Cost of Equity and Debt: A Comprehensive Guide for Corporate Finance Students

Question 1

Which of the following is **not** a component of the Capital Asset Pricing Model (CAPM)?

Accepted Answer

Dividend yield

Answer

Beta coefficient

Answer

Risk-free rate

Answer

Expected market return

Question 2

In the Capital Asset Pricing Model (CAPM), which factor has the biggest influence on a company's cost of equity?

Accepted Answer

Market risk premium

Answer

Company size

Answer

Debt-to-equity ratio

Question 3

Which of the following factors has **no** impact on a company's cost of debt?

Accepted Answer

Company's dividend policy

Answer

Company's credit rating

Answer

Current market interest rates

Answer

Term of the loan

Question 4

Which formula accurately calculates the cost of equity according to the Capital Asset Pricing Model (CAPM)?

Accepted Answer

Cost of equity = Risk-free rate + Beta * (Expected market return - Risk-free rate)

Answer

Cost of equity = Yield to maturity + Beta * (Expected market return - Yield to maturity)

Answer

Cost of equity = Debt-to-equity ratio * Cost of debt

Answer

Cost of equity = Return on equity * Beta

Question 5

The yield to maturity (YTM) of a bond represents:

Accepted Answer

The rate of return an investor would earn if they held the bond until maturity

Answer

The annual interest rate paid on the bond

Answer

The price at which the bond is sold

Answer

The bond's number of years to maturity

Question 6

The Capital Asset Pricing Model (CAPM) is used to calculate primarily:

Accepted Answer

Cost of equity

Answer

Cost of debt

Answer

Weighted average cost of capital

Answer

Return on assets

Question 7

Which factor does NOT directly influence the cost of equity according to the Capital Asset Pricing Model (CAPM)?

Accepted Answer

Company's dividend payout ratio

Answer

Company's beta

Answer

Risk-free rate

Answer

Market risk premium

Question 8

A company has a beta of 1.5, a risk-free rate of 5%, and an expected market return of 10%. Calculate the company's cost of equity using CAPM.

Accepted Answer

12.5%

Answer

7.5%

Answer

10%

Answer

15%

Question 9

Which of the following is NOT an advantage of debt financing?

Accepted Answer

None of the above (all are advantages)

Answer

Tax deductibility of interest payments

Answer

Potentially lower cost of capital

Answer

Increased flexibility for future borrowing

Question 10

Which factor influences a company's cost of equity, as per the Capital Asset Pricing Model (CAPM)?

Accepted Answer

Market risk premium

Answer

Credit rating

Answer

Dividend payout ratio

Answer

Debt-to-equity ratio

Question 11

The weighted average cost of capital (WACC) is a measure of:

Accepted Answer

The overall cost of a company's financing

Answer

The cost of debt only

Answer

The cost of equity only

Answer

The cost of retained earnings only

Question 12

Which inputs are required to calculate the cost of equity using the Capital Asset Pricing Model (CAPM)?

Accepted Answer

Beta, risk-free rate, and market risk premium

Answer

Beta and risk-free rate

Answer

Risk-free rate and market risk premium

Answer

Beta and market risk premium

Question 13

The yield to maturity on a debt issue represents:

Accepted Answer

The annualized return an investor will earn if the debt is held until maturity

Answer

The total interest paid over the life of the debt

Answer

The percentage gain or loss on the debt if sold before maturity

Answer

The current market interest rate

Question 14

Which factor would generally lead to a higher cost of equity for a company?

Accepted Answer

Higher financial leverage

Answer

Lower beta

Answer

Stable cash flows

Answer

Lower dividend payout ratio

Question 15

A company's capital structure refers to:

Accepted Answer

The mix of different sources of financing used by the company

Answer

The total amount of assets owned by the company

Answer

The ratio of debt to equity

Answer

The weighted average cost of capital

Question 16

Which is a potential benefit of using debt financing?

Accepted Answer

Tax savings

Answer

Reduced financial flexibility

Answer

Increased ownership concentration

Answer

Lower cost of capital

Question 17

The weighted average cost of capital (WACC) is calculated as:

Accepted Answer

Cost of equity multiplied by equity weight plus cost of debt multiplied by debt weight

Answer

Cost of equity plus cost of debt

Answer

Equity weight divided by debt weight

Answer

Cost of equity minus cost of debt

Question 18

A company has a beta of 1.2, a risk-free rate of 5%, and a market risk premium of 8%. What is its cost of equity using CAPM?

