Relationship between Risk and the Cost of Capital

1. d. The risk of potential changes in interest rates, or the maturity premium, is subsumed under the "risk-free" rate.

2. c

3. b

4. b

True or Faise Questions

5. True

6. True

7. True

Fill-sn-the-Blank Questions

8. a. Maturity risk (horizon risk, interest rate risk)

b. Systematic risk (market risk)

c. Unsystematic risk (company risk, specific risk, residual risk)

9. Beta

10. Weighted average cost of capital (W ACQ

1. b

2. b

3. b

True or False Questions

4. Tine. However, some bank provisions require the debt to be at zero for some period, such as 30 days. Tn such case, one normally would not reclassify the debt as long term.

5. True

Fill-in-the-Blank Questions

6. a. Debt

b. Preferred stock

c. Common stock

7. a. Convertible preferred stock

b. Convertible debt

c. Warrants

d. Options

e. Leases

8. a. Straight bond or preferred b. A warrant or option

9. a. Dividends or distributions (withdrawals)

b. Appreciation or depreciation in market value

10. kd = kd(p!}(\--f)

Where:

kd = Discount rate for debt (net of tax effect)

kd(p!j = Rate of interest for debt (the company's pretax cost of debt capital)

t - tax rate

0.08 (1 - 0.20) = 0.08 (0.8) = 0.064 = 6.4%

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