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Unformatted text preview: STUDENT QUESTIONS FOR CHAPTERS 9 – 11 QUIZZES CHAPTER 9: THE COST OF CAPITAL Stephan’s Question Question 5:- Answer c: “there is no cost associated with retained earnings”. Does this imply no flotation cost, because that would be true?- Answer b: “The WACC depends upon the component costs of existing capital”. On page 291 of the textbook, the last paragraph of the Composite, or WACC section: “these costs depend more on the future weights that investors expect than the current weights, which fluctuate due to market conditions” As a result, I thought this implied this was correct. My Response 5. Which of the following statements is most correct ? a. The WACC is an after-tax cost of capital. This is most correct. b. The WACC depends upon the component costs of existing capital. Not correct – it depends on the cost of raising capital in the FUTURE. c. There is no cost associated with retained earnings. False. There is an opportunity cost. d. Both A and B are correct. False. e. Both A and C are correct. False. Answer is A Stephan’s Question Question 8:- I also thought answer ‘e’ was correct. As r(b) is 13.5% and r(a) is 10.5%, should not division b have more stand alone risk? My Response 8. Schubert Technologies has two divisions of equal size. Division A has a beta of 0.9, while Division B has a beta of 1.5. Schubert has no debt, and is completely equity- financed. The real risk-free rate is 6%, and the market risk premium is 5%. Schubert performs proper risk adjustment on projects according to their risk. In other words, projects in Division A are discounted at A's required return, and Division B's projects are discounted at B's required return. Which of the following statements is most correct ? a. Division B has a lower cost of capital than does Division A. False. r A = 6+ 0.9(5) = 10.5% r B = 6+ 1.5(5) = 13.5% b. All else equal, Division B's required return would increase by a greater amount than would Division A's required return if the risk-free rate increased by 1%. False. They would both increase by the same amount…1%. r A = 7+ 0.9(5) = 11.5% r B = 7+ 1.5(5) = 14.5% c. If the firm used a composite WACC to both divisions, this would result in too many Division B projects being accepted and too few Division A projects being accepted. True r A = 10.5% r B = 13.5% r Average = 12.0% If the firm used 12% to evaluate all projects, then it could incorrectly accept projects in Division B and incorrectly reject projects in division A. d. The overall composite WACC must be less than 12%, because the cost of debt (which is not given in the problem) must be less than that of the cost of equity. False. The problem states that the firm has no debt....
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This note was uploaded on 06/22/2008 for the course FIN 3450 taught by Professor Gomez during the Spring '08 term at Florida College.
- Spring '08
- Cost Of Capital