You are on page 1of 4

1.

Correct

The key sources of value (earning an excess return) for a company can be attributed primarily to __________. Your answer: industry attractiveness and competitive advantage Correct. The overall (weighted average) cost of capital is composed of a weighted average of __________. Your answer: the cost of common equity the cost of preferred stock and the cost of debt Correct. !hat is the overall (weighted average) cost of capital in the following situation" The firm has #$% million in long&term debt #' million in preferred stock and #( million in common equity && all at market values. The before&tax cost for debt preferred stock and common equity forms of capital are () *) and $+) respectively. ,ssume a -%) tax rate. Your answer: *..%) Correct. /or which of the following costs is it generally necessary to apply a tax ad0ustment to a yield measure" Your answer: Cost of debt Correct. !hich of the following is not a recogni1ed approach for determining the cost of equity" Your answer: 2efore&tax cost of preferred stock plus risk premium approach Correct. 3n estimating a firm4s cost of equity you decide to use the . methods discussed in the text and then to take a simple average of the three separate estimates as you feel that in this instance all . methods seem equally 0ustified. The before& tax cost of debt is () risk premium above debt is assumed to be 5) the risk&free rate is +) the beta is .*% and the expected market return is $5). 3n addition the firm is expected to grow dividends at a constant (.$) rate indefinitely and will pay a #'.%% dividend next year. The firm4s common equity is currently selling at #'+ per share. The average figure that you come up with should be closest to __________. Your answer: $-.%) The correct answer: $+.%) 3ncorrect. The three methods generate a cost of equity equal to #'6#'+ 7 .%($ 8 $5.$)9 () 7 5) 8 $-)9 and +) 7 .* ($5) & +)) 8 $-.*). The average cost is $+). :acques /auxpas is attempting to determine his company4s 11. Correct 8. Correct

2.

Correct

weighted&average cost of capital. ;is first step was to determine the required rates of return for his company4s long& term debt preferred stock and common stock. ;e then ad0usted these required rates of return by multiplying each return by one minus the company4s marginal tax rate. :acques is planning on using these three ad0usted required return figures as his component costs of capital. ;ow is :acques doing so far" Your answer: <nly the required return (yield) on debt should have been ad0usted for taxes. Correct. ;ow is economic value added (=>,) calculated" Your answer: 3t is the firm4s net operating profit after tax (?<@,T) less a dollar cost of capital charge. Correct. !hat is the difference between economic profit and accounting profit" Your answer: =conomic profit includes a charge for all providers of capital while accounting profit includes only a charge for debt. Correct. !hat is the idea behind pro0ect&specific required rates of return for a firm or division" Your answer: ,ll of the above are correct. The correct answer: Aifferent pro0ects should have different required rates of return because they are not alike with respect to risk. 3ncorrect. Aifferent pro0ects should have different required rates because they are not alike with respect to risk. !hat is meant by using proxy firms with the C,@B model" Your answer: , proxy firm is a publicly traded firm which may be entirely engaged in a business that is nearly identical to the pro0ect used to estimate the beta for a pro0ect. Correct. , company that has more than half of its voting shares owned by another company is generally referred to as a __________ of the other firm. Your answer: subsidiary Correct. !hich of the following is correct regarding the capital component costs for a group" Your answer: The component cost of debt is based on the firm4s component cost of debt. Correct.

3.

Correct

9.

Correct

4.

Correct

10. Incorrect

5.

Correct

6.

Incorrect

12. Correct

13. Correct

7.

