Chapter 14 Common Final FRL 301

. 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

The aftertax cost of debt: A. varies inversely to changes in market interest rates. B. will generally exceed the cost of equity if the relevant tax rate is zero. C. will generally equal the cost of preferred if the tax rate is zero. D. is unaffected by changes in the market rate of interest. E. has a greater effect on a firm's cost of capital when the debt-equity ratio increases.

. has a greater effect on a firm's cost of capital when the debt-equity ratio increases

The cost of preferred stock is computed the same as the:

. is equal to the dividend yield

The dividend growth model:

. is only as reliable as the estimated rate of growth.

Assigning discount rates to individual projects based on the risk level of each project

. may cause the firm's overall weighted average cost of capital to either increase or decrease over time.

Wilderness Adventures specializes in back-country tours and resort management. Travel Excitement specializes in making travel reservations and promoting vacation travel. Wilderness Adventures has an aftertax cost of capital of 13 percent and Travel Excitement has an aftertax cost of capital of 11 percent. Both firms are considering building wilderness campgrounds complete with man-made lakes and hiking trails. The estimated net present value of such a project is estimated at $87,000 at a discount rate of 11 percent and -$12,500 at a 13 percent discount rate. Which firm or firms, if either, should accept this project?

. neither Wilderness Adventures nor Travel Excitement

. Which one of the following statements is correct? A. Firms should accept low risk projects prior to funding high risk projects. B. Making subjective adjustments to a firm's WACC when determining project discount rates unfairly punishes low-risk divisions within a firm. C. A project that is unacceptable today might be acceptable tomorrow given a change in market returns. D. The pure play method is most frequently used for projects involving the expansion of a firm's current operations. E. Firms that elect to use the pure play method for determining a discount rate for a project cannot subjectively adjust the pure play rate.

A project that is unacceptable today might be acceptable tomorrow given a change in market returns.

The cost of equity for a firm: A. tends to remain static for firms with increasing levels of risk. B. increases as the unsystematic risk of the firm increases. C. ignores the firm's risks when that cost is based on the dividend growth model. D. equals the risk-free rate plus the market risk premium. E. equals the firm's pretax weighted average cost of capital.

C. ignores the firm's risks when that cost is based on the dividend growth model.

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

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

E. depends upon how the funds raised are going to be spent.

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. A. I and III only B. II and III only C. I, II, and III only D. II, III, and IV only E. I, II, III, and IV

II and III only

. Which of the following statements are correct? I. The SML approach is dependent upon a reliable measure of a firm's unsystematic risk. II. The SML approach can be applied to firms that retain all of their earnings. III. The SML approach assumes a firm's future risks are similar to its past risks. IV. The SML approach assumes the reward-to-risk ratio is constant.

II, III, and IV only

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

Which one of the following statements is correct for a firm that uses debt in its capital structure? A. The WACC should decrease as the firm's debt-equity ratio increases. B. When computing the WACC, the weight assigned to the preferred stock is based on the coupon rate multiplied by the par value of the preferred. C. The firm's WACC will decrease as the corporate tax rate decreases. D. The weight of the common stock used in the computation of the WACC is based on the number of shares outstanding multiplied by the book value per share. E. The WACC will remain constant unless a firm retires some of its debt.

The WACC should decrease as the firm's debt-equity ratio increases.

Morris Industries has a capital structure of 55 percent common stock, 10 percent preferred stock, and 45 percent debt. The firm has a 60 percent dividend payout ratio, a beta of 0.89, and a tax rate of 38 percent. Given this, which one of the following statements is correct?

The firm's cost of equity is unaffected by a change in the firm's tax rate

Which one of the following statements related to the SML approach to equity valuation is correct? Assume the firm uses debt in its capital structure. A. This model considers a firm's rate of growth. B. The model applies only to non-dividend paying firms. C. The model is dependent upon a reliable estimate of the market risk premium. D. The model generally produces the same cost of equity as the dividend growth model. E. This approach generally produces a cost of equity that equals the firm's overall cost of capital.

The model is dependent upon a reliable estimate of the market risk premium.

What is the primary determinant of a firm's cost of capital?

Use of the funds

All else constant, which one of the following will increase a firm's cost of equity if the firm computes that cost using the security market line approach? Assume the firm currently pays an annual dividend of $1 a share and has a beta of 1.2. A. a reduction in the dividend amount B. an increase in the dividend amount C. a reduction in the market rate of return D. a reduction in the firm's beta E. a reduction in the risk-free rate

a reduction in the risk-free rate

The dividend growth model can be used to compute the cost of equity for a firm in which of the following situations? I. firms that have a 100 percent retention ratio II. firms that pay a constant dividend III. firms that pay an increasing dividend IV. firms that pay a decreasing dividend

all of them

The capital structure weights used in computing the weighted average cost of capital:

are based on the market value of the firm's debt and equity securities.

The subjective approach to project analysis

assigns discount rates to projects based on the discretion of the senior managers of a firm

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

cost of debt

A firm's overall cost of equity is:

highly dependent upon the growth rate and risk level of the firm.

. The pre-tax cost of debt: A. is based on the current yield to maturity of the firm's outstanding bonds. B. is equal to the coupon rate on the latest bonds issued by a firm. C. is equivalent to the average current yield on all of a firm's outstanding bonds. D. is based on the original yield to maturity on the latest bonds issued by a firm. E. has to be estimated as it cannot be directly observed in the market.

is based on the current yield to maturity of the firm's outstanding bonds.

The weighted average cost of capital for a wholesaler: A. is equivalent to the aftertax cost of the firm's liabilities. B. should be used as the required return when analyzing a potential acquisition of a retail outlet. C. is the return investors require on the total assets of the firm. D. remains constant when the debt-equity ratio changes. E. is unaffected by changes in corporate tax rates.

is the return investors require on the total assets of the firm.

Markley and Stearns is a multi-divisional firm that uses its 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: A. receive less project funding if its line of business is riskier than that of the other divisions. B. avoid risky projects so it can receive more project funding. C. become less risky over time based on the projects that are accepted. D. have equal probability of receiving funding as compared to the other divisions. E. prefer higher risk projects over lower risk projects.

prefer higher risk projects over lower risk projects.

The discount rate assigned to an individual project should be based on:

the risks associated with the use of the funds required by the project

The average of a firm's cost of equity and aftertax cost of debt that is weighted based on the firm's capital structure is called the:

weighted average cost of capital.