Relationship between Risk and the Cost of Capital

This chapter defines risk and gives the three types of risk in the economic sense as used in the conventional methods of estimating cost of capital. It also tells us that as risk goes up, the cost of capital goes up. Finally, it tells us that common equity capital, preferred equity capital, and debt are components of tola invested capital and that the blended cost of these is the weighted average cost of capital (WACC).

MULTIPLE CHOICE QUESTIONS 1, The cost of capital is comprised of w7hich of the following factors?

a.  The "risk-free rate/1 plus a holding period premium, plus a premium for risk.

b.  The "risk-free rate," plus a premium for potential changes in interest rates, plus a pre­ mium for risk.

c.   The "risk-free rate," plus a maturity premium, plus a premium for risk.

d.  The "risk-free rate," plus a premium for risk.

2. "Unsystematic risk" encompasses all of the following BXCBPT:

a.  Industry risk.

b.  Company-specific risk.

c.   The risk of changes in the general level of market returns.

d.  Risk arising from leverage.

3.  In which of the following methods of estimating the cost of equity capital is a risk premium explicitly added to a risk-free rate?

a.  The build-up method, the Capital Asset Pricing Model, and the DCF method.

b.  The build-up method and the Capital Asset Pricing Model but not the DCF method.

c.   The build-up method and the DCF method but not the Capital Asset Pricing Model.

d.  The Capital Asset Pricing Model and the DCF method but not the build-up method.

4. The risk-free rate:

a.  Excludes any type of risk.

b.  Excludes the risk of default, but not the risk of changes in interest rates.

c.   Excludes the risk of default, but not the risk of changes in the general prices of equities
in the market

d.  Excludes the risk of default, the risk of changes in interest rates, and the risk of changes
in the general prices of equities in the market.

5.   Arguably, the most widely accepted definition of risk in the context of business appraisal is "the degree of uncertainty as to trie realization of expected future economic income".

6.       As risk increases, the cost of capital increases, and vice versa.

7.       Uncertainty is in the minds of investors; therefore, we cannot measure it directly.

True      False True      False

True      False

I.  In an economic sense, as used in the conventional sense of estimating the cost of capital theory divides risk into what three components?

9. What is the name of the factor commonly used to measure systematic risk?

1.0. The overall cost of a company's capital (blended cost of common equity, preferred equity. and long-term debt) is called what?

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