings is based on the opportunity cost principle.

true

When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use long-term or short-term rates for rRF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the market risk premium, RPM. These problems leave us unsure of the true value of rs.

true

When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs.

true

When estimating the cost of equity by use of the dividend growth method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return. This problem leaves us unsure of the true value of rs.

true