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 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. However, evaluation
methods exist to determine this value by financial managers.

T. 3. Formal historical accounting procedures include explicit records of debt

(interest and principal) and dividend capital costs.

F. 4. Public financial markets are markets for the creation, sale and trade of
illiquid securities having less standardized negotiated features.

F. 5. A venture’s “riskiness” in terms of poor performance or failure is usually

very high during the maturity stage of its life cycle.

T. 6. A venture’s “riskiness” in terms of poor performance or failure is usually

high to moderate during the rapid-growth stage of its life cycle.

T. 7. First-round financing during a venture’s survival stage comes primarily

from venture capitalists and investment banks.

F. 8. Startup financing usually comes from entrepreneurs, business angels, and

investment bankers.

T. 9. Commercial banks provide liquidity-stage financing for ventures in the

rapid-growth stage of their life cycles.

T. 10. A venture’s “riskiness” in terms of the likelihood of poor performance or

failure decreases as it moves from its development stage through to its rapid-
growth stage.

T. 11. A nominal interest rate is an observed or stated interest rate.

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.

45
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. 17. Bond ratings reflect the inflation risk of a firm’s bonds.

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.

T 23. Investment risk is the chance or probability of financial loss on one’s

venture investment, and can be assumed by debt, equity, and founding
investors.

F. 24. A venture with a higher expected return relative to other ventures will
necessarily have a higher standard deviation or returns.

F. 25. Historically, large-company stocks have averaged higher long-term returns

than small-company stocks

T. 26. The coefficient of variation measures the standard deviation of a venture’s

return relative to its expected return.

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.

T. 30. Market cap is determined by multiplying a firm’s current stock price by

the number of shares outstanding.

F. 31. The excess average return of long-term government bonds over common
stock is called the market risk premium.

T. 32. The weighted average cost of capital is simply the blended, or weighted
cost of raising equity and debt capital.

Multiple-Choice Questions

e. 1. Which of the following markets involve liquid securities with standardized

contract features such as stocks and bonds?
a. private financial market
b. derivatives market
c. commodities market
d. real estate market
e. public financial market

d. 2. Which of the following markets involve direct two-party negotiations over

illiquid, non-standardized contracts such as bank loans and direct placement of
debt?
a. primary market
b. secondary market
c. options market
d. private financial market
e. public financial market

d. 3. Which of the following is an example of rent on financial capital?

a. interest on debt
b. dividends on stock
c. collateral on equity
d. a and b
e. a, b, and c

b. 4. Which of the following describes the observed or stated interest rate?

a. real rate
48 Chapter 7: Types and Costs of Financial Capital

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

e. 8. Which of the following is not a component in determining the cost of debt?

a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity risk premium
e. interest rate premium

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

a. 15. The “risk-free” interest rate is the sum of:

a. a real rate of interest and an inflation premium
b. a real rate of interest and a default risk premium
c. an inflation premium and a default risk premium
d. a default risk premium and a liquidity premium
e. a liquidity premium and a maturity premium

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
e. market risk 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. 23. Corporate bonds might involve which of the following types of

“premiums.”
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity premium
e. all of the above
f. none of the above

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

a. 25. A venture’s “riskiness” in terms of possible poor performance or failure

would be considered to be “very high” in which of the following life cycle
stages:
a. Startup stage
b. Survival stage
c. Rapid-growth stage
d. Maturity stage

e. 26. Which of the following types of financing would be associated with the
highest target compound rate of return?
52 Chapter 7: Types and Costs of Financial Capital

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%

d. 31. Calculate the after-tax WACC based on the following information:

nominal interest rate on debt = 16%; cost of common equity = 30%; equity to
value = 60%; debt to value = 40%; and a tax rate = 25%.
a. 10%
b. 16%
 Chapter 7: Types and Costs of Financial Capital 53

c. 19.8%
d. 22.8%
e. 30%

c. 32. Calculate the after-tax WACC based on the following information:

nominal interest rate on debt = 12%; cost of common equity = 25%; common
equity = $700,000; interest-bearing debt = $300,000; and a tax rate = 25%.
a. 15%
b. 16.4%
c. 20.2%
d. 22.8%
e. 30%

