Finance Applications And Theory 4th Edition By Cornett – Test Bank

Chapter 11 Calculating the Cost of Capital Answer Key

Multiple Choice Questions

1. When calculating the weighted average cost of capital, weights are based on

1. book values.
2. book weights.
3. market values.
4. market betas.

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

Blooms: Remember

Difficulty: 1 Basic

Gradable: automatic

Learning Goal: 11-01 Understand the relationship of cost of capital to the investors required return.

Topic: Capital structure weights

2. Which of these completes this statement to make it true? The constant growth model is

1. always going to have assumptions that will hold true.
2. adjustable for stocks that don’t expect constant growth without sizeable errors.
3. only going to be appropriate for the limited number of stocks that just happen to expect constant growth.
4. only going to be appropriate for the limited number of stocks that just happen to expect nonconstant growth.

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

Blooms: Remember

Difficulty: 2 Intermediate

Gradable: automatic

Learning Goal: 11-01 Understand the relationship of cost of capital to the investors required return.

Topic: Constant-growth stock

3. When firms use multiple sources of capital, they need to calculate the appropriate discount rate for valuing their firm’s cash flows as

1. a simple average of the capital components costs.
2. a sum of the capital components costs.
3. a weighted average of the capital components costs.
4. they apply to each asset as they are purchased with their respective forms of debt or equity.

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

Blooms: Remember

Difficulty: 1 Basic

Gradable: automatic

Learning Goal: 11-01 Understand the relationship of cost of capital to the investors required return.

Topic: Weighted average cost of capital

4. Which of the following is a true statement?

1. To estimate the before-tax cost of debt, we need to solve for the Yield to Maturity (YTM) on the firm’s existing debt.
2. To estimate the before-tax cost of debt, we need to solve for the Yield to Call (YTC) on the firm’s existing debt.
3. To estimate the before-tax cost of debt, we use the coupon rate on the firm’s existing debt.
4. To estimate the before-tax cost of debt, we use the average rate on the firm’s existing debt.

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

Blooms: Remember

Difficulty: 1 Basic

Gradable: automatic

Learning Goal: 11-02 Use the weighted-average cost of capital (WACC) formula to calculate a projects cost of capital.

Topic: Cost of debt

5. Which of the following is a true statement regarding the appropriate tax rate to be used in the WACC?

1. One would use the marginal tax rate that the firm paid the prior year.
2. One would use the average tax rate that the firm paid the prior year.
3. One would use the weighted average of the marginal tax rates that would have been paid on the taxable income shielded by the interest deduction.
4. One would use the marginal tax rates that would have been paid on the taxable income shielded by the interest deduction.

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

Blooms: Remember

Difficulty: 1 Basic

Gradable: automatic

Learning Goal: 11-03 Explain how the firm chooses among estimating costs of equity, preferred stock, and debt.

Topic: Cost of debt

6. Which of these statements is true regarding calculating weights for WACC?

1. If we are calculating WACC for the firm, then equity, preferred stock and debt would be the entire book value of each source of capital.
2. If we are calculating WACC for the firm, then equity, preferred stock and debt would be the entire market value of each source of capital.
3. If we are calculating WACC for a project, then equity, preferred stock and debt would be the entire book value of each source of capital.
4. If we are calculating WACC for a project, then equity, preferred stock and debt would be the entire market value of each source of capital.

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

Blooms: Remember

Difficulty: 2 Intermediate

Gradable: automatic

Learning Goal: 11-03 Explain how the firm chooses among estimating costs of equity, preferred stock, and debt.

Topic: Capital structure weights

7. Which of the following statements is true?

1. If the new project is riskier than the firm’s existing projects, then it should be charged a higher cost of capital.
2. If the new project is riskier than the firm’s existing projects, then it should be charged a lower cost of capital.
3. If the new project is riskier than the firm’s existing projects, then it should be charged the firm’s cost of capital.
4. The new project’s risk is not a factor in determining its cost of capital.

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

Blooms: Remember

Difficulty: 2 Intermediate

Gradable: automatic

Learning Goal: 11-05 Identify which elements of WACC are used to calculate a project-specific WACC.

Topic: Divisional and project costs of capital

8. Which of the following makes this a true statement? If the new project does significantly increase the firm’s overall risk

1. the increased risk will be borne equally amongst the bondholders, preferred stockholders, and common stockholders.
2. the increased risk will be borne disproportionately by bondholders.
3. the increased risk will be borne disproportionately by preferred stockholders.
4. the increased risk will be borne disproportionately by common stockholders.

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

Blooms: Remember

Difficulty: 2 Intermediate

Gradable: automatic

Learning Goal: 11-05 Identify which elements of WACC are used to calculate a project-specific WACC.

Topic: Divisional and project costs of capital

9. An average of which of the following will give a fairly accurate estimate of what a project’s beta will be?

1. flotation beta
2. proxy beta
3. pure-play proxies
4. weighted average beta

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

Blooms: Remember

Difficulty: 1 Basic

Gradable: automatic

Learning Goal: 11-05 Identify which elements of WACC are used to calculate a project-specific WACC.

Topic: Beta

10. Which of the following makes this a true statement? Ideally, when searching for a beta for a new line of business

1. one could find other firms engaged in the proposed new line of business and use their betas as proxies to estimate the project’s risk.
2. one would like to find at least three or four pure-play proxies.
3. two (or even one) proxies might represent a suitable sample if their line of business resembles the proposed new project closely enough.
4. All of these choices are correct.

AACSB: Reflective Thinking

Accessibility: Keyboard Navigation

Blooms: Remember

Difficulty: 2 Intermediate

Gradable: automatic

Learning Goal: 11-05 Identify which elements of WACC are used to calculate a project-specific WACC.

Topic: Beta