Chapter 7: Types and Costs of Financial Capital

CHAPTER 7
TYPES AND COSTS OF FINANCIAL CAPITAL
True-False Questions
F. 1. The accounting emphasis on accrued revenue and expenses and
depreciation is the same emphasis as that of finance managers.
T. 2. Traditional accounting does not focus on the implicit cost of equity, that is
the required capital gains to complement dividends. o!ever, evaluation
methods exist to determine this value "y financial managers.
F. #. $nflation premium is the rising prices not offset "y increasing quality of
goods "eing purchased.
F. %. The relationship "et!een real interest rates and time to maturity !hen
default ris& is constant is called the term structure of interest rates.
T. '. The graph of the term structure of interest rates, !hich plots interest rates to
time to maturity is called the yield curve.
F. (. )u"ordinated de"t is secured "y a venture*s assets, !hile senior de"t has an
inferior claim to a venture*s assets.
T. 7. $nvestment ris& is the chance or pro"a"ility of financial loss on one*s
venture investment, and can "e assumed "y de"t, equity, and founding
investors.
F. +. Closely held corporations are those companies !hose stoc& is traded over,
the,counter.
T. -. .rgani/ed exchanges have physical locations !here trading ta&es place,
!hile the over,the,counter mar&et is comprised of a net!or& of "ro&ers and
dealers that interact electronically.
T. 10. 1ar&et cap is determined "y multiplying a firm*s current stoc& price "y
the num"er of shares outstanding.
F. 11. The excess average return of long,term government "onds over common
stoc& is called the mar&et ris& premium.
T. 12. The !eighted average cost of capital is simply the "lended, or !eighted
cost of raising equity and de"t capital.
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Chapter 7: Types and Costs of Financial Capital
T. 1#. Formal historical accounting procedures include explicit records of de"t
2interest and principal3 and dividend capital costs.
F. 1%. 4u"lic financial mar&ets are mar&ets for the creation, sale and trade of
illiquid securities having less standardi/ed negotiated features.
F. 1'. The ris&,free interest rate is the interest rate on de"t that is virtually free of
inflation ris&.
T. 1(. 5 nominal interest rate is an o"served or stated interest rate.
F. 17. 5 venture*s 6ris&iness7 in terms of poor performance or failure is usually
very high during the maturity stage of its life cycle.
T. 1+. 5 venture*s 6ris&iness7 in terms of poor performance or failure is usually
high to moderate during the rapid,gro!th stage of its life cycle.
T. 1-. First,round financing during a venture*s survival stage comes primarily
from venture capitalists and investment "an&s.
F. 20. )tartup financing usually comes from entrepreneurs, "usiness angels, and
investment "an&ers.
T. 21. Commercial "an&s provide liquidity,stage financing for ventures in the
rapid,gro!th stage of their life cycles.
T. 22. 5 venture*s 6ris&iness7 in terms of the li&elihood of poor performance or
failure decreases as it moves from its development stage through to its rapid,
gro!th stage.
T. 2#. 68efault,ris&7 is the ris& that a "orro!er !ill not pay the interest and9or
the principal on a loan.
T. 2%. The 6real interest rate7 2::3 is the interest one !ould face in the a"sence
of inflation, ris&, illiquidity, and any other factors determining the appropriate
interest rate.
F. 2'. The 6prime rate7 is the interest rate charged "y "an&s to their highest
default ris& "usiness customers.
Multiple-Coi!e Questions
e. 1. ;hich of the follo!ing mar&ets involve liquid securities !ith standardi/ed
contract features such as stoc&s and "onds<
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Chapter 7: Types and Costs of Financial Capital
a. private financial mar&et
". derivatives mar&et
c. commodities mar&et
d. real estate mar&et
e. pu"lic financial mar&et
d. 2. ;hich of the follo!ing mar&ets involve direct t!o,party negotiations over
illiquid, non,standardi/ed contracts such as "an& loans and direct placement of
de"t<
a. primary mar&et
". secondary mar&et
c. options mar&et
d. private financial mar&et
e. pu"lic financial mar&et
d. #. ;hich of the follo!ing is an example of rent on financial capital<
a. interest on de"t
". dividends on stoc&
c. collateral on equity
d. a and b
e. a, b, and c
c. %. The ris& that a "orro!er !ill not pay the interest and 9or principal on a loan
is called<
a. interest rate ris&
". re,investment rate ris&
c. default ris&
d. inflation ris&
e. ris&,free rate
". '. ;hich of the follo!ing descri"es the o"served or stated interest rate<
a. real rate
". nominal rate
c. ris&,free rate
d. prime rate
e. inflation rate
a. (. ;hich of the follo!ing descri"es the interest rate in addition to the inflation
rate expected on a ris&,free loan<
a. real rate
". nominal rate
c. ris&,free rate
d. prime rate
e. inflation rate
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Chapter 7: Types and Costs of Financial Capital
c. 7. ;hich of the follo!ing descri"es the interest rate on de"t that is virtually
free of default ris&<
a. real rate
". nominal rate
c. ris&,free rate
d. prime rate
e. inflation rate
d. +. ;hich of the follo!ing descri"es the interest rate charged "y "an&s to their
highest quality customers<
a. real rate
". nominal rate
c. ris&,free rate
d. prime rate
e. inflation rate
e. -. ;hich of the follo!ing is not a component in determining the cost of de"t<
a. inflation premium
". default ris& premium
c. liquidity premium
d. maturity ris& premium
e. interest rate premium
". 10. The additional interest rate premium required to compensate the lender for
the pro"a"ility that a "orro!er !ill not "e a"le to repay interest and principal
on a loan is &no!n as<
a. inflation premium
". default ris& premium
c. liquidity premium
d. maturity premium
e. investment ris& premium
c. 11. The additional premium added to the real interest rate "y lenders to
compensate them for a de"t instrument !hich cannot "e converted to cash
quic&ly at its existing value is called<
a. inflation premium
". default ris& premium
c. liquidity premium
d. maturity premium
e. investment ris& premium
d. 12. The added interest rate charged due to the inherent increased ris& in long,
term de"t is called<
a. inflation premium
". default ris& premium
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Chapter 7: Types and Costs of Financial Capital
c. liquidity premium
d. maturity premium
e. investment ris& premium
e. 1#. )uppose the real ris& free rate of interest is %=, maturity ris& premium is
2=, inflation premium is (=, the default ris& on similar de"t is #=, and the
liquidity premium is 2=. ;hat is the nominal interest rate on this venture*s
de"t capital<
a. 1#=
". 1%=
c. 1'=
d. 1(=
e. 17=
d. 1%. 5 venture has raised >%,000 of de"t and >(,000 of equity to finance its
firm. $ts cost of "orro!ing is (=, its tax rate is %0=, and its cost of equity
capital is +=. ;hat is the venture*s !eighted average cost of capital<
a. +.0=
". 7.2=
c. 7.0=
d. (.2=
e. (.0=
d. 1'. ?our venture has net income of >(00, taxa"le income of >1,000, operating
profit of >1,200, total financial capital including "oth de"t and equity of
>-,000, a tax rate of %0=, and a ;5CC of 10=. ;hat is your venture*s @A5<
a. >%00,000
". >200,000
c. > 0
d. 2>1+0,0003
e. 2>#00,0003
a. 1(. The 6ris&,free7 interest rate is the sum of:
a. a real rate of interest and an inflation premium
". a real rate of interest and a default ris& premium
c. an inflation premium and a default ris& premium
d. a default ris& premium and a liquidity premium
e. a liquidity premium and a maturity premium
c. 1+. Aenture investors generally use !hich one of the follo!ing target rates to
discount the proBected cash flo!s of ventures in the 6startup7 stage of their life
cycles.