Correct

14. Incorrect

!hich of the following statements is correctregarding the risk& ad0usted discount rate (C,AC) approach" Your answer: Dnder the C,AC approach we would still compare a pro0ect4s internal rate of return (3CC) to the firm4s overall weighted&average cost of capital in order to decide acceptance6re0ection. The correct answer: Dnder the C,AC approach we should accept a pro0ect if its net present value (?@>) calculated using a risk&ad0usted discount rate is positive. 3ncorrect. Dnder the C,AC approach we would compare a pro0ect4s internal rate of return (3CC) to its C,AC in order to decide acceptance6re0ection. ,ssume management is looking at a set of possible pro0ects with regards to their expected ?@> standard deviation and management4s risk attitude. The firm should attempt to take the set of pro0ects __________. Your answer: where the choice is on the indifference curve that is the farthest to the southeast The correct answer: that fall on the highest indifference curve 3ncorrect. /arthest to the northwest. !e can use the C,@B and a proxy firm to estimate the required rate of return on a pro0ect. Eometimes however it is necessary to ad0ust the beta of the proxy company for differences in capital structure between our firm and the proxy firm. ,ssuming that the proxy firm has long&term debt in its capital structure the unlevered beta of the proxy firm will be __________ its measured (levered) beta. Your answer: lower than Correct. The ad0usted present value (,@>) is best described as being __________. Your answer: equal to the discounted value of operating cash flows less any flotation costs The correct answer: equal to the discounted value of operating cash flows plus the present value of any tax&shield benefits less any flotation costs 3ncorrect. ,@> is equal to the discounted value of operating cash flows plus the present value of any tax&shield benefits less any flotation costs. !hich one of the following pro0ects && , 2 C or A && should be accepted" The expected return on the market is $5) and the risk&free rate is 5).

Your answer: @ro0ect 2 which has a beta of '.+% and has an expected return of '+.-) The correct answer: @ro0ect , which has a beta of %.+% and has an expected return of $$.') 3ncorrect. The required rate of return 8 5) 7 '.+% ($5) & 5)) 8 .$.%). 19. Correct Eocks&?&Ehoes 3nc. used a proxy company to calculate an unlevered beta of %.*% for its Eocks Aivision. The firm4s corporate cost of debt is +) on an after&tax basis. Eock&?& Ehoes finances its pro0ects with a roughly (%)6'%) mix of debt and equity. The market has an expected rate of return of $5) and the risk&free rate is 5). The required rate of return (divisional cost of capital) for the Eocks Aivision should be closest to which of the following four answers" Your answer: F) Correct. '-seven.com 3nc. is currently using a Ggroup&specific required returnG approach for handling capital budgeting hurdle rates for its four divisions. The C=<4s son Airk has 0ust been appointed the new C/<. ;e wants all four diverse divisions to have the same required return or hurdle rate and that would be the firm4s weighted&average cost of capital. 3f '-seven.com switches to a single hurdle rate for all divisions accept6re0ect capital budgeting decisions will now be __________. Your answer: biased in favor of GbadG (i.e. value&destroying) high&risk pro0ects Correct. , company can be viewed as a collection of pro0ects. Your answer: TCD= Correct. The firm should use its weighted average cost of capital (!,CC) to discount the cash flows of all pro0ects. Your answer: /,HE= Correct. The firm beta is directly influenced by financial leverage. Your answer: TCD= Correct. The !,CC is a general case of the ,@>. Your answer: /,HE=

