FIN 300 Exam 4 || with Errorless Solutions 100%.
What constitutes the before-tax cost of debt? How do you calculate the after-tax cost of debt?
correct answers a. The before-tax cost of debt is the Bondholders required rate of return. The
symbol used is rd.
b. After-tax cost of debt (rdT = rd(1-T). It is the relevant cost of new debt, taking into account
the tax deductibility of interest.
Explain the bond-yield plus risk-premium approach? correct answers a. It assumes that the return
on equity is related to rd.
b. Studies have shown that the return on equity for a particular firm is approximately 3 to 5
percentage points higher than its rd (before-tax cost of debt).
c. As a general rule of thumb, firms estimate rs by adding 3 to 5 percent to rd.
d. If rd = 10.0%, then, we might estimate the cost of retained earnings as
rs ≈ rd + 4% = 10% + 4% = 14.0%
Please compare the cost of internal equity to external equity; what causes the difference between
the two? correct answers a. Cost of retained earnings (internal equity) (rs)—return that common
stockholders require the firm to earn on the funds that have been retained and reinvested in the
firm rather than paid out as dividends
b. Cost of new (external) equity (re)—rate of return required by common stockholders after
considering the cost associated with issuing new stock (flotation costs)
c. External equity is higher than internal equity because the firm incurs floatation costs when it
issues new common stock. So, because of floatation costs, the cost of issuing common stock is
greater than the cost of retained earnings.
What is Investment Opportunity Schedule? How it is used in conjunction with Weighted
Average/Marginal Cost of Capital to decide on the optimal capital budget? correct answers a.
(IOS) - Graph of the firm's investment opportunities ranked in order of the projects' internal rates
of return (IRRs).
b. If the IOS produces an IRR > MCC that means that NPV > 0 and the project should be
accepted.
What is the relevant cost of debt? correct answers a. It is simply the after-tax cost of debt. The
symbol used is rdt.
b. Must account for the tax deductibility of interest
c. investors prefer to receive dividends now rather than receiving them in the future.
, What is the relation between target capital structure and stock price? correct answers a. Target
Capital Structure—the ideal mix of debt, preferred stock, and common equity with which the
firm plans to finance its investments.
b. Four factors that influence capital structure decisions:
· Firm's business risk
· Firm's tax position
· Financial flexibility
· Managerial attitude
c. The optimal capital structure maximizes the price of a firm's stock.
Define capital structure. correct answers a. the combination of debt and equity used to finance a
firm.
What is Business Risk? correct answers a. The risk associated with the firm's operations,
ignoring any financing effects.
b. Factors that affect business risk:
· Sales variability
· Input price variability
· Ability to adjust output prices with changes in input prices
· The extent to which costs are fixed, which is operating leverage
c. Business risk depends on business factors such as competition, product liability, and operating
leverage.
d. Single most important determinant of capital structure.
e. Variability of operating income.
Define the degree of operating, financial & total leverage. correct answers a. DOL - The
percentage change in operating income (EBIT) associated with a given percentage change in
sales. It gives an indication of business risk. (Airlines)
b. DFL - The percentage change in earnings available to common stockholders associated with a
given percentage change in EBIT. DFL gives an indication of financial risk.
c. DTL - The percentage change in EPS that results from a given percentage change in sales.
DTL gives an indication of combined risk.
What is the advantage of debt? correct answers a. To a point, the value of a firm increases as it
uses more debt.
b. Interest is tax-deductible expense, therefore using debt is less expensive than using stock to
finance the firm.
What constitutes the before-tax cost of debt? How do you calculate the after-tax cost of debt?
correct answers a. The before-tax cost of debt is the Bondholders required rate of return. The
symbol used is rd.
b. After-tax cost of debt (rdT = rd(1-T). It is the relevant cost of new debt, taking into account
the tax deductibility of interest.
Explain the bond-yield plus risk-premium approach? correct answers a. It assumes that the return
on equity is related to rd.
b. Studies have shown that the return on equity for a particular firm is approximately 3 to 5
percentage points higher than its rd (before-tax cost of debt).
c. As a general rule of thumb, firms estimate rs by adding 3 to 5 percent to rd.
d. If rd = 10.0%, then, we might estimate the cost of retained earnings as
rs ≈ rd + 4% = 10% + 4% = 14.0%
Please compare the cost of internal equity to external equity; what causes the difference between
the two? correct answers a. Cost of retained earnings (internal equity) (rs)—return that common
stockholders require the firm to earn on the funds that have been retained and reinvested in the
firm rather than paid out as dividends
b. Cost of new (external) equity (re)—rate of return required by common stockholders after
considering the cost associated with issuing new stock (flotation costs)
c. External equity is higher than internal equity because the firm incurs floatation costs when it
issues new common stock. So, because of floatation costs, the cost of issuing common stock is
greater than the cost of retained earnings.
What is Investment Opportunity Schedule? How it is used in conjunction with Weighted
Average/Marginal Cost of Capital to decide on the optimal capital budget? correct answers a.
(IOS) - Graph of the firm's investment opportunities ranked in order of the projects' internal rates
of return (IRRs).
b. If the IOS produces an IRR > MCC that means that NPV > 0 and the project should be
accepted.
What is the relevant cost of debt? correct answers a. It is simply the after-tax cost of debt. The
symbol used is rdt.
b. Must account for the tax deductibility of interest
c. investors prefer to receive dividends now rather than receiving them in the future.
, What is the relation between target capital structure and stock price? correct answers a. Target
Capital Structure—the ideal mix of debt, preferred stock, and common equity with which the
firm plans to finance its investments.
b. Four factors that influence capital structure decisions:
· Firm's business risk
· Firm's tax position
· Financial flexibility
· Managerial attitude
c. The optimal capital structure maximizes the price of a firm's stock.
Define capital structure. correct answers a. the combination of debt and equity used to finance a
firm.
What is Business Risk? correct answers a. The risk associated with the firm's operations,
ignoring any financing effects.
b. Factors that affect business risk:
· Sales variability
· Input price variability
· Ability to adjust output prices with changes in input prices
· The extent to which costs are fixed, which is operating leverage
c. Business risk depends on business factors such as competition, product liability, and operating
leverage.
d. Single most important determinant of capital structure.
e. Variability of operating income.
Define the degree of operating, financial & total leverage. correct answers a. DOL - The
percentage change in operating income (EBIT) associated with a given percentage change in
sales. It gives an indication of business risk. (Airlines)
b. DFL - The percentage change in earnings available to common stockholders associated with a
given percentage change in EBIT. DFL gives an indication of financial risk.
c. DTL - The percentage change in EPS that results from a given percentage change in sales.
DTL gives an indication of combined risk.
What is the advantage of debt? correct answers a. To a point, the value of a firm increases as it
uses more debt.
b. Interest is tax-deductible expense, therefore using debt is less expensive than using stock to
finance the firm.
