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Chapter 7: Types and Costs of Financial Capital

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CHAPTER 7
TYPES AND COSTS OF FINANCIAL CAPITAL
True-False Questions
F.

1. The accounting emphasis on accrued revenue and expenses and


depreciation is the same emphasis as that of finance managers.

T.

2. Traditional accounting does not focus on the implicit cost of equity that is
the required capital gains to complement dividends. However, evaluation
methods exist to determine this value by financial managers.

T.

3. Formal historical accounting procedures include explicit records of debt


(interest and principal) and dividend capital costs.

F.

4. Public financial markets are markets for the creation, sale and trade of
illiquid securities having less standardized negotiated features.

F.

5. A ventures riskiness in terms of poor performance or failure is usually


very high during the maturity stage of its life cycle.

T.

6. A ventures riskiness in terms of poor performance or failure is usually


high to moderate during the rapid-growth stage of its life cycle.

T.

7. First-round financing during a ventures survival stage comes primarily


from venture capitalists and investment banks.

F.

8. Startup financing usually comes from entrepreneurs, business angels,


and investment bankers.

T.

9. Commercial banks provide liquidity-stage financing for ventures in the


rapid-growth stage of their life cycles.

T.

10. A ventures riskiness in terms of the likelihood of poor performance


or failure decreases as it moves from its development stage through to its
rapid-growth stage.

T.

11. A nominal interest rate is an observed or stated interest rate.

T.

12. The real interest rate (RR) is the interest one would face in the absence
of inflation, risk, illiquidity, and any other factors determining the appropriate
interest rate.

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Chapter 7: Types and Costs of Financial Capital

F.

13. The risk-free interest rate is the interest rate on debt that is virtually free of
inflation risk.

F.

14. Inflation premium is the rising prices not offset by increasing quality of
goods being purchased.

T.

15. Default-risk is the risk that a borrower will not pay the interest and/or
the principal on a loan.

F.

16. The prime rate is the interest rate charged by banks to their highest
default risk business customers.

F.

17. Bond ratings reflect the inflation risk of a firms bonds.

F.

18. The relationship between real interest rates and time to maturity
when default risk is constant is called the term structure of interest rates.

T.

19. The graph of the term structure of interest rates, which plots interest rates
to time to maturity is called the yield curve.

F.

20. Liquidity premiums reflect the risk associated with firms that possess few
liquid assets.

F.

21. Subordinated debt is secured by a ventures assets, while senior debt has
an inferior claim to a ventures assets.

F.

22. Early-stage ventures tend to have large amounts of senior debt relative to
more mature ventures.

23. Investment risk is the chance or probability of financial loss on ones


venture investment, and can be assumed by debt, equity, and founding
investors.

F.

24. A venture with a higher expected return relative to other ventures will
necessarily have a higher standard deviation or returns.

F.

25. Historically, large-company stocks have averaged higher long-term returns


than small-company stocks

T.

26. The coefficient of variation measures the standard deviation of a ventures


return relative to its expected return.

F.

27. Closely held corporations are those companies whose stock is traded overthe-counter.

Chapter 7: Types and Costs of Financial Capital

T.

28. Typically, the stocks of closely held corporations arent publicly traded.

T.

29. Organized exchanges have physical locations where trading takes place,
while the over-the-counter market is comprised of a network of brokers and
dealers that interact electronically.

T.

30. Market cap is determined by multiplying a firms current stock price by


the number of shares outstanding.

F.

31. The excess average return of long-term government bonds over


common stock is called the market risk premium.

T.

32. The weighted average cost of capital is simply the blended, or


weighted cost of raising equity and debt capital.

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Multiple-Choice Questions
e.

1. Which of the following markets involve liquid securities with standardized


contract features such as stocks and bonds?
a. private financial market
b. derivatives market
c. commodities market
d. real estate market
e. public financial market

d.

