Question

1. Which of the following variables does not impact the after tax cost of debt for a firm??

	a.	The default risk of the firm.
	b.	The marginal tax rate paid by the firm.
	c.	The bottom up beta.
	d.	The current level of interest rates.

2. Which of the following is the lowest investment grade bond rating?

	a.	BBB
	b.	B
	c.	A
	d.	BB

3. Which of the following is usually true concerning the cost of capital (the weighted average cost of capital or WACC)?

	a.	The Weighted Average Cost of capital should be considered constant over time and does not change with market conditions or changes in the firm.
	b.	The WACC (or cost of capital) is generally less than the cost of debt.
	c.	The WACC (or cost of capital) is generally less than the cost of equity.
	d.	It does not matter if you use market values or book values for the amounts of each type of financing.

4. If evaluating the results of a regression, which of the following is the best indicator that the independent variable is strongly correlated to the dependent variable?

	a.	A T-Statistic of 1 with a p value of .4 associated with the coefficient on the independent variable.
	b.	A high standard error on the estimate of the slope of the line.
	c.	A T-Statistic of 4 with a p-value of .001 associated with the coefficient on the independent variable.
	d.	An R squared value of .45

5. The capital Asset pricing model measure the sensitivity of the firm to which of the following types of risk?

	a.	Industry specific Risk.
	b.	International Risk.
	c.	Market Risk.
	d.	Firm Specific Risk.

Answer 1

(1) Bottom up beta is the variable that does not impact the after tax cost of debt of the firm. Default risk of the firm relates to the failure of firm to service debt obligations therefore it impacts after tax cost of debt because lenders demand spread over interest rates due to additional risk. The marginal tax rate impacts the after tax cost of debt because the tax rate used is an effective tax rate which includes both basic and marginal tax rate to arrive at after tax cost of debt, therefore impacting it. The current level of interest rates directly relates to the interest portion of the debt, hence, impacting after tax cost of debt.

(2) BBB is the lowest investment grade bond rating whereas A is rated above under investment grade. BB and B are graded junk and hence not considered for the lowest investment grade bond rating.

The flow from high to low is AAA - AA - A - BBB under investment grade.

(3) The weighted average cost of capital is generally less than the cost of equity. It is because equity carries higher risk than debt and hence cost of equity is usually high. Upon calculation of cost of capital, cost of equity is usually higher as WACC is a combination of debt and equity.