Retained earnings break point Answer: a HARD 42 . Assume that a firm’s total dollar capital budget is fixed and will not be changed. Which of the following will increase the retained earnings break point, i.e., increase the dollar amount of total capital at which the WACC will increase due to having to issue new common stock? a. The firm’s net income increases. b. The firm increases its dividend payout ratio. c. The firm increases the percentage of equity in its target capital structure. d. The risk of the average capital budgeting project increases. e. The risk of the average capital budgeting project decreases. Chapter 10: The Cost of Capital Page 67
Retained earnings break point Answer: e HARD 43 . Assume that a firm’s total dollar capital budget is fixed and will not be changed. Which of the following will decrease the retained earnings break point, i.e., decrease the dollar amount of total capital at which the WACC will increase due to having to issue new common stock? a. The firm decides to pay out a lower percentage of its income as dividends. b. The firm increases the amount of debt in its target capital structure. c. The average risk of projects in the capital budget decreases. d. The firm’s net income increases. e. The firm has been using preferred stock in its capital structure, but it now decides to stop financing with preferred stock and to replace the preferred with common equity. Cost of capital estimation Answer: e HARD 44 . Which of the following statements is CORRECT? a. The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity. b. The after-tax cost of debt that is used as the component cost when calculating the WACC is the average after-tax cost of the firm’s outstanding debt. c. Suppose some of a publicly-traded firm’s stockholders are not diversified; they hold only the one firm’s stock. In this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will not maximize the firm’s intrinsic values. d. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm’s cost of equity capital. e. The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity. Page 68 Chapter 10: The Cost of Capital
Cost of equity estimation Answer: d HARD 45 . Which of the following statements is CORRECT? a. Although some methods used to estimate the cost of equity are subject to severe difficulties, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agreed that its key inputs—beta, the risk-free rate, and the market risk premium—can be estimated with very little error.
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