2. Which of the following markets involve direct two-party negotiations over


illiquid, non-standardized contracts such as bank loans and direct placement of
debt?
a. primary market
b. secondary market
c. options market
d. private financial market
e. public financial market

d.

3. Which of the following is an example of rent on financial capital?


a. interest on debt
b. dividends on stock
c. collateral on equity
d. a and b
e. a, b, and c

b.

4. Which of the following describes the observed or stated interest rate?


a. real rate

Chapter 7: Types and Costs of Financial Capital

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b.
c.
d.
e.

nominal rate
risk-free rate
prime rate
inflation rate

a.

5. Which of the following describes the interest rate in addition to the inflation
rate expected on a risk-free loan?
a. real rate
b. nominal rate
c. risk-free rate
d. prime rate
e. inflation rate

c.

6. Which of the following describes the interest rate on debt that is virtually
free of default risk?
a. real rate
b. nominal rate
c. risk-free rate
d. prime rate
e. inflation rate

d.

7. Which of the following describes the interest rate charged by banks to their
highest quality customers?
a. real rate
b. nominal rate
c. risk-free rate
d. prime rate
e. inflation rate

e.

8. Which of the following is not a component in determining the cost of


debt?
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity risk premium
e. interest rate premium

b.

9. The additional interest rate premium required to compensate the lender for
the probability that a borrower will not be able to repay interest and principal
on a loan is known as?
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity premium
e. investment risk premium

Chapter 7: Types and Costs of Financial Capital

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c.

10. The additional premium added to the real interest rate by lenders to
compensate them for a debt instrument which cannot be converted to cash
quickly at its existing value is called?
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity premium
e. investment risk premium

d.

11. The added interest rate charged due to the inherent increased risk in longterm debt is called?
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity premium
e. investment risk premium

e.

12. Suppose the real risk free rate of interest is 4%, maturity risk premium is
2%, inflation premium is 6%, the default risk on similar debt is 3%, and the
liquidity premium is 2%. What is the nominal interest rate on this ventures
debt capital?
a. 13%
b. 14%
c. 15%
d. 16%
e. 17%

d.

13. A venture has raised $4,000 of debt and $6,000 of equity to finance its
firm. Its cost of borrowing is 6%, its tax rate is 40%, and its cost of equity
capital is 8%. What is the ventures weighted average cost of capital?
a. 8.0%
b. 7.2%
c. 7.0%
d. 6.2%
e. 6.0%

d.

14. Your venture has net income of $600, taxable income of $1,000, operating
profit of $1,200, total financial capital including both debt and equity of
$9,000, a tax rate of 40%, and a WACC of 10%. What is your ventures EVA?
a. $400,000
b. $200,000
c. $
0
d. ($180,000)
e. ($300,000)

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Chapter 7: Types and Costs of Financial Capital

a.

15. The risk-free interest rate is the sum of:


a. a real rate of interest and an inflation premium
b. a real rate of interest and a default risk premium
c. an inflation premium and a default risk premium
d. a default risk premium and a liquidity premium
e. a liquidity premium and a maturity premium

c.

16. Venture investors generally use which one of the following target rates to
discount the projected cash flows of ventures in the startup stage of their life
cycles:
a. 20%
b. 25%
c. 40%
d. 50%

d.

17. Which one of the following components is not used when estimating the
cost of risky debt capital?
a. real interest rate
b. inflation premium
c. default risk premium
d. market risk premium
e. liquidity premium

e.

18. Which of the following components is not typically included in the rate on
short-term U.S. treasuries?
a. liquidity premium
b. default risk premium
c. market risk premium
d. b and c
e. a, b, and c

c.

19. The word risk developed from the early Italian word risicare and
means:
a. dont care
b. take a chance
c. to dare
d. to gamble

e.

20. The difference between average annual returns on common stocks and
returns on long-term government bonds is called a:
a. default risk premium
b. maturity premium
c. risk-free premium
d. liquidity premium

Chapter 7: Types and Costs of Financial Capital

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e. market risk premium


b.

