Questions For Chapter 12 In Corporate Finance

1. 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:

Pure play cost.

Cost of debt.

Weighted average cost of capital.

Subjective cost.

Cost of equity.

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 cost of debt. This is because when a company issues bonds, it agrees to pay interest to the bondholders, which represents the cost of borrowing for the company. The lenders, including Lester, expect to earn a return on their investment in the form of interest payments, making the cost of debt the correct answer.

Explanation

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 cost of debt. This is because when a company issues bonds, it agrees to pay interest to the bondholders, which represents the cost of borrowing for the company. The lenders, including Lester, expect to earn a return on their investment in the form of interest payments, making the cost of debt the correct answer.

2. 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?

Weighted average cost of capital

Pure play cost

Cost of equity

Subjective cost

Cost of debt

The return that Katie and the other shareholders require on their investment in ABC is referred to as the cost of equity. This represents the rate of return that shareholders expect to earn in order to compensate for the risk they are taking by investing in the company's stock. It is a measure of the cost of financing the company through equity and is calculated by considering the dividends expected to be received and the current market price of the stock.

Explanation

The return that Katie and the other shareholders require on their investment in ABC is referred to as the cost of equity. This represents the rate of return that shareholders expect to earn in order to compensate for the risk they are taking by investing in the company's stock. It is a measure of the cost of financing the company through equity and is calculated by considering the dividends expected to be received and the current market price of the stock.

3. The weighted average cost of capital is defined as the weighted average of a firm's:

Return on its investments.

Cost of equity and its aftertax cost of debt.

Pretax cost of debt and equity securities.

Bond coupon rates.

Dividend and capital gains yields.

The weighted average cost of capital (WACC) is a calculation that represents the average rate of return a company needs to earn on its investments in order to satisfy its investors. It is calculated by weighting the cost of equity and the aftertax cost of debt based on their respective proportions in the company's capital structure. The cost of equity represents the return required by shareholders, while the aftertax cost of debt represents the cost of borrowing for the company. By combining these two components, the WACC provides a comprehensive measure of the cost of financing for the company.

Explanation

The weighted average cost of capital (WACC) is a calculation that represents the average rate of return a company needs to earn on its investments in order to satisfy its investors. It is calculated by weighting the cost of equity and the aftertax cost of debt based on their respective proportions in the company's capital structure. The cost of equity represents the return required by shareholders, while the aftertax cost of debt represents the cost of borrowing for the company. By combining these two components, the WACC provides a comprehensive measure of the cost of financing for the company.

4. Which one of the following is the pre-tax cost of debt?

Average coupon rate on the firm's outstanding bonds

Coupon rate on the firm's latest bond issue

Weighted average yield-to-maturity on the firm's outstanding debt

Average current yield on the firm's outstanding debt

Annual interest divided by the market price per bond for the latest bond issue

The pre-tax cost of debt refers to the interest rate that a company pays on its debt before taking into account any tax benefits. The weighted average yield-to-maturity on the firm's outstanding debt represents the average return that investors expect to earn on the firm's debt securities until they mature. This yield-to-maturity takes into account the coupon rate and the market price of each bond, as well as the time remaining until maturity. Therefore, it is an appropriate measure to estimate the pre-tax cost of debt for the company.

Explanation

The pre-tax cost of debt refers to the interest rate that a company pays on its debt before taking into account any tax benefits. The weighted average yield-to-maturity on the firm's outstanding debt represents the average return that investors expect to earn on the firm's debt securities until they mature. This yield-to-maturity takes into account the coupon rate and the market price of each bond, as well as the time remaining until maturity. Therefore, it is an appropriate measure to estimate the pre-tax cost of debt for the company.

5. Which one of the following is the primary determinant of an investment's cost of capital?

Life of investment

Initial cash outlay

Level of risk

Source of funds used for the investment

Investment's net present value

The primary determinant of an investment's cost of capital is the level of risk. The cost of capital is the return that investors require in order to invest in a particular project. Higher levels of risk are associated with higher required returns, which in turn increases the cost of capital. This is because investors demand a higher return to compensate them for taking on additional risk. Therefore, the level of risk is a crucial factor in determining the cost of capital for an investment.

Explanation

The primary determinant of an investment's cost of capital is the level of risk. The cost of capital is the return that investors require in order to invest in a particular project. Higher levels of risk are associated with higher required returns, which in turn increases the cost of capital. This is because investors demand a higher return to compensate them for taking on additional risk. Therefore, the level of risk is a crucial factor in determining the cost of capital for an investment.

6. Which one of the following represents the rate of return a firm must earn on its assets if it is to maintain the current value of its securities?

Cost of equity

Internal rate of return

Aftertax cost of debt

Weighted average cost of capital

Debt-equity ratio

The weighted average cost of capital represents the rate of return a firm must earn on its assets in order to maintain the current value of its securities. It takes into account the cost of equity and the aftertax cost of debt, weighted by their respective proportions in the firm's capital structure. By calculating the weighted average cost of capital, the firm can determine the minimum rate of return it needs to generate in order to satisfy its investors and maintain the value of its securities.

Explanation

The weighted average cost of capital represents the rate of return a firm must earn on its assets in order to maintain the current value of its securities. It takes into account the cost of equity and the aftertax cost of debt, weighted by their respective proportions in the firm's capital structure. By calculating the weighted average cost of capital, the firm can determine the minimum rate of return it needs to generate in order to satisfy its investors and maintain the value of its securities.

7. In an efficient market, the cost of equity for a risky firm does which one of the following according to the security market line?

Produces a return that will be less than the market rate but higher than the risk-free rate

Equals the market rate of return for all stocks

Has a maximum cost equal to the market rate of return

Decreases as the beta of the firm's stock increases

Increases in direct relation to the stock's systematic risk

The cost of equity for a risky firm increases in direct relation to the stock's systematic risk. This means that as the firm's stock becomes riskier, the cost of equity also increases. The systematic risk of a stock is measured by its beta, which represents the stock's sensitivity to market movements. A higher beta indicates a higher systematic risk, and therefore a higher cost of equity. This relationship is consistent with the security market line, which shows the expected return of a stock based on its systematic risk.

Explanation

The cost of equity for a risky firm increases in direct relation to the stock's systematic risk. This means that as the firm's stock becomes riskier, the cost of equity also increases. The systematic risk of a stock is measured by its beta, which represents the stock's sensitivity to market movements. A higher beta indicates a higher systematic risk, and therefore a higher cost of equity. This relationship is consistent with the security market line, which shows the expected return of a stock based on its systematic risk.

8. The cost of preferred stock:

Increases when a firm's tax rate decreases.

Is constant over time.

Is unaffected by changes in the market price.

Is equal to the stock's dividend yield.

Increases as the price of the stock decreases.

The cost of preferred stock is equal to the stock's dividend yield. This means that the cost of preferred stock is determined by the dividend payments made to the stockholders. As the dividend yield increases, the cost of preferred stock also increases. Conversely, if the dividend yield decreases, the cost of preferred stock decreases. The other options are incorrect because they do not accurately represent the relationship between the cost of preferred stock and the stock's dividend yield.

Explanation

The cost of preferred stock is equal to the stock's dividend yield. This means that the cost of preferred stock is determined by the dividend payments made to the stockholders. As the dividend yield increases, the cost of preferred stock also increases. Conversely, if the dividend yield decreases, the cost of preferred stock decreases. The other options are incorrect because they do not accurately represent the relationship between the cost of preferred stock and the stock's dividend yield.