Chapter 14 - Cost of Capital
21. 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?
A. The aftertax cost of debt will be greater than the current yield-to-maturity on the firm's bonds. B. The firm's cost of preferred is most likely less than the firm's actual cost of debt. C. The firm's cost of equity is unaffected by a change in the firm's tax rate. D. The cost of equity can only be estimated using the SML approach.
E. The firm's weighted average cost of capital will remain constant as long as the capital structure remains constant. Refer to section 14.4
AACSB: N/A
Bloom's: Comprehension Difficulty: Intermediate Learning Objective: 14-3 Section: 14.4 Topic: WACC
22. 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. Refer to section 14.3
AACSB: N/A
Bloom's: Comprehension Difficulty: Intermediate Learning Objective: 14-2 Section: 14.3
Topic: Cost of debt
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Chapter 14 - Cost of Capital
23. The weighted average cost of capital for a firm may be dependent upon the firm's: I. rate of growth. II. debt-equity ratio.
III. preferred dividend payment. IV. retention ratio. A. I and III only B. II and IV only C. I, II, and IV only D. I, III, and IV only E. I, II, III, and IV Refer to section 14.4
AACSB: N/A
Bloom's: Comprehension Difficulty: Intermediate Learning Objective: 14-3 Section: 14.4 Topic: WACC
24. The weighted average cost of capital for a firm is the:
A. discount rate which the firm should apply to all of the projects it undertakes.
B. rate of return a firm must earn on its existing assets to maintain the current value of its stock. C. coupon rate the firm should expect to pay on its next bond issue. D. minimum discount rate the firm should require on any new project.
E. rate of return shareholders should expect to earn on their investment in this firm. Refer to section 14.4
AACSB: N/A
Bloom's: Comprehension Difficulty: Basic
Learning Objective: 14-3 Section: 14.4 Topic: WACC
14-12
Chapter 14 - Cost of Capital
25. 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. Refer to section 14.4
AACSB: N/A
Bloom's: Comprehension Difficulty: Intermediate Learning Objective: 14-3 Section: 14.4 Topic: WACC
26. 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. A. I and III only B. III and IV only C. I, II, and III only D. I, II, and IV only E. I, II, III, and IV Refer to section 14.4
AACSB: N/A
Bloom's: Comprehension Difficulty: Basic
Learning Objective: 14-5 Section: 14.4 Topic: WACC
14-13
Chapter 14 - Cost of Capital
27. Preston Industries has two separate divisions. Each division is in a separate line of business. Division A is the largest division and represents 70 percent of the firm's overall sales. Division A is also the riskier of the two divisions. Division B is the smaller and least risky of the two. When management is deciding which of the various divisional projects should be accepted, the managers should:
A. allocate more funds to Division A since it is the largest of the two divisions.
B. fund all of Division B's projects first since they tend to be less risky and then allocate the remaining funds to the Division A projects that have the highest net present values.
C. allocate the company's funds to the projects with the highest net present values based on the firm's weighted average cost of capital.
D. assign appropriate, but differing, discount rates to each project and then select the projects with the highest net present values.
E. fund the highest net present value projects from each division based on an allocation of 70 percent of the funds to Division A and 30 percent of the funds to Division B. Refer to section 14.5
AACSB: N/A
Bloom's: Comprehension Difficulty: Basic
Learning Objective: 14-5 Section: 14.5
Topic: Divisional cost of capital
28. 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. Refer to section 14.5
AACSB: N/A
Bloom's: Comprehension Difficulty: Basic
Learning Objective: 14-5 Section: 14.5
Topic: Divisional cost of capital
14-14
Chapter 14 - Cost of Capital
29. The discount rate assigned to an individual project should be based on: A. the firm's weighted average cost of capital.
B. the actual sources of funding used for the project.
C. an average of the firm's overall cost of capital for the past five years. D. the current risk level of the overall firm.
E. the risks associated with the use of the funds required by the project. Refer to section 14.5
AACSB: N/A
Bloom's: Knowledge Difficulty: Basic
Learning Objective: 14-5 Section: 14.5
Topic: Divisional cost of capital
30. Assigning discount rates to individual projects based on the risk level of each project: A. may cause the firm's overall weighted average cost of capital to either increase or decrease over time.
B. will prevent the firm's overall cost of capital from changing over time. C. will cause the firm's overall cost of capital to decrease over time. D. decreases the value of the firm over time.
E. negates the firm's goal of creating the most value for the shareholders. Refer to section 14.5
AACSB: N/A
Bloom's: Comprehension Difficulty: Basic
Learning Objective: 14-5 Section: 14.5
Topic: Project cost of capital
14-15
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