Chapter 13

D

A firm raised all its capital via equity rather than debt. Such a firm is also referred to as a(n) ________ firm. A) levered B) margined C) risk less D) unlevered

TRUE

A firm's cost of debt is the rate of interest it would have to pay to refinance its existing debt.

A 

A firm's overall cost of capital that is a blend of the costs of the different sources of capital is known as the firm's ________. A) weighted average cost of capital B) cost of equity infusion C) cost of debt D) cost of preferred stock

A

A levered firm is one that has ________ outstanding. A) debt B) equity C) preferred stock D) equity options

B

Anheuser Busch, a manufacturer of beverages, is planning to purchase Six Flags theme parks. Anheuser Busch should use the ________ to evaluate the business of Six Flags. A) WACC of Anheuser Busch B) WACC of Six Flags C) average market return D) divisional cost of capital

D 

Assume Bismuth Electronics has a book value of $6 billion of equity and a face value of $19.7 billion of debt. The market values of equity and debt are $2.5 billion and $18.5 billion. A Wall Street financial analyst determines values of equity and debt as $3 billion and $20 billion. Which of the following values should be used for calculating the firm's WACC? A) $6 billion of equity and $19.7 billion of debt B) $2.5 billion of equity and $20 billion of debt C) $3 billion of equity and $19.9 billion of debt D) $2.5 billion of equity and $18.5 billion of debt

C

Different divisions with differing lines of business use different costs of capital because their cost of ________ could be different. A) debt B) equity C) capital D) assets

D

Different divisions with differing lines of business use different costs of capital because their cost of equity is different and also because the ________ could be different. A) optimal volatility B) optimal current ratio C) optimal asset mix D) optimal debt-equity ratio

TRUE

Financial managers must determine their firm's overall cost of capital based on all sources of financing.

TRUE

Firms that have many divisions with different lines of business do not use a companywide WACC to evaluate projects.

FALSE

Internal financing is more costly than external financing because of issuance costs.

B

Leverage is the amount of ________ on a firm's balance sheet. A) equity B) debt C) preferred stock D) retained earnings

FALSE

One should use accounting-based book values rather than market values of debt and equity to determine the weights for the different sources of capital.

FALSE  

The WACC does not depend on the risk of a company's line of business.

TRUE

The costs of external financing must be deducted from the net present value (NPV) of a project to evaluate if it is worth undertaking.

A

The fact that the after-tax cost of debt is lower than the pretax cost of debt implicitly assumes that interest expense can be ________. A) expensed B) margined C) refinanced D) capitalized

FALSE

The fact that the interest paid on debt is a tax-deductible expense increases the cost of debt financing.

Most practitioners use net debt, which is total debt outstanding minus cash and other risk-free securities.

What type of adjustment to debt is in practice?

B 

A firm's sources of financing, which usually consists of debt and equity, represent its ________. A) total assets B) capital C) total liabilities D) current liabilities

The Capital Asset Pricing Model (CAPM) is more popular for estimating the cost of equity because of the difficulties in estimating the dividend growth rate required for the Constant Dividend Growth Model (CDGM).

Among the two models Constant Dividend Growth Model (CDGM) and Capital Asset Pricing Model (CAPM), which is a better method for computation of the cost of equity?

D

As a firm increases its level of debt relative to its level of equity, the firm is ________. A) increasing the fraction of its equity B) decreasing the fraction of its debt C) decreasing its leverage D) increasing its leverage

D 

Divisional costs of capital are more appropriate when evaluating a project for a line of business when the types of business in a firm are ________. A) mature businesses B) similar C) new businesses D) different

B

For an unlevered firm, the cost of capital can be determined by using the ________. A) yield on the traded debt B) Capital Asset Pricing Model C) dividend yield D) preferred stock yield

A

Holding everything else constant, an increase in cash ________ a firm's net debt. A) will decrease B) will have no impact on C) will increase D) may increase or decrease

Yes, it is inaccurate to use the coupon rate of debt as a company's cost of capital is forward looking while the coupon rate is a historic rate prevalent at the time of issuance of the debt.

