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Unformatted text preview: 9-1Probable Effect onkd(1 - T) ksWACCa. The corporate tax rate is lowered.+ 0 + b. The Federal Reserve tightens credit.+ + + c. The firm uses more debt; that is, it increases its debt/assets ratio.+ + 0 d. The dividend payout ratio is increased. 0 0 0 e. The firm doubles the amount of capital it raises during the year. 0 or + 0 or + 0 or +f. The firm expands into a risky new area. + + + g. The firm merges with another firm whose earnings are counter-cyclicalboth to those of the first firm andto the stock market. - - - h. The stock market falls drastically, and the firm’s stock falls along with the rest. 0 + + i. Investors become more risk averse.+ + + j. The firm is an electric utility with a large investment in nuclear plants.Several states propose a ban on nuclear power generation.+ + + 9-2Beta (market) risk refers to the project’s effect on the corporate beta coefficient. Within-firm (corporate) risk refers to the project’s effect on the stability of the firm’s earnings. Stand-alone risk Answers and Solutions: 9 - 1ANSWERS TO END-OF-CHAPTER QUESTIONS: Chapter 9refers to the inherent riskiness of the project’s expected returns when viewed alone. Theoretically, beta (market) risk is the most relevant measure because of its effect on stock prices.9-3The cost of capital for average-risk projects would be the firm’s cost of capital, 10 percent. A somewhat higher cost would be used for more risky projects, and a lower cost would be used for less risky ones. For example, we might use 12 percent for more risky projects and 9 percent for less risky projects. These choices are arbitrary.9-4Each firm has an optimal capital structure, defined as that mix of debt, preferred, and common equity that causes its stock price to be maximized. A value-maximizing firm will determine its optimal capital structure, use it as a target, and then raise new capital in a manner designed to keep the actual capital structure on target over time. The target proportions of debt, preferred stock, and common equity, along with the costs of those components, are used to calculate the firm’s weighted average cost of capital, WACC.The weights could be based either on the accounting values shown on the firm’s balance sheet (book values) or on the market values of the different securities. Theoretically, the weights should be based on market values, but if a firm’s book value weights are reasonably close to its market value weights, book value weights can be used as a proxy for market value weights. Consequently, target market value weights should be used in the WACC equation.9-5An increase in the risk-free rate will increase the cost of debt. Remember from Chapter 4, k = kRF+ DRP + LP + MRP. Thus, if kRF increases so does k (the cost of debt). Similarly, if the risk-free rate increases so does the cost of equity. From the CAPM equation, ks= kRF+ (kM– kRF)b. Consequently, if kRFincreases kswill increase too....
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This note was uploaded on 05/10/2010 for the course FMT 0438310384 taught by Professor Hung during the Spring '10 term at Aarhus Universitet, Aarhus.
- Spring '10