Chapter 14 - MCQ PDF

Preview

Summary

MCQ...

Description

Chapter 14 Cost of Capital

1. The cost of capital depends primarily on the use of funds, not the source. Ans: True

Level: Basic

Subject: Cost Of Capital

Type: Concepts

2. The market value of a firm that invests in projects providing a return equal to its WACC will not change over time. Ans: True

Level: Basic

Subject: Cost Of Capital

Type: Concepts

3. Suppose that new information regarding future inflation in Canada causes investors to become less risk averse. The SML approach indicates that, all else equal, firm cost of capital will increase. Ans: False

Level: Basic

Subject: Cost Of Equity

Type: Concepts

4. It is considered unlikely that the dividend growth and the SML approaches will result in different estimates of the cost of equity for a given firm Ans: False

Level: Basic

Subject: Cost Of Equity

Type: Concepts

5. For the purpose of estimating the firm's cost of capital, one cannot look only at the coupon rate on the firm's existing debt. Ans: True

Level: Basic

Subject: Cost Of Debt

Type: Concepts

6. For the purpose of estimating the firm's cost of debt for a project, one could observe the yield-to-maturity on recently issued bonds with a similar rating and term-to-maturity. Ans: True

Level: Basic

Subject: Cost Of Debt

Type: Concepts

7. In general, for the purpose of estimating the cost of preferred stock, one can ignore the current level of common stock dividends. Ans: True

Level: Basic

Subject: Cost Of Preferred

Type: Concepts

8. It is generally better to base estimates of the WACC on book value weights of debt and equity since market values, particularly those for equity, tend to fluctuate widely. Ans: False

Level: Basic

Subject: Capital Structure Weights

Type: Concepts

9. For a profitable firm, an increase in its marginal tax rate will increase its weighted average cost of capital. Ans: False

Level: Basic

Subject: Taxes And the WACC

Type: Concepts

10. By using a firm's WACC to analyze all potential investments, we risk incorrectly accepting some unsuitable projects. Ans: True

Level: Basic

Subject: WACC & Risk

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited. Page 1

Chapter 14 Cost of Capital

11. By using a firm's WACC to analyze all potential investments, we risk incorrectly accepting some suitable projects. Ans: False

Level: Basic

Subject: WACC & Risk

Type: Concepts

12. The best way to adjust for the existence of flotation costs is to add their percentage cost to the WACC. Ans: False

Level: Basic

Subject: Flotation Costs

Type: Concepts

13. The effect of flotation costs is to increase the computed NPV of any given project. Ans: False

Level: Basic

Subject: Flotation Costs

Type: Concepts

14. For a firm with both debt and equity in its capital structure, the weighted average flotation cost, fA, will simply be the sum of the percentage flotation cost of debt, fD, and the percentage flotation cost of equity, fE. Ans: False

Level: Basic

Subject: Flotation Costs

Type: Concepts

15. The opportunity cost associated with the firm's capital investment in a project is called its: A) Cost of capital. B) Beta coefficient. C) Capital gains yield. D) Sunk cost. E) Internal rate of return. Ans: A

Level: Basic

Subject: Cost Of Capital

Type: Definitions

16. The return that shareholders require on their investment in the firm is called the: A) Dividend yield. B) Cost of equity. C) Capital gains yield. D) Cost of capital. E) Income return. Ans: B

Level: Basic

Subject: Cost Of Equity

Type: Definitions

17. The return that lenders require on their loaned funds to the firm is called the: A) Coupon rate. B) Current yield. C) Cost of debt. D) Capital gains yield. E) Cost of capital. Ans: C

Level: Basic

Subject: Cost Of Debt

Type: Definitions

Copyright © 2005 McGraw-Hill Ryerson Limited. Page 2

Chapter 14 Cost of Capital

18. The proportions of the market value of the firm's assets financed via debt, common stock, and preferred stock are called the firm's _____________________. A) financing costs B) portfolio weights C) beta coefficients D) capital structure weights E) costs of capital Ans: D

