Chapter 11

© All Rights Reserved

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Chapter 11

© All Rights Reserved

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to cover operating costs.

Your Answer: True

CORRECT

2.

The target capital

structure is the desired

optimal mix of debt and

equity financing that

most firms attempt to

achieve and maintain.

Your Answer: False

Correct Answer: True

Incorrect. This is a 'must

know' definition.

3.

The cost of capital is the

rate of return a firm

must earn on

investments in order to

leave share price

unchanged.

Your Answer: False

Correct Answer: True

Incorrect. The cost of

capital is the rate of

return a firm must earn

to maintain the market

value of its shares.

4.

The specific cost of each

source of financing is the

after-tax cost of

obtaining the financing

using the historically-

based cost reflected by

the existing financing on

the firm's books.

Your Answer: False

CORRECT

5.

The net proceeds used in

calculating the cost of

long-term debt are funds

actually received from

the sale after paying for

flotation costs.

Your Answer: False

Correct Answer: True

Incorrect. The net

proceeds after deducting

the various costs of

issue are used in the

calculation.

6.

When the net proceeds

from sale of a bond

equals its par value, the

before-tax cost would

just equal the coupon

interest rate.

Your Answer: False

Correct Answer: True

Incorrect. This is

something that should

be permanently

embedded in your

knowledge bank on

finance.

7.

The cost of preference

shares is typically higher

than the cost of long-

term debt (bonds)

because the cost of

long-term debt (interest)

is tax deductible.

Your Answer: True

CORRECT

8.

The cost of ordinary

share equity may be

measured using either

the constant growth

valuation model or the

capital asset pricing

model.

Your Answer: False

Correct Answer: True

Incorrect. They are

alternative valuation

models.

9.

The constant growth

model uses the market

price as a reflection of

the expected risk-return

preference of investors

in the marketplace.

Your Answer: False

Correct Answer: True

Incorrect. This question

is the application of

material you should

know from Chapter 7.

10.

The cost of retained

earnings is always lower

than the cost of a new

issue of ordinary shares

due to the absence of

flotation costs when

financing projects with

retained earnings.

Your Answer: True

CORRECT

11.

Using the capital asset

pricing model (CAPM),

the cost of ordinary

shares equity is the

return required by

investors as

compensation for the

firm's non-diversifiable

risk.

Your Answer: False

Correct Answer: True

Incorrect. This is

something that should

be permanently

embedded in your

knowledge bank on

finance.

12.

Use of the capital asset

pricing model (CAPM) in

measuring the cost of

ordinary shares equity

differs from the constant

growth valuation model

in that it directly

considers the firm's risk

as reflected by beta.

Your Answer: False

Correct Answer: True

Incorrect. This is

something that should

be permanently

embedded in your

knowledge bank on

finance.

13.

The weighted average

cost that reflects the

inter-relationship of

financing decisions can

be obtained by

weighting the cost of

each source of financing

by its target proportion

in the firm's capital

structure.

Your Answer: False

Correct Answer: True

Incorrect. This is

something that should

be permanently

embedded in your

knowledge bank on

finance.

14.

In computing the

weighted average cost of

capital, the weights used

are either book value or

market value weights

based on actual capital

structure proportions.

Your Answer: True

CORRECT

15.

At any given time, the

firm's financing costs

and investment returns

will be affected by the

volume of financing and

investment undertaken.

Your Answer: True

CORRECT

16.

A firm's investment

opportunities schedule is

a ranking of investment

possibilities from best

(highest return) to worst

(lowest return).

Your Answer: True

CORRECT

17.

The larger the volume of

new financing, the

greater the risk and,

thus, the higher the

financing costs.

Your Answer: True

CORRECT

18.

The investment

opportunity schedule

(IOS) is the graph that

relates the firm's

weighted average cost of

capital (WACC) to the

level of total new

financing.

Your Answer: False

CORRECT

19.

As the cumulative

amount of money

invested in a firm's

capital projects

increases, its returns on

the projects will

increase.

Your Answer: False

CORRECT

20.

According to the firm's

owner wealth

maximisation goal, the

firm should accept

projects up to the point

where the marginal

return on its investment

is equal to its weighted

marginal cost of capital.

Your Answer: False

Correct Answer: True

Incorrect. This is an

important principle that

you should commit to

memory.

The ______ is the rate of return a firm must

earn on its investments in projects in order

to maintain the market value of its stock.

Your Answer: internal rate of return

Correct Answer: cost of capital

Incorrect. The internal rate of

return is the point where the

NPV equals zero.

2.

______ is the risk to the firm of

being unable to cover financial

obligations.

Your Answer: Total risk

Correct Answer: Financial risk

Incorrect. This is a 'must know'

definition.

