Chapter 012 The WeightedAverage Cost of Capital and Company Valuation
True / False QuestionsNew projects can be evaluated using the company cost of capital
providing that the:
1. Capital structure in essence is a firm's mix of long-term financing.
2. The company cost of capital is the expected rate of return that investors demand from the
company's assets and operations.
3. Amazon.com exhibits lower weighted-average cost of capital than Intel.
4. Weighted-average cost of capital is the expected rate of return on a portfolio of all the
firm's securities, adjusted for tax savings due to interest payments.
5. If a project has zero NPV when the expected cash flows are discounted at the weighted-
average cost of capital, then the project's cash flows are just sufficient to give debtholders and
shareholders the return they require.
6. McDonalds' weighted-average cost of capital is lower than that of Wal-Mart.
7. There are two costs of debt finance. The explicit cost of debt is the rate of interest that
bondholders demand. But there is also an implicit cost, because over-borrowing increases the
required rate of return to equity.
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8. The weighted-average cost of capital is the return the company needs to earn after tax in
order to satisfy all its security holders.
9. If the firm decreases its debt ratio, both the debt and the equity will become more risky. The
debtholders and equityholders require a higher return to compensate for the increased risk.
10. If we ignore taxes, the overall cost of capital will stay constant as the fractions of debt and
11. The company cost of capital does not make an adjustment for the tax effect.
12. The riskiness of equity securities typically exceeds that of debt securities for firms.
13. Calculation of company costs of capital should be conducted with market values
14. Interest tax shields are available to the firm on debt and preferred stock but not on
15. New projects should only be undertaken by firms if they have the same risk as existing
16. Projects that have a zero NPV when calculated at the WACC will provide sufficient
returns to all stakeholders.
17. As a firm changes to a higher debt ratio, debtholders are likely to demand higher rates of
18. An increase in a firm's debt ratio will have no effect on the required rate of return for
19. Afirm's cost of capital can be used in valuation of every new project they encounter,
regardless of its risk.
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20. The mix of a company's short-term financing is referred to as its capital structure.
21. To the company, the cost of interest payments on bonds (issued debt) is reduced by the
amount of tax savings.
22. The interest tax shield generated by a project's actual equity financing is accounted for by
using the after-tax cost of equity in the WACC.
23. Assuming a project has the same risk and financing as the firm, it will have a positive
NPV if its rate of return is greater than the firm's WACC.
24. For most healthy firms, the YTM on their bonds is the rate of return investors expect from
holding their bonds.
25. One way to check the correctness of the expected return on bonds is through the bond
26. The WACC is the rate of return that the firm must expect to earn on its average-risk
investments in order to provide an acceptable return to its security holders.
27. When using the WACC as a discount rate, it is often adjusted upward for riskier projects
and downward for safer projects.
28. Achange in the company's capital structure will change the amount of taxes paid but will
not change the WACC.
Multiple Choice Questions
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29. Capital structure decisions refer to the:
A. dividend yield of the firm's stock.
B. blend of equity and debt used by the firm.
C. capital gains available on the firm's stock.
D. maturity date for the firm's securities.
30. What appears to be the targeted debt ratio of a firm that issues $15 million in bonds and
$35 million in equity to finance its new capital projects?
31. Proposed assets can be evaluated using the company cost of capital providing that the:
A. firm does not pay taxes.
B. firm is all equity financed.
C. cost of debt is less than the cost of equity.
D. new assets have the same risk as existing assets.
32. The company cost of capital for a firm with a 65/35 debt/equity split, 8% cost of debt,
15% cost of equity, and a 35% tax rate would be:
0.65x 8% + 0.35 x 15% = 10.45%
33. The company cost of capital, after tax, for a firm with a 65/35 debt/equity split, 8% cost
of debt, 15% cost of equity, and a 35% tax rate would be:
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