Accepted Answer

15%

Answer

13%

Answer

18%

Answer

20%

Question 19

The optimal capital structure for a company:

Accepted Answer

Minimizes the cost of capital and maximizes the firm's value

Answer

Maximizes the firm's value and increases its financial risk

Answer

Requires a high level of debt and reduces financial flexibility

Answer

Increases the cost of capital and minimizes the firm's value

Question 20

Which factor is most likely to increase the cost of equity for a company?

Accepted Answer

Higher market risk premium

Answer

Lower company beta coefficient

Answer

Stable dividend payments

Answer

Strong financial performance

Question 21

Explain how inflation impacts the cost of debt:

Accepted Answer

Increases the real cost of debt

Answer

Decreases the real cost of debt

Answer

Has no effect on the real cost of debt

Answer

Varies depending on the type of debt

Question 22

Which methods can be employed to calculate the cost of equity?

Accepted Answer

Both CAPM and DDM

Answer

Capital Asset Pricing Model (CAPM)

Answer

Dividend Discount Model (DDM)

Answer

Weighted Average Cost of Capital (WACC)

Question 23

A company's debt-to-equity ratio is 1.5. What does this indicate about its capital structure?

Accepted Answer

Higher proportion of debt financing

Answer

Equal proportion of debt and equity financing

Answer

Lower proportion of debt financing

Answer

No information about capital structure

Question 24

Which of the following ratios is most directly related to the cost of equity for a publicly-traded company?

Accepted Answer

Dividend Yield

Answer

Debt-to-Equity Ratio

Answer

Return on Assets

Question 25

When determining the weighted average cost of capital (WACC), which statement is accurate?

Accepted Answer

WACC assigns greater significance to funding sources with lower costs.

Answer

WACC assigns equal significance to all funding sources.

Answer

WACC solely considers the cost of debt financing.

Answer

WACC does not account for the risk associated with the project for which capital is being raised.

Question 26

How does a company's credit rating affect its cost of debt?

Accepted Answer

Companies with higher credit ratings generally have lower cost of debt

Answer

Companies with higher credit ratings generally have higher cost of debt

Answer

There is no relationship between credit rating and cost of debt

Question 27

What is the fundamental distinction between cost of equity and cost of debt?

Accepted Answer

Cost of equity represents the return demanded by equity investors, while cost of debt represents the return required by debt holders

Answer

Cost of equity is always higher than cost of debt

Question 28

Which assumption is crucial to the CAPM model?

Accepted Answer

Investors are risk-averse and diversify their portfolios

Answer

All stocks have the same beta

Answer

The market is always efficient

Question 29

Define the weighted average cost of capital (WACC).

Accepted Answer

The average cost of capital from all sources, weighted by their respective proportions in the capital structure

Answer

The cost of the least expensive source of capital

Answer

The cost of the most expensive source of capital

Question 30

The yield to maturity is primarily used to calculate the:

Accepted Answer

Cost of debt

Answer

Cost of equity

Answer

Capital gains yield

Answer

Weighted average cost of capital

Question 31

According to the Capital Asset Pricing Model (CAPM), the expected return on a stock is determined by:

Accepted Answer

Risk-free rate + Beta * (Market risk premium)

Answer

Beta * (Risk-free rate + Market risk premium)

Answer

Yield to maturity + Beta * (Weighted average cost of capital)

Answer

Cost of debt + (1 - Beta) * (Market risk premium)

Question 32

The weighted average cost of capital (WACC) is calculated by:

Accepted Answer

Multiplying the cost of equity by the proportion of equity financing, and adding the cost of debt multiplied by the proportion of debt financing

Answer

Dividing the cost of equity by the cost of debt

Question 33

The risk premium primarily serves to:

Accepted Answer

Compensate investors for assuming additional risk

Answer

Calculate the cost of equity

Answer

Determine the WACC

Answer

Assess the creditworthiness of a company

Question 34

Which of the following is an advantage of using debt financing?

Accepted Answer

Tax deductibility of interest payments

Answer

No obligation to repay principal

Answer

Reduced risk for investors

Answer

Higher flexibility in capital structure

Question 35

Which of the following factors is most likely to increase the cost of equity for a company?

Accepted Answer

Higher business risk

Answer

Improved financial performance

Answer

Government subsidies

Answer

Lower interest rates

Question 36

What is the key difference between the cost of debt and the cost of equity?

