QUESTION: 43 Topic 1: Part 2 Sec One (1 to 52)

A firm seeking to optimize its capital budget has calculated its marginal cost of capital and projected rates of return on several potential projects. The optimal capital budget is determined by

Calculating the point at which marginal cost of capital meets the projected rate of return, assuming that the most profitable projects are accepted first.
Calculating the point at which average marginal cost meets average projected rate of return, assuming the largest projects are accepted first.
Accepting all potential projects with projected rates of return exceeding the lowest marginal cost of capital
Accepting all potential projects with projected rates of return lower than the highest marginal cost of capital.

Answer(s): A

Explanation:

In economics, a basic principle is that a firm should increase output until marginal cost equals marginal revenue. Similarly, the optimal capital budget is determined by calculating the point at which marginal cost of capital (which increases as capital requirements increase) and marginal efficiency of investment (which decreases if the most profitable projects are accepted first) intersect.

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QUESTION: 44 Topic 1: Part 2 Sec One (1 to 52)

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In referring to the graph of a firm's cost of capital, if e is the current position, which one of the following statements best explains the saucer or U-shaped curve?

The cost of capital is almost always favorably' influenced by increases in financial leverage
The cost of capital is almost always negative' influenced by increases in financial leverage.
The financial markets will penalize firms that borrow even in moderate amounts
Use of at least some debt financing will enhance the value of the firm.

Answer(s): D

Explanation:

The U-shaped curie indicates that the cost of capital is quite high when the debt-to-equity ratio is quite low. As debt increases, the cost of capital declines as long as the cost of debt is less than that of equity. Eventually, the decline in the cost of capital levels off because the cost of debt ultimately rises as more debt is used. Additional increases in debt (relative to equity) will then increase the cost of capital. The implication is that some debt is present in the optimal capital structure because the cost of capital initially declines when debt is added. However, a point is reached at which debt becomes excessive and the cost of capital begins to rise.

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QUESTION: 45 Topic 1: Part 2 Sec One (1 to 52)

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An analysis of a company's planned equity financing using the capital asset pricing model (or security market line) would incorporate only the

Expected market earnings, the current U.S. Treasury bond yield, and the beta coefficient.
Expected market earnings and the price-earnings ratio,
Current U.S. Treasury bond yield, the price-earnings ratio, and the beta coefficient.
Current U.S. Treasury bond yield and the dividend payout ratio.

Answer(s): A

Explanation:

The capital asset pricing model adds the risk-tree rate to the product of the market risk premium and the beta coefficient. The market risk premium is the amount above the risk- free rate (approximated by the U.S. Treasury bond yield) that must be paid to induce investment in the market The beta coefficient of an individual stock is the correlation between the price volatility of the stock market as a whole and the price volatility of the individual stock.

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QUESTION: 46 Topic 1: Part 2 Sec One (1 to 52)

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Which of the changes in leverage would apply to a company that substantially increases its investment in fixed assets as a proportion of total assets and replaces some of its long- term debt with equity?

Increase Decrease
Decrease Increase
Increase Increase
Decrease Decrease

Answer(s): B

Explanation:

Leverage is the amount of the fixed cost of capital, principally debt, in a firm's capital structure relative to its operating income It is also defined as the ratio of debt to total assets or debt to capital. Leverage, by definition, creates financial risk, which relates directly to the question of the cost of capital The more leverage, the higher the financial risk, and the higher the cost of debt capital. An increase in the equity component of the capital structure, however, decreases financial leverage Operating leverage is based on the degree that fixed costs are used in the production process. A company with a high percentage of fixed costs is riskier than a firm in the same industry that relies more on variable costs to produce. When fixed assets increase, operating leverage also increases

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QUESTION: 43 Topic 1: Part 2 Sec One (1 to 52)

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QUESTION: 44 Topic 1: Part 2 Sec One (1 to 52)

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QUESTION: 45 Topic 1: Part 2 Sec One (1 to 52)

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QUESTION: 46 Topic 1: Part 2 Sec One (1 to 52)

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