21. What has been the approximate average annual rate of return on publicly
traded small company stocks since the mid-1920s?
a. 10%
b. 16%
c. 25%
d. 30%
e. 40%

e.

22. Venture investors generally use which one of the following target rates to
discount the projected cash flows of ventures in the development stage of
their life cycles:
a. 15%
b. 20%
c. 25%
d. 40%
e. 50%

e.

23. Corporate bonds might involve which of the following types of


premiums.
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity premium
e. all of the above
f. none of the above

e.

24. Which of the following venture life cycle stages would involve seasoned
financing rather than venture financing?
a. Development stage
b. Startup stage
c. Survival stage
d. Rapid-growth stage
e. Maturity stage

a.

25. A ventures riskiness in terms of possible poor performance or failure


would be considered to be very high in which of the following life cycle
stages:
a. Startup stage
b. Survival stage
c. Rapid-growth stage
d. Maturity stage

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Chapter 7: Types and Costs of Financial Capital

e.

26. Which of the following types of financing would be associated with the
highest target compound rate of return?
a. public and seasoned financing
b. second-round and mezzanine financing
c. first-round financing
d. startup financing
e. seed financing

b.

27. The cost of equity for a firm is 20%. If the real interest rate is 5%, the
inflation premium is 3%, and the market risk premium is 2%, what is the
investment risk premium for the firm?
a. 10%
b. 12%
c. 13%
d. 15%

b.

28. Use the SML model to calculate the cost of equity for a firm based on the
following information: the firms beta is 1.5; the risk free rate is 5%; the
market risk premium is 2%.
a. 4.5%
b. 8.0%
c. 9.5%
d. 10.5%

c.

29. Calculate the weighted average cost of capital (WACC) based on the
following information: the capital structure weights are 50% debt and 50%
equity; the interest rate on debt is 10%; the required return to equity holders is
20%; and the tax rate is 30%.
a. 7%
b. 10%
c. 13.5%
d. 17.5%
e. 20%

d.

30. Calculate the weighted average cost of capital (WACC) based on the
following information: the equity multiplier is 1.66; the interest rate on debt is
13%; the required return to equity holders is 22%; and the tax rate is 35%.
a. 11.5%
b. 13.9%
c. 15.0%
d. 16.6%

d.

31. Calculate the after-tax WACC based on the following information:


nominal interest rate on debt = 16%; cost of common equity = 30%; equity to
value = 60%; debt to value = 40%; and a tax rate = 25%.

Chapter 7: Types and Costs of Financial Capital

a.
b.
c.
d.
e.
c.

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10%
16%
19.8%
22.8%
30%

32. Calculate the after-tax WACC based on the following information:


nominal interest rate on debt = 12%; cost of common equity = 25%; common
equity = $700,000; interest-bearing debt = $300,000; and a tax rate = 25%.
a. 15%
b. 16.4%
c. 20.2%
d. 22.8%
e. 30%

Supplemental Problems related to Chapter 7 Appendix A (and Chapter 4


Appendix A)
b.

1. Estimate a firms NOPAT based on: Net sales = $2,000,000; EBIT =


$600,000; Net income = $20,000; and Effective tax rate = 30%.
a. $600,000
b. $420,000
c. $150,000
d. $70,000
e. $40,000

c.

2. Estimate a firms economic value added (EVA) based on: NOPAT =


$400,000; amount of financial capital used = $1,600,000; and WACC = 19%.
a. $26,000
b. $36,000
c. $96,000
d. $54,000
e. $64,000

d.

3. Find a ventures economic value added (EVA) based on the following


information: EBIT = $200,000; financial capital used = $500,000; WACC =
20%; effective tax rate = 30%.
a. $20,000
b. $25,000
c. $30,000
d. $40,000
e. $50,000