T or F: The reason why reinvested earnings have a cost equal to the firm’s cost
ID: 2732445 • Letter: T
Question
T or F: The reason why reinvested earnings have a cost equal to the firm’s cost of common equity, rs, is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm’s common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should distribute those earnings to its investors. Thus, the cost of reinvested earnings is based on the opportunity cost principle
T or F: If the firm has a low level of debt, ‘underinvestment problem’ is more likely to occur
T or F: In ‘bait-and-switch,’ the firm borrows money, then sells its relatively safe assets and invests the proceeds in assets for a large new project that is far riskier. If the risky project is successful, most of the benefits go to the bondholders. However, if the project is unsuccessful, the shareholders take a loss
T or F: The calculate WACC, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure.
T or F: Studies show that firms located in countries with strong legal protection for investors have a stronger corporate governance and that this is reflected in better access to financial markets, a lower cost of equity, increases in market liquidity, and less nonsystematic volatility in stock returns.
Explanation / Answer
T or F: The reason why reinvested earnings have a cost equal to the firm’s cost of common equity, rs, is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm’s common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should distribute those earnings to its investors. Thus, the cost of reinvested earnings is based on the opportunity cost principle
True
T or F: If the firm has a low level of debt, ‘underinvestment problem’ is more likely to occur
False
T or F: In ‘bait-and-switch,’ the firm borrows money, then sells its relatively safe assets and invests the proceeds in assets for a large new project that is far riskier. If the risky project is successful, most of the benefits go to the bondholders. However, if the project is unsuccessful, the shareholders take a loss.
False
T or F: The calculate WACC, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure.
True
T or F: Studies show that firms located in countries with strong legal protection for investors have a stronger corporate governance and that this is reflected in better access to financial markets, a lower cost of equity, increases in market liquidity, and less nonsystematic volatility in stock returns.
True
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