Level: Basic

Subject: Capital Structure Weights

Type: Definitions

19. The weighted average of the firm's costs of equity, preferred stock, and after tax debt is the: A) Reward to risk ratio for the firm. B) Expected capital gains yield for the stock. C) Expected capital gains yield for the firm. D) Portfolio beta for the firm. E) Weighted average cost of capital (WACC) . Ans: E

Level: Basic

Subject: WACC

Type: Definitions

20. For a firm with multiple business units, the cost of capital developed for each unit is called a: A) Divisional cost of capital. B) Pure play approach. C) Subjective risk adjustment. D) Stratified beta coefficient. E) Fundamental beta coefficient. Ans: A

Level: Basic

Subject: Divisional Cost Of Capital

Type: Definitions

21. When firms develop a WACC for individual projects based on the cost of capital for other firms in similar lines of business as the project, the firm is utilizing a ____________________. A) subjective risk approach B) pure play approach C) divisional cost of capital approach D) capital adjustment approach E) security market line approach Ans: B

Level: Basic

Subject: Pure Play Approach

Type: Definitions

22. The costs incurred by the firm when new issues of stocks or bonds are sold are called: A) Required rates of return. B) Costs of capital. C) Flotation costs. D) Capital structure weights. E) Costs of equity and debt. Ans: C

Level: Basic

Subject: Flotation Costs

Type: Definitions

Copyright © 2005 McGraw-Hill Ryerson Limited. Page 3

Chapter 14 Cost of Capital

23. The approach to computing the cost of equity financing which does not explicitly consider risk is called the: A) Weighted average cost of capital. B) After-tax cost of debt. C) Dividend growth model. D) Stock financing model. E) Security market line. Ans: C

Level: Basic

Subject: Dividend Growth Model

Type: Definitions

24. WACC is the overall rate of return a firm must earn on its assets to maintain: A) Its current credit rating. B) Its current level of cash flows. C) The book value of its assets. D) The value of its stock. E) Its current cost of debt. Ans: D

Level: Basic

Subject: WACC

Type: Definitions

25. The term used to indicate the percentage of financing derived from equity and the percentage derived from debt is: A) Capital structure. B) Weighted average cost of capital. C) Market rate of return. D) Book value weights. E) Market to book ratio Ans: A

Level: Basic

Subject: Capital Structure

Type: Definitions

26. WACC is the: A) Cost of obtaining equity financing. B) Required rate of return on a firm. C) Average IRR of the firm's current projects. D) Average rate of return needed to increase the value of a firm's stock. E) Discount rate based on the pre-tax cost of capital. Ans: B

Level: Basic

Subject: WACC

Type: Definitions

27. The target capital structure is the debt-equity mix that: A) Maximizes the cost of capital. B) Maximizes the value of the firm. C) Minimizes the cost of equity financing. D) Minimizes the cost of debt financing. E) Minimizes the overall debt level of a firm. Ans: B

Level: Basic

Subject: Target Capital Structure

Type: Definitions

Copyright © 2005 McGraw-Hill Ryerson Limited. Page 4

Chapter 14 Cost of Capital

28. The approach to computing the cost of equity financing that utilizes the Treasury bill rate is called the: A) Dividend growth model. B) Weighted average cost of capital. C) Security market line. D) After-tax cost of equity. E) Inflation adjusted cost of equity. Ans: C

Level: Basic

Subject: SML

Type: Definitions

29. In the SML formula, g is defined as the: A) Most recent increase in the firm's dividend. B) Most recent increase in the firm's level of sales. C) Historical growth rate of a firm's dividends. D) Expected growth rate of a firm's dividends. E) Expected growth of a firm's sales. Ans: D

Level: Basic

Subject: SML

Type: Definitions

30. The market-required rate of return on debt is called the: A) Coupon rate. B) After-tax current yield. C) Yield to maturity. D) Yield to call. E) Current yield. Ans: C

Level: Basic

Subject: Yield-To-Maturity

Type: Definitions

31. When the number of shares of common stock outstanding multiplied by the price per share is divided by the total market value of the firm the resulting value is defined as the: A) Market weight of debt. B) Debt-equity ratio. C) Cost of capital ratio. D) Capital structure weight. E) Equity to market weight. Ans: D

