Chapter 15: Required Returns and the Cost of Capital MCQs

Multiple-Choice Quiz

Chapter 15:   Required Returns and the Cost of Capital

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1. A single, overall cost of capital is often used to evaluate projects because:

it avoids the problem of computing the required rate of return for each investment proposal.

it is the only way to measure a firm's required return.

it acknowledges that most new investment projects have about the same degree of risk.

it acknowledges that most new investment projects offer about the same expected return.

2. The cost of equity capital is all of the following EXCEPT:

the minimum rate that a firm should earn on the equity-financed part of an investment.

a return on the equity-financed portion of an investment that, at worst, leaves the market  price of the stock unchanged.

by far the most difficult component cost to estimate.

generally lower than the before-tax cost of debt.

3. In calculating the proportional amount of equity financing employed by a firm, we should use:

the common stock equity account on the firm's balance sheet.

the sum of common stock and preferred stock on the balance sheet.

the book value of the firm.

the current market price per share of common stock times the number of shares outstanding.

4. To compute the required rate of return for equity in a company using the CAPM, it is necessary to know all of the following EXCEPT:

the risk-free rate.

the beta for the firm.

the earnings for the next time period.

the market return expected for the time period.

5. In calculating the costs of the individual components of a firm's financing, the corporate tax rate is important to which of the following component cost formulas?

common stock.

debt.

preferred stock.

none of the above.

6. The common stock of a company must provide a higher expected return than the debt of the same company because

there is less demand for stock than for bonds.

there is greater demand for stock than for bonds.

there is more systematic risk involved for the common stock.

there is a market premium required for bonds.

7. A quick approximation of the typical firm's cost of equity may be calculated by

adding a 5 percent risk premium to the firm's before-tax cost of debt.

adding a 5 percent risk premium to the firm's after-tax cost of debt.

subtracting a 5 percent risk discount from the firm's before-tax cost of debt.

subtracting a 5 percent risk discount from the firm's after-tax cost of debt.

8. Market values are often used in computing the weighted average cost of capital because

this is the simplest way to do the calculation.

this is consistent with the goal of maximizing shareholder value.

this is required in the U.S. by the Securities and Exchange Commission.

this is a very common mistake.

9. For an all-equity financed firm, a project whose expected rate of return plots            should be rejected.

above the characteristic line

above the security market line

below the security market line

below the characteristic line

10. Some projects that a firm accepts will undoubtedly result in zero or negative returns. In light of this fact, it is best if the firm

adjusts its hurdle rate (i.e., cost of capital) upward to compensate for this fact.

adjusts its hurdle rate (i.e., cost of capital) downward to compensate for this fact.

does not adjust its hurdle rate up or down regardless of this fact.

raises its prices to compensate for this fact.

11. The Tchotchke Knick-Knack Company relies on preferred stock, bonds, and common stock for its long-term financing. Rank in ascending order (i.e., 1 = lowest, while 3 = highest) the likely after-tax component costs of the Tchotchke Company's long-term financing.

1 = bonds; 2 = common stock; 3 = preferred stock.

1 = bonds; 2 = preferred stock; 3 = common stock.

1 = common stock; 2 = preferred stock; 3 = bonds.

1 = preferred stock; 2 = common stock; 3 = bonds.

12. Lei-Feng, Inc.'s $100 par value preferred stock just paid its $10 per share annual dividend. The preferred stock has a current market price of $96 a share. The firm's marginal tax rate (combined federal and state) is 40 percent, and the firm plans to maintain its current capital structure relationship into the future. The component cost of preferred stock to Lei-Feng, Inc. would be closest to          .

6 percent

6.25 percent

10 percent

10.4 percent                Correct!

 $10/$96 = .1042

 Remember, dividends are not a tax deductible expense so we do NOT multiply $10 by one minus the tax rate before continuing our calculation.

13. David Ding is evaluating two conventional, independent capital budgeting projects (X and Y) by making use of the risk-adjusted discount rate (RADR) method of analysis. Projects X and Y have internal rates of return of 16 percent and 12 percent, respectively. The RADR appropriate to Project X is 18 percent, while Project Y's RADR is only 10 percent. The company's overall, weighted-average cost of capital is 14 percent. David should         .

accept Project X and accept Project Y.

accept Project X and reject Project Y.

reject Project X and accept Project Y.             Correct!

                                 The IRR of Project X (16%) is less than its RADR (18%), therefore reject.

 

                                 The IRR of Project Y (12%) is greater than its RADR (10%), therefore accept

reject Project X and reject Project Y.

14. One way to visualize the RADR approach is to make (new) use of an "old friend," the          .

Security Market Line (SML)

characteristic line

NPV profile           CORRECT!

The NPV profile for a project can be used to highlight the NPV for a project at any number of alternative risk-adjusted discount rates -- including the weighted-average cost of capital (WACC) for the firm.