FIN 3403 Chapter 14 Concepts

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

A firm's overall cost of equity is

depends upon how the funds raised are going to be spent

A firms cost of capital

Cost of Equity

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

a reduction in the risk free rate

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.

may cause the firm's overall WACC to either increase or decrease over time

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

be weighted and included in the initial cash flow

Flotation costs for a levered firm should

I, II, III, and IV

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

increase the initial cash outflow of the project

Incorporating flotation costs into the analysis of a project will

Prefer higher risk projects over lower risk projects

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:

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

Morris Industries has a capital structure of 55% common stock, 10% preferred stock, and 45% debt. The firm has a 60% dividend payout ratio, a beta of .89, and a tax rate of 38%. Given this, which one of the following statements is correct?

both Phil's and Theresa's

Phil's is a sit-down restaurant that specializes in home-cooked meals. Theresa's is a walk-in deli that specializes in specialty soups and sandwiches. Both firms are currently considering expanding their operations during the summer months by offering pre-wrapped donuts, sandwiches, and wraps at a local beach. Phil's currently has a WACC of 14 percent while Theresa's WACC is 10 percent. The expansion project has a projected net present value of $12,600 at a 10 percent discount rate and a net present value of -$2,080 at a 14 percent discount rate. Which firm or firms should expand and offer food at the local beach during the summer months?

assign appropriate, but differing, discount rates to each project and then select the projects with the highest net present values

Preston Industries has two separate divisions. Each division is in a separate line of business. Division A is the largest division and represents 70% of the firm's overall sales. Division A is also the riskier of the two divisions. Division B is the smaller and least risk of the two. When management is deciding which of the various divisional projects should be accepted, the managers should

by using the capital asset pricing model

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 .40 and retains all profits to fund the firm's rapid growth. How should the firm determine its cost of equity?

Cost of Debt

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

rate of return a firm must earn on its existing assets to maintain the current value of its stock

The WACC for a firm is the

I, II, III, and IV

The WACC for a firm may be dependent upon the firm's

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

The aftertax cost of debt

II and III

The aftertax cost of debt generally increases when

weighted average cost of capital

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

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

The capital structure weights used in computing the WACC

is equal to the dividend yield

The cost of preferred stock

return on a perpetuity

The cost of preferred stock is computed the same as the

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

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

Is only as reliable as the estimated rate of growth

The dividend growth model

II, III, and IV

The dividend growth model can be used to compute the cost of equity for a firm in which of the following situations

the weighted average of the flotation costs associated with each form of financing

The flotation cost for a firm is computed as

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

The pretax cost of debt

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

The subjective approach to project analysis

increase the initial project cost by dividing that cost by (1 - .07)

When a firm has flotation costs equal to 7% of the funding

Pure play

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

II, III, and IV

Which of the following statements is correct?

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

Which one of the following statements is correct

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.

Which one of the following statements is correct

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

Which one of the following statements is correct for a firm that uses debt in its capital structure

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

Which one of the following statements relate to the SML approach to equity valuation is correct? Assume the firm uses debt in its capital structure

neither

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?

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

the cost of equity for a firm

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

the weighted average cost of capital for a wholesaler

use of funds

which one of the following is the primary determinant of a firm's cost of capital