Question 1

The "pure play" approach to estimating a divisions WACC involves

Accepted Answer

The "pure play" approach involves comparing the division to free standing firms with businesses similar to the division in order to estimate an appropriate WACC.

Question 2

When calculating the cost of common equity, it is important to consider the common stock and retained earnings accounts separately.

Accepted Answer

When calculating the cost of common equity, the focus is on the cost to the company to issue new shares or the returns expected by investors, not on the accounting treatment of common stock and retained earnings.

Question 3

Difficulties in estimating a divisional cost of capital include

Accepted Answer

The answer of Difficulties in estimating a divisional cost of...

Question 4

Estimating a divisional cost of capital by comparing the division to a similar free-standing company is known as

Accepted Answer

Estimating a divisional cost of capital by comparing the division to a similar free-standing company is known as the "pure play" approach. Choice A (Divisional Average Cost of Capital approach) and Choice B (Segmental Capital Structure approach) are not commonly used terms in finance literature. Choice D (Project Specific Approach) is used to estimate the cost of capital for a specific project, not a division as a whole.

Question 5

Why is it important to use market-based weights rather than balance sheet weights when estimating a company's weighted average cost of capital?

Accepted Answer

The answer of Why is it important to use market-based...

Question 6

In most instances, as the amount of debt rises, the common stockholders will decrease their required rate of return.

Accepted Answer

As the amount of debt rises, the risk to the common stockholders also increases. Hence, they would require a higher rate of return to compensate for the increased risk, not a decrease.

Question 7

Plimoth Plantation's overall WACC is 11%. It has an opportunity to accept a project that involves nearly riskless cash flows, but will earn only 7%. This project will require a significant portion of the firm's capital. If Plimoth accepts this project,

Accepted Answer

The answer of Plimoth Plantation's overall WACC is 11%. It...

Question 8

Lott Bros Developers evaluates a great many small to medium size projects each year. Some are riskier than others. Lott Bros should probably

Accepted Answer

Using the company's overall WACC for all projects is appropriate when the projects are similar in risk to the company's existing operations. This approach saves time and resources compared to estimating discount rates for each project individually. It is also more consistent and easier to implement as it simplifies the decision-making process. Therefore, Lott Bros should use their overall WACC for all projects as it is a better option than the other choices.

Question 9

The average cost of capital is the appropriate rate to use when evaluating new investments, even though the new investments might be in a higher risk class.

Accepted Answer

The average cost of capital is not appropriate to use for evaluating new investments with higher risk. It should be adjusted based on the risk profile of the investment. Higher risk investments should have a higher required rate of return to compensate investors for the additional risk.

Question 10

The weighted cost of capital assumes that the company maintains a constant debt to equity ratio.

Accepted Answer

The weighted cost of capital assumes that the company maintains a constant debt to equity ratio because it calculates the cost of each type of capital (debt and equity) based on their respective proportions in the company's capital structure. Therefore, if the company were to change its debt to equity ratio, the weight of each type of capital would change and the weighted cost of capital would also change.

Question 11

Alio e Olio has restaurants throughout the United States, Canada, and Western Europe. It is considering a proposal to open several restaurants in major cities of India and China.

Accepted Answer

Evaluating projects in different regions at discount rates that reflect the risk inherent in those projects is the best option, as it considers the specific risks and opportunities of each location. The overall WACC may not accurately reflect the risk of investing in India and China, and using a lower discount rate may result in overvaluing the projects. Adjusting the discount rate for specific sources of funding is not necessary in this scenario.

Question 12

In theory using the same discount rate to evaluate all projects can lead to

Accepted Answer

Using the same discount rate to evaluate all projects can lead to rejection of low risk projects that should be accepted, acceptance of high risk projects that should be rejected, and control of efforts by employees with a vested interest in a project to manipulate the discount rate. Therefore, none of the options are ideal and all should be considered when using a single discount rate to evaluate multiple projects.

Question 13

The weighted average cost of capital is the minimum required return that must be earned on additional investment if firm value is to remain unchanged.

Accepted Answer

This statement is true. The weighted average cost of capital (WACC) represents the average cost of all the capital sources that a company uses to finance its operations, such as debt, equity, and preferred stock. By using a weighted average, the WACC reflects the proportion of each type of capital used, and the cost associated with each type. Companies need to earn a return on investment equal to or higher than the WACC to maintain or increase their value.

Question 14

A strong stock market and reasonably good earnings have caused the price of the firm's common stock to increase by 25%.

Accepted Answer

An increase in the price of a firm's common stock, all else being equal, lowers the cost of equity capital because the firm can raise a given amount of capital with fewer shares, effectively reducing the equity portion of its cost of capital.

Question 15

National Gridlock's capital structure consisted of $125 million of debt and $250 million of equity before it issued bonds to borrow an additional $125 million. The new funds will be used to finance infrastructure improvements and expansion. The company believes that the project will generate enough cash to retire 1/5 of the bonds each year. How do the borrowing and the repayment plan affect the discount rate(s) that should be used to evaluate this project?

Accepted Answer

The answer of National Gridlock's capital structure consisted of $125...

Question 16

Pilgrim's WACC is 12%. It has one opportunity to invest in a high risk project with an expected rate of return of 25%. It has another opportunity to lease a building to a government agency. The expected rate of return on the lease is 10%.

Accepted Answer

Ideally, Pilgrim should discount the cash flows from each project at a rate appropriate to its risk. The WACC of 12% is not appropriate to use for both projects since one project has a higher level of risk and expected return. Pilgrim should determine a separate discount rate for each project based on its risk profile, and then decide whether to accept or reject each project based on their respective net present values.

Question 17

Problems with using the same company-wide cost of capital for all projects potentially include

Accepted Answer

The problems with using the same company-wide cost of capital for all projects include biasing project selection toward high risk, high return projects, rejection of worthwhile low risk projects, and spending an unjustified amount of managerial time and effort justifying a lower cost of capital so that pet projects will be accepted. Therefore, all of the above options are correct.

Question 18

Which of the following circumstances would invalidate the constant cost of capital assumption?

Accepted Answer

A change in the marginal tax rate would affect the cost of debt and therefore invalidate the constant cost of capital assumption. The other options do not necessarily invalidate the constant cost of capital assumption.

Question 19

Which of the following is a good reason to use divisional costs of capital?

Accepted Answer

Divisional costs of capital are useful in businesses where the different divisions have well-defined lines of business with different risk characteristics. This makes it important to have separate costs of capital for each division to accurately evaluate the investment opportunity within each division. Choice A is incorrect as division managers may have an incentive to underestimate capital costs to make their division more attractive. Choice B is incorrect as estimating divisional costs of capital can be complex and time-consuming. Choice C is incorrect as comparison firms can also have well-defined lines of business, making it possible to use their cost of capital information.

Question 20

All things equal, as the tax rate increases, the incentive to use more debt financing increases.

Accepted Answer

This is because interest payments on debt are tax-deductible, meaning that as tax rates increase, the tax shield from debt increases, making it more attractive to use debt financing.

Quiz 14: The Cost of Capital