Practice Midterm I - Practice Midterm I - Financial...

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1 . For a typical firm, which of the following is correct? All rates are after taxes, and assume the firm operates at its target capital structure. a. r d > r e > r s > WACC. b. r s > r e > r d > WACC. c. WACC > r e > r s > r d . d. r e > r s > WACC > r d . e. WACC > r d > r s > r e . 2 . Which of the following statements is CORRECT? a. The WACC is calculated using before-tax costs for all components. b. The after-tax cost of debt usually exceeds the after-tax cost of equity. c. The WACC that should be used in capital budgeting is the firm’s marginal, after-tax cost of capital. d. Retained earnings that were generated in the past and are reflected on the firm’s balance sheet are generally available to finance the firm’s capital budget during the coming year. e. The after-tax cost of debt is generally more expensive than the after-tax cost of preferred stock. 3 . Which of the following statements is CORRECT? a. Since debt capital is riskier than equity capital, the after-tax cost of debt is always greater than the WACC. b. Because of the risk of bankruptcy, the cost of debt capital is always higher than the cost of equity capital. c. If a company assigns the same cost of capital to all of its projects regardless of the project’s risk, then it follows that the company will tend to reject some safe projects that it actually should accept and accept some risky projects that it should reject. d. Because companies’ flotation costs are not required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt. e. Higher flotation costs tend to reduce the cost of equity capital. 4 . The Nunnally Company has equal amounts of low-risk, average-risk, and high-risk projects. Nunnally estimates that its overall WACC is 12%. The CFO believes that this is the correct WACC for the company’s average-risk projects, but that a lower rate should be used for lower risk projects and a higher rate for higher risk projects. However, the CEO argues that, even though the company’s projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO’s opinion is followed, what is likely to happen over time? a. The company will take on too many low-risk projects and reject too many high-risk projects. b. The company will take on too many high-risk projects and reject too many low-risk projects. c. Things will generally even out over time, and, therefore, the firm’s risk should remain constant over time. d. The company’s overall WACC should decrease over time because its stock price should be increasing. e.
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