Exam 10: The Cost of Capital

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A) 10.69%
B) 11.25%
C) 11.84%
D) 12.43%
E) 13.05%

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A) The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever.
B) If the calculated beta underestimates the firm's true investment risk-i.e., if the forward­looking beta that investors think exists exceeds the historical beta-then the CAPM method based on the historical beta will produce an estimate of rs and thus WACC that is too high.
C) Beta measures market risk, which is, theoretically, the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm's stockholders are well diversified.
D) An advantage shared by both the DCF and CAPM methods when they are used to estimate the cost of equity is that they are both "objective" as opposed to "subjective," hence little or no judgment is required.
E) The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk- premium approach.

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A) 4.28%
B) 4.46%
C) 4.65%
D) 4.83%
E) 5.03%

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A) 11.30%
B) 11.64%
C) 11.99%
D) 12.35%
E) 12.72%

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A) 9.06%
B) 9.44%
C) 9.84%
D) 10.23%
E) 10.64%

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A) While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant's recommendation, this should not affect the firm's intrinsic value.
B) The decision not to adjust for risk means, in effect, that it is favoring the data processing division. Therefore, that division is likely to become a larger part of the consolidated company over time.
C) The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division. This will lead to a reduction in the firm's intrinsic value over time.
D) The decision not to risk-adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business. This will lead to a reduction in its intrinsic value over time.
E) The decision not to risk adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business. This may affect the firm's capital structure but it will not affect its intrinsic value.

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A) 12.60%
B) 13.10%
C) 13.63%
D) 14.17%
E) 14.74%

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A) 9.29%
B) 9.68%
C) 10.08%
D) 10.50%
E) 10.92%

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A) The component cost of preferred stock is expressed as rp(1 − T) . This follows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes.
B) A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm's stockholders would themselves expect to earn a return on earnings that were paid out rather than retained and reinvested.
C) No cost should be assigned to retained earnings because the firm does not have to pay anything to raise them. They are generated as cash flows by operating assets that were raised in the past, hence they are "free."
D) Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future. In this case, the firm's before-tax and after-tax costs of debt for purposes of calculating the WACC will both be equal to the interest rate on the firm's currently outstanding debt, provided that debt was issued during the past 5 years.
E) If a firm has enough retained earnings to fund its capital budget for the coming year, then there is no need to estimate either a cost of equity or a WACC.

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A) 1.55%
B) 1.72%
C) 1.91%
D) 2.13%
E) 2.36%

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A) If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.
B) If evaluated using the correct post-merger WACC, Project X would have a negative NPV.
C) After the merger, Safeco/Risco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y.
D) Safeco/Risco's WACC, as a result of the merger, would be 10%.
E) After the merger, Safeco/Risco should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%.

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A) 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 risk­free rate, and the market risk premium-can be estimated with little error.
B) 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.
C) 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.
D) 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.
E) 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.

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