Question 1

Firms should use their weighted average cost of capital (WACC)when they are funding their capital projects with a variety of sources.However,when the firm plans on using only debt or only equity to fund a particular project,it should use the after-tax cost of the specific source of capital to evaluate that project.

Accepted Answer

The answer of Firms should use their weighted average cost...

Question 2

The firm's cost of capital represents the maximum rate of return earned on the firm's investments.

Accepted Answer

The firm's cost of capital represents the minimum rate of return required by investors in order to invest in the firm. It is not the maximum rate of return earned on the firm's investments.

Question 3

The cost of debt outstanding or the historical cost of debt is the appropriate component cost of debt that should be used in the firm's investments decisions.

Accepted Answer

The cost of debt outstanding or the historical cost of debt is not the appropriate component cost of debt that should be used in the firm's investment decisions. Instead, the current cost of debt or the yield to maturity on the firm's outstanding debt should be used as the component cost of debt in investment decisions.

Question 4

The investment opportunity schedule is a graph of the firm's investment opportunities ranked in order of the projects' expected rates of return.

Accepted Answer

The investment opportunity schedule is indeed a graph that ranks the firm's investment opportunities by their expected rates of return.

Question 5

Flotation costs lower the cost of capital to a firm when issuing new securities.

Accepted Answer

Flotation costs are the costs incurred by a company when issuing new securities, such as underwriting fees and legal expenses. These costs increase the cost of capital to a firm because they reduce the net amount of funds that the company receives from the sale of the securities. Therefore, flotation costs actually increase the cost of capital rather than lowering it.

Question 6

Publicly placed bonds do not typically involve flotation costs due to the availability of publicly placed funds,but privately placed debt typically does involve flotation costs because of the difficulty involved in raising private funds.

Accepted Answer

Publicly placed bonds are sold to the general public through investment banks, which charge a fee for their services. Privately placed bonds are sold to a small number of investors, and the issuer typically pays a fee to the placement agent.

Question 7

Retained earnings have no cost since the firm does not have to issue securities to raise retained earnings.

Accepted Answer

Retained earnings have a cost, which is the opportunity cost of not distributing the earnings to shareholders as dividends or using them to invest in other potentially profitable projects. Additionally, retaining earnings may limit the firm's ability to raise capital through external sources such as issuing securities.

Question 8

Only long-term debt should be used to compute the component cost of debt used in the WACC.

Accepted Answer

The component cost of debt used in the WACC should reflect only the cost of long-term debt because it represents the cost of borrowing for a longer period of time. Short-term debt may have lower interest rates, but it also includes the risk of interest rate fluctuations and uncertain refinancing options. Therefore, using short-term debt in the computation of the WACC may underestimate the true cost of capital for the company.

Question 9

Interest paid on corporate debt is tax deductible from the investor's point of view leading investors to accept a lower before-tax return on the corporation's debt.

Accepted Answer

Interest paid on corporate debt is tax deductible from the corporation's perspective, not the investor's. This allows corporations to offer lower interest rates on their debt, as the interest expense reduces their taxable income. Investors' tax obligations on received interest depend on their personal tax situations.

Question 10

The items in the asset section of the balance are its capital components.

Accepted Answer

The items in the asset section of the balance sheet are not capital components. They represent the resources owned by the company and can include cash, investments, property, and equipment. Capital components refer to the sources of a company's financing, such as common stock, retained earnings, and other long-term liabilities.

Question 11

The cost of capital used to evaluate investment opportunities should be calculated as a weighted average of the various types of funds generally used,regardless of the specific financing used to fund a particular project.

Accepted Answer

The cost of capital used to evaluate investment opportunities should indeed be calculated as a weighted average of the various types of funds generally used, regardless of the specific financing used to fund a particular project. This approach is known as the "weighted average cost of capital" (WACC) and takes into account the cost of equity, debt, and other sources of financing to determine the overall cost of capital for a company or project. This allows for a more accurate assessment of the true cost of funds and can help ensure that investment decisions are properly evaluated and justified.

Question 12

Retained earnings costs are lower than the costs of newly issued equity since a new issue will have flotation costs.

Accepted Answer

Flotation costs are fees and expenses incurred when a company issues new equity or debt securities. These costs can include underwriting fees, legal and accounting fees, and other administrative costs. Retained earnings, on the other hand, are profits that a company has made and kept instead of distributing them to shareholders as dividends. Since there are no external fees or expenses associated with retained earnings, their cost is generally lower than the cost of newly issued equity with flotation costs.

Question 13

The weighted average cost of capital should be used when making investment decisions regardless of the specific financing used to fund a project.

Accepted Answer

The weighted average cost of capital (WACC) is the minimum rate of return that a company must earn on its investments in order to satisfy its creditors, owners, and other stakeholders. By calculating the WACC, a company can determine whether a potential investment opportunity is worth pursuing or not. Since the WACC takes into account the costs of all sources of financing (debt and equity), it provides a more accurate estimate of the true cost of capital than using just one method of financing. Therefore, the WACC should be used as the discount rate when evaluating investment opportunities regardless of the specific financing used.

Question 14

The after-tax cost of debt is always less than the before-tax cost of debt for all firms.

Accepted Answer

The answer of The after-tax cost of debt is always...

Quiz 12: The Cost of Capital