Chapter 12 - Cost of Capital
Chapter 12 Cost of Capital
Multiple Choice Questions
1. Katie owns 100 shares of ABC stock. Which one of the following terms is used to refer to the return that Katie and the other shareholders require on their investment in ABC? A. Weighted average cost of capital B. Pure play cost C. Cost of equity D. Subjective cost E. Cost of debt
2. Lester lent money to The Corner Store by purchasing bonds issued by the store. The rate of return that he and the other lenders require is referred to as the: A. pure play cost. B. cost of debt.
C. weighted average cost of capital. D. subjective cost. E. cost of equity.
3. The weighted average cost of capital is defined as the weighted average of a firm's: A. return on its investments.
B. cost of equity and its aftertax cost of debt. C. pretax cost of debt and equity securities. D. bond coupon rates.
E. dividend and capital gains yields.
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Chapter 12 - Cost of Capital
4. Farmer's Supply, Inc. is considering opening a clothing store, which would be a new line of business for the firm. Management has decided to use the cost of capital of a similar clothing store as the discount rate that should be used to evaluate this proposed expansion. Which one of the following terms is used to describe the approach Farmer's Supply is taking to establish an appropriate discount rate for the project? A. Equity approach B. Aftertax approach C. Subjective approach D. Market play
E. Pure play approach
5. Kate is the CFO of a major firm and has the job of assigning discount rates to each project that is under consideration. Kate's method of doing this is to assign an incrementally higher rate as the risk level of the project increases over that of the current firm. Likewise, she assigns lower rates as the risk level declines. Which one of the following approaches is Kate using to assign the discount rates? A. Pure play approach B. Divisional rating C. Subjective approach
D. Straight WACC approach E. Equity rating
6. Ted is trying to decide what cost of capital he should assign to a project. Which one of the following should be his primary consideration in this decision? A. Amount of debt used to finance the project
B. Use, or lack thereof, of preferred stock to finance the project C. Mix of funds used to finance the project D. Risk level of the project E. Length of the project's life
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Chapter 12 - Cost of Capital
7. Black Stone Furnaces wants to build a new facility. The cost of capital for this investment is primarily dependent upon which one of the following? A. Firm's overall source of funds
B. Source of the funds used to build the facility C. Current tax rate
D. The nature of the investment
E. Firm's historical average rate of return
8. Which one of the following statements is correct related to the dividend growth model approach to computing the cost of equity?
A. The rate of growth must exceed the required rate of return. B. The rate of return must be adjusted for taxes.
C. The annual dividend used in the computation must be for year one if you are using today's stock price to compute the return.
D. The cost of equity is equal to the return on the stock plus the risk-free rate.
E. The cost of equity is equal to the return on the stock multiplied by the stock's beta.
9. A firm has a return on equity of 12.4 percent according to the dividend growth model and a return of 18.7 percent according to the capital asset pricing model. The market rate of return is 13.5 percent. What rate should the firm use as the cost of equity when computing the firm's WACC?
A. 12.4 percent because it is lower than 18.7 percent B. 18.7 percent because it is higher than 12.4 percent
C. The arithmetic average of 12.4 percent and 18.7 percent
D. The arithmetic average of 12.4 percent, 13.5 percent, and 18.7 percent E. 13.5 percent
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Chapter 12 - Cost of Capital
10. Which of the following features are advantages of the dividend growth model? I. easy to understand II. model simplicity
III. constant dividend growth rate
IV. model's applicability to all common stocks A. II only
B. I and III only C. II and IV only D. I and II only E. I, II, and III only
11. Which of the following are weaknesses of the dividend growth model? I. market risk premium fluctuations II. lack of dividends for some firms III. reliance on historical beta
IV. sensitivity of model to dividend growth rate A. II only
B. I and II only C. I and III only D. II and IV only E. I, II, III, and IV
12. In an efficient market, the cost of equity for a risky firm does which one of the following according to the security market line?
A. Produces a return that will be less than the market rate but higher than the risk-free rate B. Equals the market rate of return for all stocks
C. Has a maximum cost equal to the market rate of return D. Decreases as the beta of the firm's stock increases
E. Increases in direct relation to the stock's systematic risk
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Chapter 12 - Cost of Capital
13. Which of the following will increase the cost of equity for a firm with a beta of 1.1? I. decrease in the security's beta
II. decrease in the market risk premium III. decrease in the risk-free rate IV. increase in the risk-free rate A. II only B. III only C. I and II only D. II and III only E. I and IV only
14. Which one of the following will increase the cost of equity, all else held constant? A. Increase in the dividend growth rate B. Decrease in beta
C. Decrease in future dividends D. Increase in stock price
E. Decrease in market risk premium
15. All else constant, which of the following will increase the aftertax cost of debt for a firm? I. increase in the yield to maturity of the firm's outstanding debt II. decrease in the yield to maturity of the firm's outstanding debt III. increase in the firm's tax rate IV. decrease in the firm's tax rate A. I only
B. I and III only C. I and IV only D. II and III only E. II and IV only
16. Which one of the following is the pre-tax cost of debt? A. Average coupon rate on the firm's outstanding bonds B. Coupon rate on the firm's latest bond issue
C. Weighted average yield-to-maturity on the firm's outstanding debt D. Average current yield on the firm's outstanding debt
E. Annual interest divided by the market price per bond for the latest bond issue
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