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Ijaz Tahir M.Com & M.

A (Econ)

Chapter 15
Required Returns and the Cost of Capital
Multiple choice questions
Q:1 A single, overall cost of capital is often used to evaluate projects because:

a. It avoids the problem of computing the required rate of return for each
investment
proposal.
b. It is the only way to measure a firm's required return.
c. It acknowledges that most new investment projects have about the
same degree of risk.
d. It acknowledges that most new investment projects offer about the
same expected return.

Q:2 The cost of equity capital is all of the following EXCEPT:

a. The minimum rate that a firm should earn on the equity-financed part
of an investment.
b. A return on the equity-financed portion of an investment that, at
worst,
leaves
the
market
price of the stock unchanged.
c. By far the most difficult component cost to estimate.
d. Generally lower than the before-tax cost of debt.

Q:3 In calculating the proportional amount of equity financing employed by a firm, we


should use:
a.
b.
c.
d.

The common stock equity account on the firm's balance sheet.


The sum of common stock and preferred stock on the balance sheet.
The book value of the firm.
The current market price per share of common stock times the number
of shares outstanding.

Q:4 To compute the required rate of return for equity in a company using the CAPM, it
is necessary to know all of the following EXCEPT:
a.
b.
c.
d.

The
The
The
The

risk-free rate.
beta for the firm.
earnings for the next time period.
market return expected for the time period.

Q:5 In calculating the costs of the individual components of a firm's financing, the
corporate tax rate is important to which of the following component cost formulas?
a.
b.
c.
d.

Common stock.
Debt.
Preferred stock.
None of the above.

Q:6 The common stock of a company must provide a higher expected return than the debt
of the same company because
a.
b.
c.
d.

There
There
There
There

is
is
is
is

less demand for stock than for bonds.


greater demand for stock than for bonds.
more systematic risk involved for the common stock.
a market premium required for bonds.

Q:7 A quick approximation of the typical firm's cost of equity may be calculated by

a. Adding a 5 percent risk premium to the firm's before-tax cost of debt.


b. Adding a 5 percent risk premium to the firm's after-tax cost of debt.
c. Subtracting a 5 percent risk discount from the firm's before-tax cost of
debt.
d. Subtracting a 5 percent risk discount from the firm's after-tax cost of
debt.

Q:8 Market values are often used in computing the weighted average cost of capital
because

a. This is the simplest way to do the calculation.


b. This is consistent with the goal of maximizing shareholder value.
c. This is required in the U.S. by the Securities and Exchange
Commission.
d. This is a very common mistake.

Q:9 For an all-equity financed firm, a project whose expected rate of return plots
should be rejected.
a.
b.
c.
d.

above the characteristic line


above the security market line
below the security market line
below the characteristic line

Ijaz Tahir M.Com & M.A (Econ)

Ijaz Tahir M.Com & M.A (Econ)

Q:10 Some projects that a firm accepts will undoubtedly result in zero or negative
returns. In light of this fact, it is best if the firm
a. Adjusts its hurdle rate (i.e., cost of capital) upward to compensate for
this fact.
b. Adjusts its hurdle rate (i.e., cost of capital) downward to compensate
for this fact.
c. Does not adjust its hurdle rate up or down regardless of this fact.
d. Raises its prices to compensate for this fact.

Q:11 One way to visualize the RADR approach is to make (new) use of an "old friend,"
the
.
a. Security Market Line (SML)
b. characteristic line
c. NPV profile

True or false questions


Q:1 The MINIMUM required rate of return for accepting any investment proposal should
be the one that keeps the common stock price (at the least) unchanged.

True
False

Q:2 A firm's overall cost of capital is simply the sum of the firm's cost of equity, cost of
debt, and cost of preferred stock.

True
False

Q:3 A bond's yield to maturity is the same thing as the before-tax cost of debt, kd.

True
False

Q:4 The cost of preferred stock formula is not adjusted for the tax effect because the
payment of preferred dividends occurs after taxes are paid.

True
False

Q:5 The tax advantage that comes from debt financing is of special benefit to a firm that
is losing money.

True
False

Q:6 The complexity of the CAPM is offset by the fact that it gives an exact measure of
the cost of equity capital.

True
False

Q:7 A good proxy for E(Rm), the expected return for the market, is the expected return on
a broad-based stock market index such as Standard and Poor's 500.

True
False

Q:8 In calculating financing weights, the book values of the various financing
components should be used, as they are consistent with the goal of maximizing
shareholders' wealth.

True
False

Q:9 The critical assumption in any cost of capital weighting system is that the firm will
raise funds in the future in the weighting proportions specified.

True
False

Q:10 A sometimes questionable assumption underlying the capital-asset pricing model


approach to project evaluation is that only the systematic risk of the firm is important.

True
False

Answers Multiple choice questions: 1- a 2-d 3-d 4-c 5-b 6-c 7-a
8-b 9-c 10-c 11-c
Answers True or false questions: 1-T 2-F 3-T 4 -T 5-F 6-F
7-T
8-F 9-T 10-T

Ijaz Tahir M.Com & M.A (Econ)