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Multiple Choice

1. The cost of capital should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets.

a. True
b. False

Answer: ___________ _________________

2. The cost of common stock is the rate of return the marginal stockholder requires on the firm's common stock.

a. True
b. False

Answer: ______________ ______________

3. For capital budgeting and cost of capital purposes, the firm should always consider retained earnings as the first source of capital, i.e., use these funds first, because retained earnings have no cost to the firm.

a. True
b. False

Answer: ____________________________

4. If a firm's marginal tax rate is increased, this would, other things held constant, increase the cost of debt used to calculate its WACC.

a. True
b. False

Answer: ____________________________

5. In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project.

a. True
b. False

Answer: ____________________________

6. You have funds that you want to invest in bonds, and you just noticed in the financial pages of the local newspaper that you can buy a $1,000 par value bond for $800. The coupon rate is 10% (with annual payments), and there are 10 years before the bond will mature and pay off its $1,000 par value. You should buy the bond if your required return on bonds with this risk is 12%.

a. True
b. False

Answer: ____________________________

7. The payment made each period on an amortized loan is constant, and it consists of some interest and some principal. The closer we are to the end of the loan's life, the greater the percentage of the payment that will be a repayment of principal.

a. True
b. False

Answer: ____________________________

8. If a bank compounds savings accounts quarterly, the nominal rate will exceed the effective annual rate.

a. True
b. False

Answer: ____________________________

9. The present value of a future sum decreases as either the discount rate or the number of periods per year increases.

a. True
b. False

Answer: ____________________________

10. A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically, calls are exercised if interest rates rise, because when rates rise the bondholder can get the principal amount back and reinvest it elsewhere at higher rates.

a. True
b. False

Answer: ____________________________

11. The market value of any real or financial asset, including stocks, bonds, or art work purchased in hope of selling it at a profit, may be estimated by determining future cash flows and then discounting them back to the present.

a. True
b. False

Answer: ____________________________

12. Because short-term interest rates are much more volatile than long-term rates, you would, in the real world, generally be subject to much more interest rate price risk if you purchased a 90-day Tbill than if you bought a 30-year Treasury bond.

a. True
b. False

Answer: ____________________________

13. According to the nonconstant growth model discussed in the Financial Management course, the discount rate used to find the present value of the expected cash flows during the initial growth period is the same as the discount rate used to find the Present Values of cash flows during the subsequent constant growth period.

a. True
b. False

Answer: ____________________________

14. If an investor buys enough stocks, he or she can, through diversification, eliminate all of the market risk inherent in owning stocks, but as a general rule it will not be possible to eliminate all company-specific risk.

a. True
b. False

Answer: ____________________________

15. If the returns of two firms are negatively correlated, then one of them must have a negative beta.

a. True
b. False

Answer: ____________________________

Solution Summary

The solution explains various multiple choice questions relating to cost of capital, cost of stock, WACC, bond return, compounding and present value

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