finance test 2

Time value of money can be calculated in a few different ways such as time value of money tables, calculator, and/or equation, which all come up with a very similar answer.

True

Compounding refers to the growth process that turns $1 today into a greater value several periods in the future.

True

The time value of money is not a useful concept in determining the value of a bond or in capital investment decisions.

False

The present value of a 10-year annuity can become negative as inflation rates become higher and higher.

False

In paying off a mortgage loan, the amount of the periodic payment that goes toward the reduction of principal increases over the life of the mortgage.

True

The valuation of a financial asset is based on the concept of determining the present value of future cash flows that this financial asset will accumulate.

True

By using different discount rates, the market allocates capital to companies based on their risk, efficiency, and expected returns.

True

The cost of debt is equal to the current bond yield on bonds of similar risk class, adjusted for the corporate tax rate.

True

The only difference in the cost of retained earnings and the cost of new common stock is the flotation cost on new common stock.

True

A firm that does not earn the cost of capital in the long run will not maximize shareholder wealth.

True

The use of the optimum capital structure minimizes the cost of capital.

True

A dollar today is worth more than a dollar to be received in the future because:

Inflation

The concept of time value of money is important to financial decision making because _________.

The value of money in the future is different than today

As the interest rate increases, the present value of a bond will _________.

Decrease

In a general sense, the value of any asset is the ________ of the cash flows expected to be received from the asset.

Present value

Which type of financial assets is likely to have the highest required rate of return based on risk? (debt, preferred stock, or common stock)

Common stock

Stock valuation models are dependent upon 3 things. Expected _________, future _________, and an appropriate _________ rate.

Dividends, growth, return

What are 3 types of financial capital that companies can attain to finance capital projects?

Common stock, preferred stock, debt

For a firm paying 5% for new debt, the higher the firm's tax rate, the ________ the after-tax cost of debt.

Lower

The cost of equity capital in the form of new common stock will be higher than the cost of retained earnings because of _________.

Flotation cost

The coupon rate on an issue of debt is 8%. The corporate tax rate is 25%. What would be the approximate after-tax cost of debt for a new issue of bonds?

6%

How is valuation of any financial asset related to future cash flows?

Present value

Why might investors demand a lower rate of return for an investment in Microsoft as compared to United Airlines?

Less risk

What are the three factors that influence the required rate of return by investors?

Risk-free rate, inflation premium, risk premium

If inflationary expectations increase, the yield to maturity (the required rate of return) will ________ (increase or decrease). The price of bonds will go ________ (up or down).

Increase, down

Why is the remaining time to maturity an important factor in evaluating the impact of a change in yield to maturity on bond prices?

The longer the time, the more risk

What two components make up the required rate of return on common stock?

Dividend yield and growth

Why do we use the overall cost of capital for investment decisions even when only one source of capital will be used (e.g., debt)?

All projects evaluate the firm

In computing the cost of capital, do we use the historical costs of existing debt and equity, or the current costs as determined in the market? Why?

Current cost

Why is the cost of debt less than the cost of preferred stock if both securities are priced to yield 10 percent in the market?

Tax

What are the two sources of equity (ownership) capital for the firm?

Retained earnings and common stock

Explain why retained earnings have an associated opportunity cost?

Shareholders could invest elsewhere

Why is the cost of issuing new common stock higher than the cost of retained earnings?

Flotation cost

How are the weights determined to arrive at the optimal weighted average cost of capital?

Balance between equity and debt

What six factors might influence a firm’s price-earnings ratio?

Dividend policy, earnings, sales growth, risk, debt/equity structure, management quality