Accepted Answer

The cost of debt is usually tax-deductible, while the cost of equity is not.

Answer

The cost of equity is typically higher than the cost of debt.

Answer

The cost of debt is more volatile than the cost of equity.

Question 37

Which of the following is a potential disadvantage of using equity financing?

Accepted Answer

Dilution of ownership and control

Answer

Lower cost of capital compared to debt

Answer

Higher flexibility in capital structure

Question 38

What is the risk premium in the CAPM?

Accepted Answer

The expected return on the market portfolio minus the risk-free rate

Answer

The expected return on the individual stock minus the risk-free rate

Answer

The beta of the individual stock multiplied by the risk-free rate

Question 39

Which of the following methods is used to calculate the cost of debt?

Accepted Answer

Yield to maturity

Answer

Dividend discount model

Answer

Comparable company analysis

Question 40

What is the impact of a higher cost of capital on a company's valuation?

Accepted Answer

Lower valuation

Answer

Increased volatility in valuation

Answer

No impact on valuation

Question 41

Which of the following is a component of the Capital Asset Pricing Model (CAPM) formula?

Accepted Answer

Market risk premium

Answer

Cost of debt

Answer

Dividend payout ratio

Question 42

How does increasing the debt-to-equity ratio generally affect a company's Weighted Average Cost of Capital (WACC)?

Accepted Answer

Increases the WACC

Answer

Cannot be determined without additional information

Answer

Does not affect the WACC

Answer

Decreases the WACC

Question 43

Which of the following is NOT a component of the Capital Asset Pricing Model (CAPM) formula?

Accepted Answer

Dividend yield

Answer

Risk-free rate

Answer

Beta

Answer

Market risk premium

Question 44

Which of the following factors would generally increase a company's cost of equity?

Accepted Answer

An increase in the company's perceived business risk

Answer

A decrease in the risk-free rate

Answer

A decrease in the market risk premium

Question 45

Which of the following is a disadvantage of using debt financing?

Accepted Answer

It increases the company's financial leverage and risk of bankruptcy.

Answer

Interest payments on debt are not tax-deductible.

Answer

Debt financing dilutes the ownership of existing shareholders.

Question 46

What does a beta of 1 indicate about a company's systematic risk?

Accepted Answer

The company's systematic risk is equal to the market risk.

Answer

The company's systematic risk is lower than the market risk.

Answer

The company has no systematic risk.

Question 47

In corporate finance, what is the primary reason for determining the cost of capital?

Accepted Answer

It serves as the discount rate for evaluating the profitability of potential investment projects.

Answer

It directly reflects a company's overall profitability.

Answer

It determines a company's tax liability.

Question 48

Which financial metric is calculated using the Capital Asset Pricing Model (CAPM)?

Accepted Answer

Cost of equity

Answer

Internal rate of return

Answer

Net present value

Answer

Cost of debt

Question 49

What is the correct formula for the Capital Asset Pricing Model (CAPM)?

Accepted Answer

r = rf + β(rm - rf)

Answer

r = rf + (1 - β)(rm - rf)

Answer

r = rm + β(rf - rm)

Answer

r = rf - β(rm - rf)

Question 50

What does the term 'yield to maturity' represent when discussing bonds?

Accepted Answer

The annual rate of return an investor can anticipate receiving if they hold a bond until its maturity date.

Answer

The price at which a bond is initially issued to the market.

Answer

The face value or principal amount of a bond.

Question 51

What is the most accurate definition of a firm's cost of capital?

Accepted Answer

The weighted average cost of all the different sources of financing a company uses, such as debt, equity, and preferred stock.

Answer

The cost of debt financing only.

Answer

The cost of preferred stock financing only.

Answer

The cost of equity financing only.

Question 52

In the context of CAPM, what does the 'risk premium' represent?

Accepted Answer

The difference between the expected return on the overall market and the return on a risk-free investment.

Answer

The sum of the cost of equity and the cost of debt financing.

Answer

The difference between the cost of equity and the cost of debt financing.

Question 53

What is the primary goal of optimizing a company's capital structure?

Accepted Answer

To achieve the lowest possible weighted average cost of capital, which minimizes the overall cost of financing.

Answer

To maximize the company's return on equity.

Answer

To maximize the company's debt-to-equity ratio.

Answer

To minimize the risk of the company going bankrupt.