Cost of Capital: A Comprehensive Guide for Finance Students

Question 1

The risk premium in the Capital Asset Pricing Model (CAPM) is:

Accepted Answer

The difference between the expected return on the risk-free asset and the expected return on the market

Answer

The expected return on the risk-free asset

Answer

The expected return on the market

Answer

The expected return on the company's stock

Question 2

The optimal capital structure is the one that minimizes:

Accepted Answer

WACC

Answer

Cost of equity

Answer

Cost of debt

Answer

Capital gains tax

Question 3

Which of the following is NOT a factor to consider when determining the target debt-to-equity ratio?

Accepted Answer

Expected inflation rate

Answer

Industry norms

Answer

Credit rating

Answer

Company size

Question 4

Which of the following is **NOT** a component of the cost of equity?

Accepted Answer

Debt-to-asset ratio

Answer

Dividend yield

Answer

Capital gains yield

Answer

Risk premium

Question 5

What is the purpose of calculating the weighted average cost of capital (WACC)?

Accepted Answer

To determine the overall cost of raising capital

Answer

To compare the costs of debt and equity

Answer

To assess the riskiness of a company

Answer

To calculate the cost of a specific investment

Question 6

What is the main difference between the weighted average cost of capital (WACC) and the marginal cost of capital (MCC)?

Accepted Answer

WACC considers all sources of capital, while MCC considers only new capital

Answer

MCC is used for capital budgeting decisions, while WACC is not

Answer

WACC is typically higher than MCC

Answer

There is no difference between WACC and MCC

Question 7

What is the relationship between the cost of debt and the firm's credit rating? Select the option that accurately describes the relationship.

Accepted Answer

Positively correlated: firms with higher credit ratings have lower costs of debt

Answer

Negatively correlated: firms with higher credit ratings have higher costs of debt

Answer

No relationship: the firm's credit rating does not affect its cost of debt

Answer

Quadratic relationship: the cost of debt decreases initially as the credit rating improves, but then increases as the credit rating improves further

Question 8

Which method of calculating the cost of equity is specifically designed for situations where the firm has a stable dividend growth rate?

Accepted Answer

Gordon Growth Model

Answer

Capital Asset Pricing Model (CAPM)

Answer

Dividend Discount Model

Answer

Discounted Cash Flow Model

Question 9

What is the general impact of inflation on the cost of capital? Select the option that accurately describes the impact.

Accepted Answer

Inflation tends to increase both the cost of equity and the cost of debt

Answer

Inflation tends to decrease both the cost of equity and the cost of debt

Answer

Inflation tends to increase the cost of equity but decrease the cost of debt

Answer

Inflation tends to decrease the cost of equity but increase the cost of debt

Question 10

What is the primary reason for adjusting the cost of debt for taxes? Select the option that best describes the purpose of this adjustment.

Accepted Answer

To reflect the actual after-tax cost of debt, which is lower than the pre-tax cost due to tax deductibility of interest payments

Answer

To make the cost of debt comparable to the cost of equity, which is also typically expressed on an after-tax basis

Answer

To reduce the overall cost of capital, as the tax adjustment effectively lowers the cost of debt

Answer

To increase the firm's borrowing capacity, as the after-tax cost of debt is lower than the pre-tax cost

Question 11

What is the difference between the pre-tax cost of debt and the after-tax cost of debt? Select the option that accurately describes the difference.

Accepted Answer

The difference is equal to the tax rate multiplied by the pre-tax cost of debt

Answer

The difference is equal to the amount of interest paid

Answer

There is no difference between the pre-tax and after-tax cost of debt

Answer

The difference is equal to the amount of principal repaid

Question 12

How does a firm's cost of capital impact its choice of debt and equity financing?

Accepted Answer

A lower cost of capital allows firms to take on more financial risk.

Answer

A higher cost of capital encourages firms to use more debt financing.

Answer

The cost of capital has no influence on a firm's optimal capital structure.

Question 13

How does a company's capital structure influence its WACC?

Accepted Answer

Adjustments in debt-to-equity ratios affect the WACC.

Answer

The WACC remains unaffected by capital structure.

Answer

Only changes in the cost of equity impact the WACC.

Question 14

What is the main purpose of calculating the cost of capital?

Accepted Answer

To make sound investment and financing decisions

Answer

To ascertain the company's market value

Answer

To comply with regulatory requirements

Question 15

How is the cost of capital related to the NPV of a project?

Accepted Answer

A higher cost of capital results in a lower NPV.

Answer

The cost of capital has no impact on the NPV.

Answer

A higher cost of capital leads to a higher NPV.

Question 16

Which of the following can potentially increase a company's cost of capital?

Accepted Answer

Increased risk

Answer

Stable economic conditions

Answer

Improved financial performance

Answer

Lower interest rates

Question 17

The cost of capital plays a crucial role in determining a company's:

Accepted Answer

Investment decisions

Answer

Marketing strategies

Answer

Operating costs

Answer

Employee benefits

Question 18

Which of the following is a widely recognized method for estimating the cost of equity?

Accepted Answer

Capital Asset Pricing Model (CAPM)

Answer

Internal Rate of Return (IRR)

Answer

Net Present Value (NPV)

Answer

Weighted Average Cost of Capital (WACC)

Question 19

The formula for calculating the Weighted Average Cost of Capital (WACC) includes:

Accepted Answer

Debt and equity costs weighted by their respective proportions

Answer

Only equity costs

Answer

Only debt costs

Question 20

Which of the following actions by a company can potentially decrease its cost of equity?

Accepted Answer

Reducing company-specific risk

Answer

Paying higher dividends

Answer

Increasing leverage