Module 6 Conceptuals

Which of the following statements is not (or least) correct?

• Because of the tax shelter created by issuing preferred stock dividends (remember that 70 percent of dividends are excluded from taxes), the firm’s after-tax cost of preferred stock may be significantly less than its before-tax cost

• The weighted average cost of embedded/historical capital (capital already raised by the firm) will have little significance when the firm looks at taking on new projects that will require them to issue additional capita

• Assume that a firm is comprised of two divisions that differ significantly in risk and, therefore, in terms of their divisional screening rates. If the firm evaluates all investments by using a weighted average corporate cost of capital (rather than using divisional screening rates), the firm is likely to become more risky by taking on more of the higher-risk projects and become less valuable by taking on projects that earn a rate of return that is less than what they should be earned based on the actual risk of the project.

• Flotation costs may not be a significant factor for a firm’s bonds, since many bond issues are privately placed (sold to institutional investors) with minimal administrative expense. That is, the firm essentially nets what the institutional investor pays.

• Flotation costs may be a significant factor when a firm issues new shares of common stock. If so, the firm’s cost of equity (new issues of common stock) will be higher than the firm’s cost of retained earnings, but the firm’s cost of retained earnings will still be equal to the investors’ required rate of return on the firm’s common stock

If a U.S. company with two divisions, one very risky and the other with significantly less risky, uses the same corporate discount rate to evaluate all projects, the most likely outcome, as discussed in class, is that the firm will become:

• Riskier over time, and its value will decline.

• Riskier over time, and its value will rise.

• Less risky over time, and its value will rise.

• Less risky over time, and its value will decline.

• There is no reason to expect its risk position or value to change over time as a result of its use of a single discount rate

A firm is considering the purchase of an asset whose risk is greater than the current risk of the firm, based on any method for assessing risk. In evaluating this asset, the decision maker should:

• Increase the IRR of the asset to reflect the greater risk.

• Increase the NPV of the asset to reflect the greater risk.

• Reject the asset, since its acceptance would increase the risk of the firm.

• Ignore the risk differential if the asset to be accepted would comprise only a small fraction of the total assets of the firm.

• Increase the cost of capital used to evaluate the project to reflect the higher risk of the project.

Select the statement that is most correct.

• Since most stock is privately placed, a firm’s required rate of return for a new issue of common stock will be equal to the investors’ required rate of return for that same issue.

• The WACC represents the historical cost of capital and is usually calculated on a before-tax basis.

• When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are tax deductible.

• Since the money is readily available, the cost of retained earnings is usually a lot cheaper than the cost of debt financing.

• When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are tax deductible.

Select the statement that is most correct.

• When a bond’s coupon rate is greater than its yield to maturity, the coupon rate should be used as the firm’s before-tax cost of debt.

• All other things equal (including component costs), a higher tax rate will lower a firm’s WACC only if the firm uses debt financing.

• While higher-than-average risk projects require discounting cash flows at a rate above the firm’s WACC, it is usually not appropriate to discount lower-thanaverage risk projects at a rate below the firm’s WACC.

• Even if project risks vary widely within a firm, a project’s cash flows should always be discounted at the corporate cost of capital (WACC).

• Because of the sheer size of large, publicly traded firms, it is more difficult to use the CAPM to estimate their cost of equity than to estimate it for small, privately held firms.

Which of the following statements is most correct?

• An increase in the corporate tax rate, all other factors held constant, should lead to an increase in a firm’s weighted average cost of capital.

• A firm can lower its component cost of debt simply by issuing debt with a lower coupon rate.

• The “enterprise” value of the firm can be found by taking the free cash flow available to all investor’s and discounting it at the firm’s weighted average cost of capital.

• Since most equity is privately placed for publicly traded corporations, flotation costs are negligible, and the firm’s cost of a new issue of common stock will be, therefore, essentially the same as the investor’s required rate of return.

• Since the market value of the firm’s debt and equity will continuously change throughout the day, and since the firm’s book value of debt and equity is much more stable over time, the firm should use book value weight to define its optimal capital structure.

Which of the following statements is most correct?

• If a company’s tax rate increases but the yield to maturity of its noncallable bonds remains the same, then, all other factors held constant, the firm’s WACC should decrease.

• If the beta of a company’s equity decreases, then, even when flotation costs have been accounted for, it is possible for a company to achieve a lower WACC by issuing new shares of common stock to meet its equity needs, rather than relying upon retained earnings to meet those needs.

• Typically, the before-tax cost of debt financing exceeds the after-tax cost of equity financing.

• Since the firm retains any earnings that are not needed to be paid out as dividends, the cost of retained earnings is usually much cheaper that the cost of debt financing.

• All of the statements above are incorrect.

Which of the following statements is correct (most correct)?

• Since there are no flotation costs associated with it, the cost of retained earnings will always be less than the after-tax cost of debt financing.

• When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are tax deductible for the issuing firm.

• If a company’s tax rate increases then, all else equal, the company’s weighted average cost of capital will also increase.

• A decrease in the risk-free rate, all else equal, will likely increase the marginal costs of both debt and equity securities.

• A company’s targeted capital structure will affect its cost of capital. Changes from the target may cause the weighted average cost of capital to either increase or decrease.

Select the statement that is most correct.

• The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC.

• The total return on a share of stock refers to the dividend yield less any commissions paid when the stock is purchased and sold.

• The cost of issuing preferred stock by a corporation must be adjusted to an after-tax figure because of the 70 percent dividend exclusion provision for corporations holding other corporations' preferred stock.

• The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.

• The component costs of capital are market-determined variables in as much as they are based on investors' required returns.