A) Although some methods used to estimate the cost of equity are subject to severe limitations, 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 agree that its key inputs--beta, the risk-free rate, and the market risk premium--can be estimated with little error.
B) The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF model's logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain.
C) The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm's own cost of debt and its risk premium, can be found by using standardized and objective procedures.
D) Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity.
E) The DCF model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield.
G) A) and D)
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A) M should have the lower WACC because it is like most other companies, and investors like that fact.
B) M and W should have identical WACCs because their risks as measured by the standard deviation of returns are identical.
C) If M and W merge, then the merged firm MW should have a WACC that is a simple average of M's and W's WACCs.
D) Without additional information, it is impossible to predict what the merged firm's WACC would be if M and W merged.
E) Since M and W move counter cyclically to one another, if they merged, the merged firm's WACC would be less than the simple average of the two firms' WACCs.
G) C) and D)
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A) Increase the dividend payout ratio for the upcoming year.
B) Increase the percentage of debt in the target capital structure.
C) Increase the proposed capital budget.
D) Reduce the amount of short-term bank debt in order to increase the current ratio.
E) Reduce the percentage of debt in the target capital structure.
G) C) and E)
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A) 12.60%
B) 13.10%
C) 13.63%
D) 14.17%
E) 14.74%
G) C) and E)
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B) False
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B) False
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A) The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital.
B) The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt.
C) The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets.
D) There is an "opportunity cost" associated with using retained earnings, hence they are not "free."
E) The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year.
G) B) and E)
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B) False
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B) False
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A) The market risk premium declines.
B) The flotation costs associated with issuing new common stock increase.
C) The company's beta increases.
D) Expected inflation increases.
E) The flotation costs associated with issuing preferred stock increase.
G) A) and B)
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B) False
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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 should be used as the component cost when calculating the WACC is the average after-tax cost of all 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 reduce the firm's intrinsic value.
D) 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.
E) The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital.
G) C) and D)
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A) rs > re > rd > WACC.
B) re > rs > WACC > rd.
C) WACC > re > rs > rd.
D) rd > re > rs > WACC.
E) WACC > rd > rs > re.
G) A) and C)
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A) 8.15%
B) 8.48%
C) 8.82%
D) 9.17%
E) 9.54%
G) A) and C)
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B) False
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A) Project B, which is of below-average risk and has a return of 8.5%.
B) Project C, which is of above-average risk and has a return of 11%.
C) Project A, which is of average risk and has a return of 9%.
D) None of the projects should be accepted.
E) All of the projects should be accepted.
G) A) and E)
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A) Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.
B) The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes.
C) If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.
D) Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt.
E) Higher flotation costs tend to reduce the cost of equity capital.
G) C) and D)
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A) 9.06%
B) 9.44%
C) 9.84%
D) 10.23%
E) 10.64%
G) D) and E)
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A) The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever.
B) If the calculated beta underestimates the firm's true investment risk--i.e., if the forward-looking beta that investors think exists exceeds the historical beta--then the CAPM method based on the historical beta will produce an estimate of rs and thus WACC that is too high.
C) Beta measures market risk, which is, theoretically, the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm's stockholders are well diversified.
D) An advantage shared by both the DCF and CAPM methods when they are used to estimate the cost of equity is that they are both "objective" as opposed to "subjective," hence little or no judgment is required.
E) The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach.
G) B) and D)
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A) 7.16%
B) 7.54%
C) 7.93%
D) 8.35%
E) 8.79%
G) B) and D)
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