Supplemental Problems related to Chapter 7 Appendix A (and Chapter 4

Appendix A)

b. 1. Estimate a firm’s NOPAT based on: Net sales = $2,000,000; EBIT =

$600,000; Net income = $20,000; and Effective tax rate = 30%.
a. $600,000
b. $420,000
c. $150,000
d. $70,000
e. $40,000

c. 2. Estimate a firm’s economic value added (EVA) based on: NOPAT =

$400,000; amount of financial capital used = $1,600,000; and WACC = 19%.
a. $26,000
b. $36,000
c. $96,000
d. $54,000
e. $64,000

d. 3. Find a venture’s “economic value added” (EVA) based on the following

information: EBIT = $200,000; financial capital used = $500,000; WACC =
20%; effective tax rate = 30%.
a. $20,000
b. $25,000
c. $30,000
d. $40,000
e. $50,000
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 Peggy knelt down, so as to come nearer to the tub, and looked
down into it. Then she uttered a little wail. “O father, I think they’re all
looking sick somehow! Look at my flounders!”
One of the flounders, alas! was dead already, as well as the crab,
and the other looked rather sorry for himself. Colonel Roberts,
however, would not let Peggy cry.
“Look here, child,” he said; “they want to be put back into the sea
—that’s all. There are too many of them all crowded together in the
tub; we’ll take them back to a pool on the shore, and they will soon
be as frisky as ever again.”
“Not the dead ones,” said Peggy solemnly.
“No, not the poor dead ones, but the sick ones. Go and fetch me
a pail, and we’ll carry them down to the shore.”
“But then I won’t ever see them again,” Peggy objected.
“Now, don’t be a selfish little girl. You would rather they lived and
were happy, wouldn’t you?”
“Ye—s,” Peggy faltered.
“Well, go and fetch the pail.”
After all, it would be good fun to put them all back into the sea,
Peggy thought; so she ran away and fetched the garden pail from
the shed. Colonel Roberts pulled up his sleeves, and dived his arm
into the tub, and fished up the creatures one by one. They all looked
rather flabby and sick.
“Now, we must take them down to the shore,” he said.
They selected a nice large pool, and one by one placed the poor
sick creatures into it. Then Peggy sat down to watch. She had not
long to wait: the sick flounder revived in the most extraordinary
manner, the anemones began to wave their feelers about in the nice
clean water as if they too felt all right.
“See! they are all quite happy again, Peggy,” said her father.
 “Oh, I am sorry not to keep them,” said she. “Do you think I’ll ever
get anything to play with that I can love so much?”
“Well, that depends upon yourself, Peggy; but as we walk back to
the house you can guess what I’ve got for you at home.”
“Have you got something new for me—something I’ll love?”
“Yes, quite new. I fancy you’ll love it very much.”
“As much as my sea beasts?”
“Oh, a great deal more. What do you think would be the nicest
thing you could have?”
“A Shetland pony?”
“No, far nicer.”
“A big Persian pussy-cat?”
“No, nicer still.”
Peggy began to dance with impatience. “Oh, do tell me; what is
it?” she cried.
“Well, you will find a new sister at home, very small and pink, with
blue eyes and a lot of nice black hair.”
Peggy received this description dumbly; indeed, she walked on
for a few yards before she said bitterly,—
“O father, I’d have liked the Shetland pony ever so much better;
couldn’t you change it yet? Is the sister much cheaper? I’ll give you
my shilling!”
She was rather hurt by the way her father laughed at this
proposal.
“Why, Peggy, a sister will be ever so much nicer than a pony; she
will be able to play with you and speak to you soon.”
“Can’t she speak? She can’t be a very good one,” said Peggy
dolefully.
“No, she can only cry as yet—she cries a good deal.”
 “Well, I don’t want her then, father. Do please send her away, and
get me the pony instead, or even the cat.”
“I think we’ve got to keep her, Peggy. Suppose you wait till you
see her. Perhaps you won’t wish then to send her away.”
“Can she walk, if she is so stupid, and can’t talk?” Peggy asked
suspiciously.
“Oh no, she can’t walk; she is dressed in long robes, just like your
Belinda.”
“Who has been playing with her?” Peggy asked. “Has mother? It
doesn’t amuse her much to play with Belinda, and if this thing is just
like her, I wonder mother cares to play with it either.”
“Yes, mother has played with her most of the time.”
“Well, I think it’s very queer of her, for she doesn’t like Belinda a
bit,” said Peggy. Then, after a moment’s silence, she added,
“Perhaps I’ll like it too; I don’t feel as if I would. And please, father,
will you let me ride up to the house on your back?”
This ended the discussion about the new sister.
And now, if I were to tell you how precious the new sister was to
Peggy, it would take another volume as big as this to tell it. For when
Peggy’s sister grew a little older, they had such wonderful
adventures together that Peggy used to wonder how she had got on
all the tiresome years when she was alone.
 TRANSCRIBER NOTES

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