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45

CHAPTER 7

TYPES AND COSTS OF FINANCIAL CAPITAL

True-False Questions

F.

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.

(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.

very high during the maturity stage of its life cycle.

T.

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

T.

from venture capitalists and investment banks.

F.

and investment bankers.

T.

rapid-growth stage of their life cycles.

T.

or failure decreases as it moves from its development stage through to its

rapid-growth stage.

T.

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.

46

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.

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.

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.

than small-company stocks

T.

return relative to its expected return.

F.

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

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.

the number of shares outstanding.

F.

common stock is called the market risk premium.

T.

weighted cost of raising equity and debt capital.

47

Multiple-Choice Questions

e.

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.

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.

a. interest on debt

b. dividends on stock

c. collateral on equity

d. a and b

e. a, b, and c

b.

a. real rate

48

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.

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

49

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)

50

a.

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

51

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.

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.

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

52

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.

nominal interest rate on debt = 16%; cost of common equity = 30%; equity to

value = 60%; debt to value = 40%; and a tax rate = 25%.

a.

b.

c.

d.

e.

c.

53

10%

16%

19.8%

22.8%

30%

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%

Appendix A)

b.

$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.

$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.

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

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