e. None of the statements above is correct. Page 6 Chapter 10: Determining the Cost of Capital -
(10.8) CAPM cost of equity estimation Answer: Diff: M 35 . Which of the following statements is most correct? a. The CAPM approach to estimating a firm's cost of common stock never gives a better estimate than the DCF approach. b. The CAPM approach is typically used to estimate a firm's cost of preferred stock. c. The risk premium used in the bond-yield-plus-risk-premium method is the same as the one used in the CAPM method. d. In practice (as opposed to in theory), the DCF method and the CAPM method usually produce exactly the same estimate for r s . e. The statements above are all false. (10.8) Miscellaneous concepts Answer: Diff: M 36 . Which of the following statements is most correct? a. Suppose a firm is losing money and thus, is not paying taxes, and that this situation is expected to persist for a few years whether or not the firm uses debt financing. Then the firm's after-tax cost of debt will equal its before-tax cost of debt. b. The component cost of preferred stock is expressed as r ps (1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of debt interest. c. The reason that a cost is assigned to retained earnings is because these funds are already earning a return in the business; the reason does not involve the opportunity cost principle. d. The bond-yield-plus-risk-premium approach to estimating a firm's cost of common equity involves adding a subjectively determined risk-premium to the market risk-free bond rate. e. All of the statements above are false. (10.8) Miscellaneous concepts Answer: Diff: M 37 . Which of the following statements is most correct? a. The before-tax cost of preferred stock may be lower than the before-tax cost of debt, even though preferred stock is riskier than debt. b. If a company's stock price increases, this increases its cost of common stock. c. If the cost of equity capital increases, it must be due to an increase in the firm's beta. d. Statements a and b are correct. e. Answers a, b, and c are correct. (10.10) Capital components Answer: Diff: M 38 . Which of the following statements is most correct? a. Capital components are the types of capital used by firms to raise money. All capital comes from one of three components: long-term debt, preferred stock, and equity. b. Preferred stock does not involve any adjustment for flotation cost since the dividend and price are fixed. c. The cost of debt used in calculating the WACC is an average of the after-tax cost of new debt and of outstanding debt. d. The opportunity cost principle implies that if the firm cannot invest retained earnings and earn at least r s , it should pay these funds to its stockholders and let them invest directly in other assets that do provide this return.