Section One Questions
This chapter presents a variety of concepts about the nature of cost of capital and how it is measured.
1. Cost of capital usually is expressed:
a. In percentage terms, as a percentage of the face value of the investment, h. in percentage terms, as a percentage of the amount invested.
c. In dollar terms, in real dollars.
d. In dollar terms, in nominal dollars.
2. The components of a company's capital structure include:
a. Accounts payable, long-term debt, and preferred stock.
h. Accounts payable, preferred stock, and common stock.
c. Accounts payable, long-term debt, and common stock.
d. Long-term debt, preferred stock, and common stock.
3. Cost of capital for an acquisition or a project is a function of:
a. The company's marginal overall cost, of capital.
b. The company's average overall cost of capital.
c. The company's marginal cost of equity capital.
d. The investment (the use to which the capital is put).
4. Which of the following items are referred to as the "time value of money"?
a. The expected 'teal" rate of return, expected inflation, and risk.
b. The expected "real'1 rate of return and expected inflation but not risk.
c. Expected inflation and risk but not the expected "real" rate of return.
d. The expected "real" rate of return and risk but not expected inflation.
5. Which of the following is a correct statement?
a. Cost of capital is based on market value and usually is stated in real terms.
b. Cost of capital is based on book value and usually is stated in real terms.
c. Cost of capital is based on market value and usually is stated in nominal terms.
d. Cost of capital is based on book value and usually is stated in nominal terms.
6. Which of the following terms are often (properly) interchangeable?
a. Cost of capital discount rate, and required rate of return.
b. Cost of capital and discount rate but not required rate of return.
c. Cost of capital and required rate of return but not discount rate.
d. Required rate of return and discount rate but not cost of capital.
7. Which of the following is used as a divisor to convert a single element of return to an esti mate of present value?
a. Cost of capital,
b. Discount rate.
c. Capitalization rate.
d. Required rate of return.
8. Cost of capital is market driven. True False
9. Cost of capital is based on historical returns. True False
10. The discount rate is the link that equates expected future returns for the life of the investment with the present value of the investment at a given date. True False
This chapter discusses using the cost of capital as the discount rate in valuation and project selection- It gives the present value formula and an example of applying it to estimate the value of a bond. It discusses briefly the relationship between a discount rate and a capitalization rate.
1. For valuation and capital investment project selection, what is the measure of economic in come on which most analysts today prefer to focus?
a. Net cash flow.
b. Net income.
c. EBIT.
d. EBITDA.
2. If a company's overall cost of capital is 10%, and a project the company is considering is riskier than the average of the company's overall risk, the rate at which the expected returns from the project should be discounted would be:
a. Less than 10%.
b. 10%.
c. More than 10%.
d. The rate that (he proposed project manager recommends.
3. The discount rate represents:
a. The reciprocal of the price/net cash flow ratio.
b. The total expected rate of return.
c. The current yield on the investment.
d. The reciprocal of the capitalization rate.
4. The procedure for using cost of capital to evaluate an acquisition is basically similar to the procedure used for project selection. True False
5. Cost of capital is used to convert expected future returns to present val ue. True False
6. Net cash flow is also referred to as:
A yield rate used to convert a single payment or measure of economic income into a present value is called:
["liven the following:
Face value of Interest rate on face val ue: Bond pays interest once a year, at end of year. Bond matures, from valuation date: Market yield on bonds of comparable risk and other characteristics as of valuation date:
I, Compute the value of this bond at the valuation date.
SI ,000 |
7% |
4 years |
10% |
9. What is the company's embedded cost of capital for this bond?
10. What is the company's market cost of capital for debt such as this?
This chapter defines net cash flow, both to equity and to invested capital, and explains why it is considered the preferred measure of return for valuation and capital budgeting. It also states that (he estimates of net cash (low should be probability-weighted expected values and shows how to calculate them.
MULTIPLE CHOICE QUESTIONS
1. Which of (he following must be subtracted from EBITDA to compute net cash How to in vested capital?
a. Depreciation, interest (tax-affected), capital expenditures, and additions to working
capital.
b. Depreciation, capital expenditures, and addition to working capital but not interest
c. Capital expenditures, additions to working capital, and interest (tax-affected) but not depreciation.
d. Capital expenditures and additions to working capital, but neither depreciation nor interest.
2. The net cash flows that theoretically should be discounted in future periods are:
a. The most likely outcomes.
b. Amounts based on extrapolation of historical net cash flows.
c. The probability-weighted expected values.
d. The most conservative estimates of net cash flows.
3. In a symmetrical distribution of possible outcomes, the cash most likely to occur is the expected value of the probability distribution. True False
4. Net cash flow is the amount of money available to be distxibuted ise. Tine False
5. Net cash flow* is the economic income measure for which we have the best historical data available for estimating cost of equity capital. True False
Use the following balance sheet and income statement for questions 6 and 7.
Current Assets $ 1,000,000
Furniture, fixtures, & equipment (net of depreciation) 500,000
Total Assets $1,500,000
Liabilities and Equity
Accounts payable 200,000
Current portion of lone-term debt 100.000
Total current liabilities $300,000
Long-term debt 400,000
Stockholders' equity 800,000
Total liabilities and equity $1,500,000
KC
Revenue S9,000,000
Cost of direct labor ...A^jOO^OOO
Gross margin 5,400,000
General & administrative expenses:
Depreciation $100,000
Other G& A ...1,700,000 ...3,800,000
Operating profit 81,600,000
Interest expense 50.000
Pretax income 51,550,000
Corporate income taxes (federal and state) .... 620,000
income .. $930,000
Assume the following:
Target working capital: 8% of last year's revenue Expected capital expenditures: $120,000
6. Compute the net cash flow to equity.
7. Compute the net cash flow to invested capi Lai.
"liven the following distribution of possible outcomes (unrelated to questions 6 and ;ompute tlie expected value (probability-weighted value):
-SI 00 |
10% |
0 |
20% |
+$100 |
40% |
+$150 |
20% |
+$200 |
10% |
9. What is tlie most likely outcome of the above distribution?
Chapter 2 briefly introduced the present value formula, which is at the heart of the discounting method, while this chapter presents the capitalization method. The reason the discounting method was presented first, even though the capitalization method is simpler, is that the capitalization method is merely a shortcut version of the discounting method. The student should have a firm understanding of the discounting metliod to intelligently determine whether results produced by the capitalization method are within a reasonable range of value.
This chapter presents the functional relationship between discounting and capitalizing and a formula for converting a discount rate to a capitalization rate if certain assumptions are met It also introduces trie Gordon Growth Model. Tf shows how discounting and capitalization models can be combined by using a capitalization model for the "terminal value" in a discounting model
Finally, the chapter introduces the "midyear convention," which assumes that cash flows are realized more or less evenly throughout the year rather than at the end of the year.
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Section One Questions