FIN 534 Quiz 5 Solution - 20053

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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.

 

 

 

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