Companies borrow from various institutions in the capital market to finance theirbusinesses for short and long term periods. The concept of a weighted cost of capitalmay be new to some of you, but if you were a financial manager why would the weightedcost of capital be important to you as you examine the cost of borrowing on behalf ofyour firm? Why or why not?

Companies borrow from various institutions in the capital market to finance their Businesses in the…

Answered: Companies borrow from various…

Financial Reporting, Financial Statement Analysis and Valuation

8th Edition

ISBN:9781285190907

Author:James M. Wahlen, Stephen P. Baginski, Mark Bradshaw

Publisher:James M. Wahlen, Stephen P. Baginski, Mark Bradshaw

Chapter13: Valuation: Earnings-based Approach

Section: Chapter Questions

Problem 8QE

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Similar questions

Define the term capital intensity. Explain how a decline in capital intensity would affect the AFN, other things held constant. Would economies of scale combined with rapid growth affect capital intensity, other things held constant? Also, explain how changes in each of the following would affect AFN, holding other things constant: the growth rate, the amount of accounts payable, the profit margin, and the payout ratio.
Modigliani and Miller assumed that firms do not grow. How does positive growth change their conclusions about the value of the levered firm and its cost of capital?
Which of the following is most correct about the cost of capital? The cost of debt reflects the interest rates on debt capital before taking into account the tax effects. Cost of capital is affected by the required rates of return of each of the source of capital, regardless of the capital structure. The capital asset pricing model is the most widely used model to estimate the cost of common equity. To minimize the cost of capital, firms should borrow more than their capacity because increasing the lower cost of debt yields the lowest cost of capital, thus, enhances shareholder value.
How does a cost-efficient capital market help reduce the prices of goods and services? Describe the different ways in which capital can be transferred from suppliers of capital to those who are demanding capital. Is an initial public offering an example of a primary or a secondary market transaction? Indicate whether the following instruments are examples of money market or capital market securities. a. US Treasury bills b. Long-term corporate bonds c. Common stocks d. Preferred stocks e. Dealer commercial paper Briefly explain what is meant by the term efficiency continuum.
In each of the theories of capital structure, the cost of equity increases as the amount of debt increases. So why don't financial managers use as little debt as possible to keep the cost of equity down? After all, aren't financial managers supposed to maximize the value of a firm?
Companies have the opportunity to use varying amounts of different sources of financing, including internal and external sources, to acquire their assets, debt (borrowed) funds, and equity funds. A) Which of the following is considered a financially leveraged firm? A company that uses debt to finance some of its assets A company that uses only equity to finance its assets B) Which of the following is true about the leveraging effect? Under economic growth conditions, firms with relatively more leverage will have higher expected returns. Under economic growth conditions, firms with relatively low leverage will have higher expected returns. C) Blue Sky Drone Company has a total asset turnover ratio of 8.50x, net annual sales of $40 million, and operating expenses of $18 million (including depreciation and amortization). On its balance sheet and income statement, respectively, it reported total debt of $1.75 million on which it pays a 7%…
According to the M&M propositions WITH and WITHOUT taxes, should a financial manager spend time analysing a firm’s capital structure? What is the optimal capital structure with and without tax? Discuss.
Which statement about capital structure is the most correct? a. The more the company borrows, the lower will be the after-tax WACC. This increases the present value of the firm free cash flows which represents the value of the levered firm. Therefore, a firm should always seek to borrow as much debt as possible. b. The more the company borrows, the higher will be its tax shields, therefore a company will always prefer to issue debt than equity. c. Because the cost of debt is cheaper than the cost of equity, a company should use as much debt as possible to finance their projects d. Lenders rank ahead of shareholders when the company goes bankrupt. This increased risk for shareholders means the cost of equity is higher than the cost of debt. e. A company should always try to reduce its debt because of the high bankruptcy risk associated with debt. A company should aim to have 100% equity financing if it is possible.
The cost of equity rises as the quantity of debt rises in each of the capital structure theories. So, why don't financial managers employ as little debt as feasible to keep equity costs low? After all, aren't finance managers expected to increase a company's value?
Under normal circumstances, the weighted average cost of capital is used as the firm's required rate of return because a. as long as the firm's investments earn returns greater than the cost of capital, the value of the firm will increase b. it is comparable to the average of all the interest rates on debt that currently prevail in the financial markets c. returns below the cost of capital will cover all the fixed costs associated with capital and provide excess returns to the firm's stockholders
The relationship between WACC and investors' required rates of return The required rate of return of an investor is the rate of return that an investor demands to purchase a firm’s stocks or bonds and thus provide funds for capital investment. Therefore, required returns from the investors’ point of view correspond to the required returns or the weighted average cost of capital (WACC) from the firm’s point of view. Indicate in the following table whether each of the statements about WACC and the required rates of return of investors is true or false. Statement True False Flotation costs increase the cost of newly issued stock compared to the cost of the firm’s existing, or already outstanding, common stock or retained earnings. The firm’s cost of debt is what an investor is willing to pay for the firm’s stock before considering flotation costs. The amount that an investor is willing to pay for a firm’s bonds is inversely related to the…
What is opportunity cost and why is it an important concept in the capital budgeting process? The opportunity cost concept applies to almost every financial decision we make as individuals. Can you give an example from your own experience? What is capital rationing from the perspective of capital budgeting? Give an example of a strength and a weakness of the accounting rate of return approach.

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