Level: Basic

Subject: WACC Weight

Type: Definitions

32. The subjective approach: A) Can be defined as a stair step method of applying WACC. B) Is the method of using information from another firm when calculating WACC. C) Employs pure play strategy. D) Is defined as the application of one cost of capital rate to all projects under consideration. E) Is defined as the inclusion of flotation costs in the WACC. Ans: A

Level: Basic

Subject: Subjective Approach

Type: Definitions

Copyright © 2005 McGraw-Hill Ryerson Limited. Page 5

Chapter 14 Cost of Capital

33. The cost of capital in a firm that has both debt and equity ____________________. A) is what a firm must earn on a project to compensate investors for the use of their funds B) depends on the source of the funds for a project C) is equal to the cost of debt or equity, depending on which type of financing the firm uses more D) is also known as the internal rate of return E) will be the same for its different divisions Ans: A

Level: Basic

Subject: Cost Of Capital

Type: Concepts

34. Which of the following is/are true: The cost of capital _______________________. I. is an opportunity cost that depends on the use of the funds, not the source II. is the same thing as the required rate of return III. is the same as the WACC for projects with equal risk to the firm as a whole IV. is also known as the appropriate discount rate A) II and III only B) I, II, and IV only C) II, III, and IV only D) I, III, and IV only E) I, II, III, and IV Ans: E

Level: Basic

Subject: Cost Of Capital

Type: Concepts

35. The appropriate discount rate to be used when analyzing an investment project is _______________. A) the rate of return that will result in the highest NPV B) the internal rate of return on that investment C) equal to the cost of capital based on the firm's historical assets D) the rate of return financial markets offer on investments of similar risk E) the rate of interest the firm would pay if it sold bonds Ans: D

Level: Basic

Subject: Discount Rate

Type: Concepts

36. The appropriate cost of capital for a project depends on __________________. A) the risk associated with the project B) the type of security issued to finance the project C) the type of assets used in the project (that is, whether they are current or fixed assets) D) the total risk of the firm's equity E) the interest rate on the firm's outstanding long-term bonds Ans: A

Level: Basic

Subject: Discount Rate

Type: Concepts

37. The interest rate that should be used when evaluating a capital investment project is sometimes called the ___________________. I. internal rate of return II. appropriate discount rate III. cost of capital A) I only B) II only C) III only D) II and III only E) I, II and III Ans: D

Level: Basic

Subject: Discount Rate

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited. Page 6

Chapter 14 Cost of Capital

38. Which of the following formulas correctly describes the cost of equity capital? A) RE = D0/P0 + g B) RE = D1+ g/P0 C) RE = D1/P0 + g D) RE = Rf – b ´ (Rf – Rm) E) RE = Rf + b ´ (Rm + Rf) Ans: C

Level: Basic

Subject: Cost Of Equity

Type: Concepts

39. Which of the following are potential problems associated with the use of the dividend growth model to compute the cost of equity? I. The estimated cost of equity is sensitive to the estimated dividend growth rate II. Everything needed for the model is directly observable except the current dividend III. The approach explicitly considers risk A) I only B) II only C) III only D) I and II only E) II and III only Ans: A

Level: Basic

Subject: Cost Of Equity

Type: Concepts

40. Which of the following is true about estimating a firm's cost of equity capital? A) We have no model that will provide reasonable estimates. B) It is relatively easy to calculate the firm's cost of debt and then back out the cost of equity. C) The cost of equity is equal to the weighted average cost of capital. D) The cost of equity depends on the total risk of the firm's equity. E) There is no way to directly observe the return required by the firm's equity investors. Ans: E

Level: Basic

Subject: Cost Of Equity

Type: Concepts

41. Which of the following is true regarding the use of the dividend growth model for estimating the cost of equity capital? A) A key advantage to this model is its high degree of complexity. B) The results from this model are not sensitive to changes in the dividend growth rate. C) One method of estimating future growth rates is the use of historical growth rates. D) The model works particularly well for companies that maintain a mostly unsteady dividend growth rate. E) The model explicitly considers risk. Ans: C

