FIN 534 Quiz 5
1.
If a typical U.S. company 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
Answer
become riskier over time, but its intrinsic value will be maximized. become less risky over time,
and this will maximize its intrinsic value.accept too many low-risk projects and too few high-risk
projects.become more risky and also have an increasing WACC. Its intrinsic value will not be
maximized.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.
1.
Which of the following statements is CORRECT?
Answer
When calculating the cost of debt, a company needs to adjust for taxes, because interest payments
are deductible by the paying corporation.
When calculating the cost of preferred stock, companies must adjust for taxes, because dividends
paid on preferred stock are deductible
by the paying corporation.
Because of tax effects, an increase in the risk-free rate
will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by
the CAPM.
If a company’s beta increases, this will increase the cost of equity used to calculate the WACC,
but only if the company does not have enough retained earnings to take care of its equity financing and
hence must issue new stock.
Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a
company’s WACC.
2 points
Question 22
1.
Which of the following statements is CORRECT?
Answer
In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect
the fact that 70% of the dividends received by corporate investors are excluded from their taxable income.
We should use historical measures of the component costs from prior financings that are still
outstanding when estimating a company’s WACC for capital budgeting purposes.
The cost of new equity (re) could possibly be lower than the cost of retained earnings (rs) if the
market risk premium, risk-free rate, and the company’s beta all decline by a sufficiently large amount.
A firm’s cost of retained earnings is the rate of return stockholders require on a firm’s common
stock.
The component cost of preferred stock is expressed as rp(1 - T), because preferred stock
dividends are treated as
fixed charges, similar to the treatment of interest on debt.
2 points
Question 23
1.
For a company whose target capital structure calls for 50% debt and 50% common equity, which of the
following statements
is CORRECT?
Answer
The interest rate used to calculate the WACC is the average after-tax cost of all the company's
outstanding debt as shown on its balance sheet.
The WACC is calculated on a before-tax basis.
The WACC exceeds the cost of equity.
The cost of equity is always equal to or greater than the cost of debt.
The cost of retained earnings typically
exceeds the cost of new common stock.
2 points
Question 24
1.
Which of the following statements is CORRECT?
Answer
The WACC as used in capital budgeting is an estimate of a company’s before-tax cost of capital.
The percentage flotation cost associated with issuing new common equity is typically smaller
than the flotation cost for new debt.
The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has
raised to acquire its assets.
There is an “opportunity cost” associated with using retained earnings, hence they are not “free.”
The WACC as used in capital budgeting would
be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during
the coming year.
1.
Which of the following statements is CORRECT?
Answer
Although some methods used to estimate the cost of equity are subject to severe limitations, the
CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity
estimates. In particular, academics and corporate finance people generally agree that its key inputs--beta,
the risk-free rate, and the market risk premium--can be estimated with little error.
The DCF model is generally preferred by academics and financial executives over other models
for estimating the cost of equity. This is because of the DCF model’s logical appeal and also because
accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain.
The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be
accurate, but it has the advantage
that its two key inputs, the firm’s own cost of debt and its risk premium, can be found by using
standardized and objective procedures.
Surveys indicate that the CAPM is the most widely
used method for estimating the cost of equity. However, other methods are also used because CAPM
estimates may be subject to error, and people like to use different methods as checks on one another. If
all of the methods produce similar results, this increases the decision maker's confidence in the estimated
cost of equity.
The DCF model is preferred by academics and finance practitioners over other cost of capital
models because it correctly
recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains
yield.
2 points
Question 29
1.
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.
Answer
rs
> re > rd > WACC.
re
> rs > WACC > rd.
WACC > re > rs
> rd.
rd
> re > rs > WACC.
WACC > rd > rs > re.
1.
Deeble Construction Co.’s stock is trading at $30 a share. Call options on the company’s stock
are also available, some with a strike price of $25 and some with a strike price of $35. Both options
expire in three months. Which of the following best describes the value of these options?
Answer
The options with the $25 strike price will sell for $5.
The options with the $25 strike price will sell for less than the options with the $35 strike price.
The options with the $25 strike price have an exercise value greater than $5.
The options with the $35 strike price have an exercise value greater than $0.
If Deeble’s stock price rose by $5, the exercise value of the options with the $25 strike price
would also increase by $5.