3.

The cost of capital reflects the

cost of funds:

Your Answer: over a short-

run time

period.

Correct Answer: over a long-

run time

period.

Incorrect. The investment

decision is long-term so the cost

of funds is a long-term

consideration.

4.

The ______ is the firm's desired

optimal mix of debt and equity

financing.

Your Answer: market value

Correct Answer: target capital

structure

Incorrect. The correct answer is

target capital structure. This is a

'must know' definition.

5.

A tax adjustment must be made

in determining the cost of_____.

Your Answer: preference

shares.

Correct Answer: long-term

debt.

Incorrect. This is a component of

equity. Only interest charged

debt is tax deductible.

6.

The before-tax cost of debt for a

firm that has a 40 per cent

marginal tax rate is 12 per cent.

The after-tax cost of debt is:

Your Answer: 4.8 per cent.

Correct Answer: 7.2 per cent.

Incorrect. Refer to Formula 11.2

on page 434.

7.

When determining the after-tax

cost of a bond, the face value of

the issue must be adjusted to

the net proceeds amounts by

considering:

Your Answer: the risk.

Correct Answer: the flotation

costs.

Incorrect. This does not affect

the determination of net

proceeds.

8.

If a corporation has an average

tax rate of 40 per cent, the

approximate, annual, after-tax

cost of debt for a 15-year, 12

per cent, $1 000 par value bond,

selling at $950 is:

Your Answer: 10.6 per

cent.

Correct Answer: 7.6 per cent.

Incorrect. This is a simple

calculation. You must be able to

answer this type of question

without thinking about how to

perform the calculation.

9.

The cost of ordinary shares

equity may be estimated by

using the:

Your Answer: net present

value

method.

Correct Answer: Gordon

model.

Incorrect. There are two

methods used to determine the

cost of ordinary shares, but this

is not one of them.

10.

The constant growth valuation

model - the Gordon model - is

based on the premise that the

value of an ordinary shares is:

Your Answer: equal to the

present value of

all expected

future dividends.

CORRECT

11.

A firm has a beta of 1.2. The

market return equals 14 per cent

and the risk-free rate of return

equals six per cent. The

estimated cost of ordinary

shares equity is:

Your Answer: 15.6 per cent.

CORRECT

12.

Using the capital asset pricing

model, the cost of ordinary

shares equity is the return

required by investors as

compensation for:

Your Answer: the specific

risk of the

firm.

Correct Answer: the firm's

non-

diversifiable

risk.

Incorrect. The CAPM model uses

a beta that is a measure of the

firm's non-diversifiable risk.

13.

Since retained earnings are

viewed as a fully subscribed

issue of additional ordinary

shares, the cost of retained

earnings is:

Your Answer: equal to the

cost of new

ordinary

share equity.

Correct Answer: less than the

cost of new

ordinary

share equity.

Incorrect. Flotation costs reduce

the net proceeds received by the

firm, which increases the cost of

capital.

14.

Given that the cost of ordinary

share equity is 18 per cent,

dividends are $1.50 per share,

and the price of the stock is

$12.50 per share, what is the

annual growth rate of dividends?

Your Answer: five per cent

Correct Answer: six per cent

Incorrect. Using Formula 11.6 on

page 437, substitute the values

given and calculate.

15.

Generally the least expensive

source of long-term capital is:

Your Answer: retained

earnings.

Correct Answer: long-term

debt.

Incorrect. Long-term debt is

cheaper because of the tax

deductibility of the interest

payments.

16.

Weighting schemes for

calculating the weighted average

cost of capital include all of the

following EXCEPT:

Your Answer: market value

weights.

Correct Answer: optimal

value

weights.

Incorrect. Weights can be

calculated on the basis of book

value or market value and using

historic or target weights.

17.

The preferred capital structure

weights to be used in the

weighted average cost of capital

are:

Your Answer: nominal

weights.

Correct Answer: market

weights.

Incorrect. Although book values

can be used, market value

weights are the preferred basis.

18.

As the volume of financing

increases, the costs of the

various types of financing will

______, ______ the firm's

weighted average cost of capital.

Your Answer: decrease;

raising

Correct Answer: increase;

raising

Incorrect. This is a 'must know'

definition.

19.

The ______ is the level of total

financing at which the cost of

one of the financing components

rises.

Your Answer: weighted

average cost

of capital

Correct Answer: breaking

point

Incorrect. This is a 'must know'

definition.

20.

As a source of financing, once

retained earnings have been

exhausted, the weighted average

cost of capital will:

Your Answer: decrease.

Correct Answer: increase.

Incorrect. The WACC will rise

with the addition of more

expensive new ordinary shares.

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