Multiple Choice: Conceptual

a. r_s > r_e > r_d > WACC.

b. r_e > r_s > WACC > r_d.

c. WACC > r_e > r_s > r_d.

d. r_d > r_e > r_s > WACC.

e. WACC > r_d > r_s > r_e.

a. The market risk premium (RP_M).

b. The beta coefficient, b_i, of a relatively safe stock.

c. The most appropriate risk-free rate, r_RF.

d. The expected rate of return on the market, r_M.

e. The beta coefficient of “the market,” which is the same as the beta of an average stock.

a. Project B, which is of below-average risk and has a return of 8.5%.

d. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized.

e. If a company’s tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall.

a. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.

d. Its cost of retained earnings is the rate of return stockholders require on a firm’s common stock.

d. If a company’s tax rate increases, then, all else equal, its weighted average cost of capital will decline.

e. The WACC that should be used in capital budgeting is the firm’s marginal, after-tax cost of capital.

d. The cost of equity is always equal to or greater than the cost of debt.

d. The "break point" as discussed in the text refers to the point where the firm has raised so much capital that it has exhausted its supply of new retained earnings and thus must raise equity by issuing stock.

b. A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm’s stockholders would themselves expect to earn a return on earnings that were paid out rather than retained and reinvested.

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.

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.

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. The relevant WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm’s target capital structure.

e. Project A has a standard deviation of expected returns of 20%, while Project B’s standard deviation is only 10%. A’s returns are negatively correlated with both the firm’s other assets and the returns on most stocks in the economy, while B’s returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital.