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Types and Costs of Financial Capital
Types and Costs of Financial Capital
True-False Questions
T. 2. Traditional accounting does not focus on the implicit cost of equity that is
the required capital gains to complement dividends. However, evaluation
methods exist to determine this value by financial managers.
F. 4. Public financial markets are markets for the creation, sale and trade of
illiquid securities having less standardized negotiated features.
T. 12. The “real interest rate” (RR) is the interest one would face in the absence
of inflation, risk, illiquidity, and any other factors determining the appropriate
interest rate.
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46 Chapter 7: Types and Costs of Financial Capital
F. 13. The risk-free interest rate is the interest rate on debt that is virtually free of
inflation risk.
F. 14. Inflation premium is the rising prices not offset by increasing quality of
goods being purchased.
T. 15. “Default-risk” is the risk that a borrower will not pay the interest and/or
the principal on a loan.
F. 16. The “prime rate” is the interest rate charged by banks to their highest
default risk business customers.
F. 18. The relationship between real interest rates and time to maturity
when default risk is constant is called the term structure of interest rates.
T. 19. The graph of the term structure of interest rates, which plots interest rates
to time to maturity is called the yield curve.
F. 20. Liquidity premiums reflect the risk associated with firms that possess few
liquid assets.
F. 21. Subordinated debt is secured by a venture’s assets, while senior debt has
an inferior claim to a venture’s assets.
F. 22. Early-stage ventures tend to have large amounts of senior debt relative to
more mature ventures.
F. 24. A venture with a higher expected return relative to other ventures will
necessarily have a higher standard deviation or returns.
F. 27. Closely held corporations are those companies whose stock is traded over-
the-counter.
Chapter 7: Types and Costs of Financial Capital 47
T. 28. Typically, the stocks of closely held corporations aren’t publicly traded.
T. 29. Organized exchanges have physical locations where trading takes place,
while the over-the-counter market is comprised of a network of brokers and
dealers that interact electronically.
Multiple-Choice Questions
b. nominal rate
c. risk-free rate
d. prime rate
e. inflation rate
a. 5. Which of the following describes the interest rate in addition to the inflation
rate expected on a risk-free loan?
a. real rate
b. nominal rate
c. risk-free rate
d. prime rate
e. inflation rate
c. 6. Which of the following describes the interest rate on debt that is virtually
free of default risk?
a. real rate
b. nominal rate
c. risk-free rate
d. prime rate
e. inflation rate
d. 7. Which of the following describes the interest rate charged by banks to their
highest quality customers?
a. real rate
b. nominal rate
c. risk-free rate
d. prime rate
e. inflation rate
b. 9. The additional interest rate premium required to compensate the lender for
the probability that a borrower will not be able to repay interest and principal
on a loan is known as?
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity premium
e. investment risk premium
Chapter 7: Types and Costs of Financial Capital 49
c. 10. The additional premium added to the real interest rate by lenders to
compensate them for a debt instrument which cannot be converted to cash
quickly at its existing value is called?
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity premium
e. investment risk premium
d. 11. The added interest rate charged due to the inherent increased risk in long-
term debt is called?
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity premium
e. investment risk premium
e. 12. Suppose the real risk free rate of interest is 4%, maturity risk premium is
2%, inflation premium is 6%, the default risk on similar debt is 3%, and the
liquidity premium is 2%. What is the nominal interest rate on this venture’s
debt capital?
a. 13%
b. 14%
c. 15%
d. 16%
e. 17%
d. 13. A venture has raised $4,000 of debt and $6,000 of equity to finance its
firm. Its cost of borrowing is 6%, its tax rate is 40%, and its cost of equity
capital is 8%. What is the venture’s weighted average cost of capital?
a. 8.0%
b. 7.2%
c. 7.0%
d. 6.2%
e. 6.0%
d. 14. Your venture has net income of $600, taxable income of $1,000, operating
profit of $1,200, total financial capital including both debt and equity of
$9,000, a tax rate of 40%, and a WACC of 10%. What is your venture’s EVA?
a. $400,000
b. $200,000
c. $ 0
d. ($180,000)
e. ($300,000)
50 Chapter 7: Types and Costs of Financial Capital
c. 16. Venture investors generally use which one of the following target rates to
discount the projected cash flows of ventures in the “startup” stage of their life
cycles:
a. 20%
b. 25%
c. 40%
d. 50%
d. 17. Which one of the following components is not used when estimating the
cost of risky debt capital?
a. real interest rate
b. inflation premium
c. default risk premium
d. market risk premium
e. liquidity premium
e. 18. Which of the following components is not typically included in the rate on
short-term U.S. treasuries?
a. liquidity premium
b. default risk premium
c. market risk premium
d. b and c
e. a, b, and c
c. 19. The word “risk” developed from the early Italian word “risicare” and
means:
a. don’t care
b. take a chance
c. to dare
d. to gamble
e. 20. The difference between average annual returns on common stocks and
returns on long-term government bonds is called a:
a. default risk premium
b. maturity premium
c. risk-free premium
d. liquidity premium
Chapter 7: Types and Costs of Financial Capital 51
b. 21. What has been the approximate average annual rate of return on publicly
traded small company stocks since the mid-1920s?
a. 10%
b. 16%
c. 25%
d. 30%
e. 40%
e. 22. Venture investors generally use which one of the following target rates to
discount the projected cash flows of ventures in the “development” stage of
their life cycles:
a. 15%
b. 20%
c. 25%
d. 40%
e. 50%
e. 24. Which of the following venture life cycle stages would involve seasoned
financing rather than venture financing?
a. Development stage
b. Startup stage
c. Survival stage
d. Rapid-growth stage
e. Maturity stage
e. 26. Which of the following types of financing would be associated with the
highest target compound rate of return?
a. public and seasoned financing
b. second-round and mezzanine financing
c. first-round financing
d. startup financing
e. seed financing
b. 27. The cost of equity for a firm is 20%. If the real interest rate is 5%, the
inflation premium is 3%, and the market risk premium is 2%, what is the
investment risk premium for the firm?
a. 10%
b. 12%
c. 13%
d. 15%
b. 28. Use the SML model to calculate the cost of equity for a firm based on the
following information: the firm’s beta is 1.5; the risk free rate is 5%; the
market risk premium is 2%.
a. 4.5%
b. 8.0%
c. 9.5%
d. 10.5%
c. 29. Calculate the weighted average cost of capital (WACC) based on the
following information: the capital structure weights are 50% debt and 50%
equity; the interest rate on debt is 10%; the required return to equity holders is
20%; and the tax rate is 30%.
a. 7%
b. 10%
c. 13.5%
d. 17.5%
e. 20%
d. 30. Calculate the weighted average cost of capital (WACC) based on the
following information: the equity multiplier is 1.66; the interest rate on debt is
13%; the required return to equity holders is 22%; and the tax rate is 35%.
a. 11.5%
b. 13.9%
c. 15.0%
d. 16.6%
a. 10%
b. 16%
c. 19.8%
d. 22.8%
e. 30%