Level: Basic

Subject: Cost Of Equity

Type: Concepts

42. You need to calculate the cost of equity capital for a firm that is traded on the Toronto Stock Exchange. Which of the following would likely be least helpful to you? A) The rate of return on stocks of similar risk. B) Knowledge of the stock's price six months ago. C) An investment publication that provides an estimate of the firm's beta. D) An investment survey that projects future dividend growth rates for the firm. E) A data set containing dividends paid for the past 10 years. Ans: B

Level: Basic

Subject: Cost Of Equity

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited. Page 7

Chapter 14 Cost of Capital

43. Which of the following is NOT accurate regarding cost of equity capital estimates calculated using the SML approach? A) The SML applies only to firms with stable dividend growth rates. B) Like the dividend growth model, SML generally relies on using the past to predict the future. C) Unlike the dividend growth model, the SML estimate adjusts for risk. D) To implement this approach, the financial manager must estimate a market risk premium and a beta coefficient. E) The quality of the estimate using the SML approach is sensitive to the quality of the estimates for the input variables in the model. Ans: A

Level: Basic

Subject: Cost Of Equity

Type: Concepts

44. Which of the following is a disadvantage of the dividend growth model when estimating the cost of equity? A) It applies only to firms whose dividend growth rate fluctuates widely. B) It only applies to companies which are not currently paying dividends. C) It explicitly considers risk. D) The estimated cost of equity is highly sensitive to the estimated growth rate. E) It does not use discounted cash flow techniques. Ans: D

Level: Basic

Subject: Cost Of Equity

Type: Concepts

45. Which of the following is considered an advantage to using the SML approach for calculating the cost of equity? I. This approach explicitly accounts for risk. II. This approach applies only to companies that pay dividends. III. Unlike the dividend growth model, the SML approach is not sensitive to the estimates used as inputs in the model. A) I only B) III only C) I and II only D) II and III only E) I, II, and III Ans: A

Level: Basic

Subject: Cost Of Equity

Type: Concepts

46. Which of the following will always decrease a firm's cost of equity, when calculated using the SML approach? I. A decrease in the pure time value of money. II. A decrease in the amount of systematic risk. III. A decrease in the reward for bearing systematic risk. A) I only B) III only C) II only D) II and III only E) I, II, and III Ans: D

Level: Basic

Subject: Cost Of Equity

Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited. Page 8

Chapter 14 Cost of Capital

47. Which of the following is NOT generally considered to be a problem when estimating the cost of equity? A) We must estimate beta using historical information. B) We must estimate a dividend growth rate. C) We must estimate the market risk premium. D) We must estimate the risk-free rate of interest. E) If we use the dividend growth model, we cannot adjust for differences in risk. Ans: D

Level: Basic

Subject: Cost Of Equity

Type: Concepts

48. Suppose that the Federal Reserve takes actions that causes the risk-free rate to fall. All else the same, we would expect a firm's cost of equity to ____________________. A) increase if we are using the SML B) decrease if we are using the SML C) either increase or decrease if we are using the SML, but we can't determine which without more information D) increase if expected return on the market decreases E) decrease if the firm's beta increases Ans: C

Level: Basic

Subject: Cost Of Equity

Type: Concepts

49. The cost of debt capital for a firm _________________________. A) is the return that the firm's creditors demand for new borrowings B) can be calculated by estimating the beta of the firm's equity and then using the SML C) can be estimated by finding the yield on recently-issued bonds with lower bond ratings D) can be calculated by looking at the coupon rates on existing bonds of similar risk E) can be observed directly even if the firm's bonds are not publicly traded Ans: A

Level: Basic

Subject: Cost Of Debt

Type: Concepts

50. Which of the following is NOT true regarding a firm's cost of debt? A) The cost of debt must be adjusted lower due to the firm's tax deductibility of interest expense. B) The firm's cost of debt based on its past borrowing is known as its embedded debt cost. C) It is possible to determine a firm's cost of debt...