a. The cost of equity financing is greater than or equal to the cost of debt financing. b. The WACC exceeds the cost of equity financing. c. The WACC is calculated on a before-tax basis. d. The WACC represents the cost of capital based on historical aver- ages. In that sense, it does not represent the marginal cost of cap- ital. e. The cost of retained earnings exceeds the cost of issuing new common stock. Page 6 Chapter 10: Determining the Cost of Capital -
(10.11) Factors influencing WACC Answer: a Diff: E 31 . Wyden Brothers uses the CAPM to calculate the cost of equity capital. The company’s capital structure consists of common stock, preferred stock, and debt. Which of the following events will reduce the com- pany’s WACC? a. A reduction in the market risk premium. b. An increase in the risk-free rate. c. An increase in the company’s beta. d. An increase in expected inflation. e. An increase in the flotation costs associated with issuing preferred stock. Medium: (10.5) CAPM cost of equity estimation Answer: e Diff: M 32 . In applying the CAPM to estimate the cost of equity capital, which of the following elements is not subject to dispute or controversy? a. The expected rate of return on the market, r M . b. The stock's beta coefficient, b i . c. The risk-free rate, r RF . d. The market risk premium (RP M ). e. All of the above are subject to dispute. (10.6) CAPM and DCF estimation Answer: a Diff: M 33 . Which of the following statements is most correct? a. Beta measures market risk, but if a firm's stockholders are not well diversified, beta may not accurately measure stand-alone risk. b. If the calculated beta underestimates the firm's true investment risk, then the CAPM method will overestimate r s . c. The discounted cash flow method of estimating the cost of equity can't be used unless the growth component, g, is constant during the analysis period. d. An advantage shared by both the DCF and CAPM methods of estimating the cost of equity capital, is that they yield precise estimates and require little or no judgement. e. All of the statements above are false. Chapter 10: Determining the Cost of Capital Page 7
(10.8) Cost of equity estimation Answer: d Diff: M 34 . Which of the following statements is most correct? a. Although some methods of estimating the cost of equity capital en- counter severe difficulties, the CAPM is a simple and reliable model that provides great accuracy and consistency in estimating the cost of equity capital. b. The DCF model is preferred over other models to estimate the cost of equity because of the ease with which a firm's growth rate is ob- tained. c. The bond-yield-plus-risk-premium approach to estimating the cost of equity is not always accurate but its advantages are that it is a standardized and objective model. d. Depreciation-generated funds are an additional source of capital and, in fact, represent the largest single source of funds for some firms.