a. 20=
". 2'=
c. %0=
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Chapter 7: Types and Costs of Financial Capital
d. '0=
d. 1-. ;hich one of the follo!ing components is not used !hen estimating the
cost of ris&y de"t capital<
a. real interest rate
". inflation premium
c. default ris& premium
d. mar&et ris& premium
e. liquidity premium
c. 20. The !ord 6ris&7 developed from the early $talian !ord 6risicare7 and
means:
a. don*t care
". ta&e a chance
c. to dare
d. to gam"le
e. 21. The difference "et!een average annual returns on common stoc&s and
returns on long,term government "onds is called a:
a. default ris& premium
". maturity premium
c. ris&,free premium
d. liquidity premium
e. mar&et ris& premium
". 22. ;hat has "een the approximate average annual rate of return on pu"licly
traded small company stoc&s since the mid,1-20s<
a. 10=
". 17=
c. 2'=
d. #0=
e. %0=
e. 2#. Aenture investors generally use !hich one of the follo!ing target rates to
discount the proBected cash flo!s of ventures in the 6development7 stage of
their life cycles.
a. 1'=
". 20=
c. 2'=
d. %0=
e. '0=
a. 2%. 5n o"served or stated interest rate is said to "e a:
a. nominal interest rate
". real interest rate
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Chapter 7: Types and Costs of Financial Capital
c. ris&,free interest rate
d. pure interest rate
e. guaranteed interest rate
e. 2'. Corporate "onds might involve !hich of the follo!ing types of
6premiums.7
a. inflation premium
". default ris& premium
c. liquidity premium
d. maturity premium
e. all of the a"ove
f. none of the a"ove
c. 2(. Calculate the !eighted average cost of capital 2;5CC3 "ased on the
follo!ing information: the capital structure !eights are '0= de"t and '0=
equityC the interest rate on de"t is 10=C the required return to equity holders is
20=C and the tax rate is #0=
a. 7=
". 10=
c. 1#.'=
d. 17.'=
e. 20=
". 27. @stimate a firm*s D.45T "ased on: Det sales E >2,000,000C @F$T E
>(00,000C Det income E >20,000C and @ffective tax rate E #0=.
a. >(00,000
". >%20,000
c. >1'0,000
d. >70,000
e. >%0,000
c. 2+. @stimate a firm*s economic value added 2@A53 "ased on: D.45T E
>%00,000C amount of financial capital used E >1,(00,000C and ;5CC E 1-=.
a. >2(,000
". >#(,000
c. >-(,000
d. >'%,000
e. >(%,000
e. 2-. ;hich of the follo!ing venture life cycle stages !ould involve seasoned
financing rather than venture financing<
a. 8evelopment stage
". )tartup stage
c. )urvival stage
d. :apid,gro!th stage
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Chapter 7: Types and Costs of Financial Capital
e. 1aturity stage
a. #0. 5 venture*s 6ris&iness7 in terms of possi"le poor performance or failure
!ould "e considered to "e 6very high7 in !hich of the follo!ing life cycle
stages.
a. )tartup stage
". )urvival stage
c. :apid,gro!th stage
d. 1aturity stage
e. #1. ;hich of the follo!ing types of financing !ould "e associated !ith the
highest target compound rate of return<
a. pu"lic and seasoned financing
". second,round and me//anine financing
c. first,round financing
d. startup financing
e. seed financing
d. #2. Calculate the after,tax ;5CC "ased on the follo!ing information:
nominal interest rate on de"t E 1(=C cost of common equity E #0=C equity to
value E (0=C de"t to value E %0=C and a tax rate E 2'=.
a. 10=
". 1(=
c. 1-.+=
d. 22.+=
e. #0=
c. ##. Calculate the after,tax ;5CC "ased on the follo!ing information:
nominal interest rate on de"t E 12=C cost of common equity E 2'=C common
equity E >700,000C interest,"earing de"t E >#00,000C and a tax rate E 2'=.
a. 1'=
". 1(.%=
c. 20.2=
d. 22.+=
e. #0=

d. #%. Find a venture*s 6economic value added7 2@A53 "ased on the follo!ing
information: @F$T E >200,000C financial capital used E >'00,000C ;5CC E
20=C effective tax rate E #0=.
a. >20,000
". >2',000
c. >#0,000
d. >%0,000
e. >'0,000
'2