Posted: September 21st, 2016

Which of the following statements is most correct?

Which of the following statements is most correct?

a.Suppose a firm is losing money and thus, is not paying taxes, and that this situation is expected to persist for a few years whether or not the firm uses debt financing. Then the firm’s after-tax cost of debt will equal its before-tax cost of debt.
b.The component cost of preferred stock is expressed as kps(1 – T), because preferred stock dividends are treated as fixed charges, similar to the treatment of debt interest.
c.The reason that a cost is assigned to retained earnings is because these funds are already earning a return in the business; the reason does not involve the opportunity cost principle.
d.The bond-yield-plus-risk-premium approach to estimating a firm’s cost of common equity involves adding a subjectively determined risk-premium to the market risk-free bond rate.
e.All of the statements above are false

2. Which of the following statements about a not-for-profit firm=s cost of capital estimate is most correct?

a.Since a not-for-profit firm has no shareholders, its WACC estimate does not include a cost of equity (fund capital) estimate.
b.The capital structure weights for a not-for-profit firm are set at 50/50, because such firms can raise $1 of debt financing for each dollar of retained earnings.
c.The cost of tax-exempt debt issued by not-for-profit firms is increased (Agrossed up@) by 1 – T in the WACC estimate to reflect the fact that such firms do not pay taxes.
d.Equity (fund) capital has a cost that is roughly equivalent to the cost of retained earnings to similar investor-owned companies.
e.None of the above statements is correct.

3. A company forecasts free cash flow in one year to be -$10 million and free cash flow in two years to be $20 million. After the second year, free cash flow will grow at a constant rate of 4 percent per year forever. If the overall cost of capital is 14 percent, what is the current value of operations, to the nearest million?

a. $150 million
b. $167 million
c. $200 million
d. $208 million
e. $228 million