Is it incorrect to use the coupon rate of debt toward cost of debt?

A

Many financial managers use market risk premiums that are closer to 5%, which is lower than historical averages, because ________. A) the return investors require as compensation for taking on the risk of investing in equity markets has diminished over a period of time B) investors require a higher risk premium for holding risky securities than in the past C) investors require a supernormal risk premium for holding risky securities as compared with the past D) investors require the same premium for holding risky securities as in the past

Cost of equity is the return that equity holders expect from a firm and is not directly related to the firm's retained earnings.

Should a firm with high retained earnings have a lower cost of equity?

C 

The ________ of a firm's debt can be used as the firm's current cost of debt. A) current yield B) coupon rate C) yield to maturity D) discount yield

C

The after-tax cost of debt ________ the before-tax cost of debt for a firm that has a positive marginal tax rate. A) is always greater than B) is always equal to C) is always less than D) may be greater than or less than

C

The after-tax cost of equity is ________ the pretax cost of equity. A) higher than B) lower than C) the same as D) less than or equal to

C

The relative proportion of debt, equity, and other securities that a firm has outstanding constitute its ________. A) asset ratio B) current ratio C) capital structure D) retained earnings

TRUE

To attract capital from outside investors, a firm must offer potential investors an expected return that is commensurate with the level of risk that they can bear.

The implied assumption in using WACC to evaluate a firm's project is that the firm is continuously maintaining a constant ratio of market value of debt to market value of equity—a relationship referred to as the debt-equity ratio.

What is the assumption about leverage when using WACC to evaluate a project?

Using WACC in evaluating a firm's project implies that the risk of the project is comparable to the average risk of the firm's other investments.

What is the assumption about risk when using WACC to evaluate a project?

The cost of debt is the before tax cost of debt while the effective cost of debt is the after-tax cost of debt, which is lower for a profitable tax paying firm. 

What is the difference between the effective cost of debt and the cost of debt?

FALSE 

When a firm is evaluating the purchase of a business that is unrelated to its current business, it is appropriate to use the current WACC of the firm that is purchasing the business.

C

When calculating the WACC, it is a standard practice to subtract ________ to compute the net debt outstanding. A) equity B) dividends C) cash and risk-free securities D) coupons

C  

When corporate tax rates decline, the net cost of debt financing ________. A) decreases B) is unchanged C) increases D) doubles

B 

When we compute the cost of equity capital for a project we assume that the ________ of the project is equivalent to the average market risk of the firm's investments. A) diversifiable risk B) market risk C) unsystematic risk D) volatility

C

When we use the WACC to assess a project, we assume that the ________ ratio does not change. A) reward to systematic risk B) risk to reward C) debt to equity D) volatility to systematic risk

D 

Which of the following is NOT a step in the WACC valuation method? A) Compute the weighted average cost of capital. B) Discount the incremental free cash flows of the investment using the weighted average cost of capital. C) Determine the incremental free cash flows of the investment. D) Determine the mean weighted average cost of capital for the firm's industry.

The cost of common equity is most difficult to estimate as it has the highest uncertainty about its cash flows. The cash flows for debt and preferred stock are quite predictable, and hence their costs are easier to calculate.

Which of the three costs—debt, preferred stock and common equity—is most difficult to estimate?

Usually, the cost of debt is cheaper than the cost of equity due to lower risk of the debt holders as well as tax deductibility of interest payment. Thus, including debt, everything else remaining same, reduces the cost of capital for a firm.

Why do we use leverage if it increases the risk of a firm?

We use market values rather than book values because the cost of capital is based on investors' current assessment of the value of a firm and not on accounting-based book values. 

Why do we use market values rather than book values in calculation of WACC?