15. Incorrect

20. Correct

16. Correct

1. Correct

17. Incorrect

2. Correct

3. Correct

18. Incorrect

4. Correct

8. Barket values are often used in computing the weighted average cost of capital because this is the simplest way to do the calculation. 5. Correct , good proxy for the expected return on the market Cmarket is this is consistent with the %oa" o$ #a,i#i/in% shareho"der va"ue. the D.E. Treasury bill rate. this is required in the D.E. by the Eecurities and =xchange Commission. Your answer: /,HE= this is a very common mistake. Correct. 9. /or an all&equity financed firm a pro0ect whose expected rate of return plots should be re0ected. 1. , single overall cost of capital is often used to evaluate pro0ects becauseI it avoids the ro!"e# o$ co# utin% the re&uired rate o$ return $or each invest#ent above the characteristic line above the security market line ro osa". !e"ow the securit* #ar-et "ine it is the only way to measure a firm4s required return. it acknowledges that most new investment pro0ects have about the same degree of risk. below the characteristic line 10. Eome pro0ects that a firm accepts will undoubtedly result in 1ero or negative returns. it acknowledges that most new investment pro0ects offer about the same expected 3n light of this fact it is best if the firm return. ad0usts its hurdle rate (i.e. cost of capital) upward to compensate for this fact. 2. The cost of equity capital is all of the following '(C')T: the minimum rate that a firm should earn on the equity&financed part of an investment. ad0usts its hurdle rate (i.e. cost of capital) downward to compensate for this fact. does not ad0ust its hurd"e rate u or down re%ard"ess o$ this $act. a return on the equity&financed portion of an investment that at worst leaves the raises its prices to compensate for this fact. market price of the stock unchanged. 11. The Tchotchke Jnick&Jnack Company relies on preferred stock bonds and common by far the most difficult component cost to estimate. stock for its long&term financing. Cank in ascending order (i.e. $ 8 lowest while . 8 %enera""* "ower than the !e$ore+ta, cost o$ de!t. highest) the likely after&tax component costs of the Tchotchke Company4s long&term 3. 3n calculating the proportional amount of equity financing employed by a firm we financing. should useI $ 8 bonds9 ' 8 common stock9 . 8 preferred stock. the common stock equity account on the firm4s balance sheet. 1 1 !onds2 2 1 re$erred stoc-2 3 1 co##on stoc-. the sum of common stock and preferred stock on the balance sheet. $ 8 common stock9 ' 8 preferred stock9 . 8 bonds. the book value of the firm. $ 8 preferred stock9 ' 8 common stock9 . 8 bonds. the current #ar-et rice er share o$ co##on stoc- ti#es the nu#!er o$ 12. Hei&/eng 3nc.4s #$%% par value preferred stock 0ust paid its #$% per share annual shares outstandin%. 4. To compute the required rate of return for equity in a company using the C,@B it is dividend. The preferred stock has a current market price of #*5 a share. The firm4s marginal tax rate (combined federal and state) is -% percent and the firm plans to necessary to know all of the following '(C')T: maintain its current capital structure relationship into the future. The component cost of the risk&free rate. preferred stock to Hei&/eng 3nc. would be closest to . the beta for the firm. 5 percent the earnin%s $or the ne,t ti#e eriod. 5.'+ percent the market return expected for the time period. $% percent 5. 3n calculating the costs of the individual components of a firm4s financing the 10.4 ercent corporate tax rate is important to which of the following component cost formulas" 13. Aavid Aing is evaluating two conventional independent capital budgeting pro0ects (K common stock. and L) by making use of the risk&ad0usted discount rate (C,AC) method of analysis. de!t. @ro0ects K and L have internal rates of return of $5 percent and $' percent respectively. preferred stock. The C,AC appropriate to @ro0ect K is $( percent while @ro0ect L4s C,AC is only $% none of the above. 6. The common stock of a company must provide a higher expected return than the debt percent. The company4s overall weighted&average cost of capital is $- percent. Aavid should . of the same company because accept @ro0ect K and accept @ro0ect L. there is less demand for stock than for bonds. accept @ro0ect K and re0ect @ro0ect L. there is greater demand for stock than for bonds. re0ect )ro0ect ( and acce t )ro0ect Y. there is #ore s*ste#atic ris- invo"ved $or the co##on stoc-. re0ect @ro0ect K and re0ect @ro0ect L. there is a market premium required for bonds. 14. <ne way to visuali1e the C,AC approach is to make (new) use of an Gold friend G 7. , quick approximation of the typical firm4s cost of equity may be calculated by the . addin% a 5 ercent ris- re#iu# to the $ir#.s !e$ore+ta, cost o$ de!t. Eecurity Barket Hine (EBH) adding a + percent risk premium to the firm4s after&tax cost of debt. characteristic line subtracting a + percent risk discount from the firm4s before&tax cost of debt. 3)4 ro$i"e subtracting a + percent risk discount from the firm4s after&tax cost of debt. Correct.