General Economic Conditions and Capital Demand Quiz

Questions and Answers

How do general economic conditions influence the risk-free rate of return?

By determining the market price of securities

By influencing the liquidity of short-term government securities

By affecting the demand for and supply of capital (correct)

By setting the interest rate for long-term government bonds

What happens to the cost of capital when investors increase their required rate of return due to higher risk?

It remains unchanged

It decreases simultaneously

It fluctuates randomly

It increases simultaneously (correct)

Why do investors require a higher rate of return when inflation is expected to deteriorate the purchasing power of money?

To reduce the demand for money in the economy

To compensate for the anticipated loss in purchasing power (correct)

To stabilize the cost of capital

To encourage more borrowing in the economy

What is the impact of issuing more debt on the cost of debt?

The cost of debt increases Signup and view all the answers

How does increasing the payout ratio affect the marginal cost of capital schedule?

It raises the breakpoint between lower-cost equity and newly issued equity Signup and view all the answers

What is the common consequence of trying to place a large issue in the market without reducing the price of the security?

The firm's cost of capital increases Signup and view all the answers

How does granting large sums without evidence of management's capability impact suppliers of capital?

It causes them to become hesitant Signup and view all the answers

How does the investor's required rate of return change in response to a security being readily marketable and having a reasonably stable price?

It decreases due to lower risk. Signup and view all the answers

How do business risk and financial risk affect the investor's required rate of return?

Both risks increase the required rate of return. Signup and view all the answers

How does the level of financing required by the firm impact the weighted cost of capital?

The weighted cost of capital increases as the financing requirements increase. Signup and view all the answers

Study Notes

Economic Influence on Risk-Free Rate

General economic conditions stabilize or destabilize the risk-free rate, which reflects the yield on government securities unaffected by default risk.
Economic growth can lead to higher demand for investment which may increase the risk-free rate, while recessionary conditions tend to lower it.

Cost of Capital and Required Rate of Return

When investors raise their required rate of return due to perceived higher risk, the overall cost of capital increases.
A higher cost of capital affects corporate investments, potentially slowing growth as projects become less attractive.

Higher Rate of Return and Inflation

Investors demand a higher rate of return during expected inflation to compensate for the loss of purchasing power over time.
The required return aligns with the risk of inflation eroding real returns, leading to adjustments in investment strategies.

Impact of Issuing More Debt

Issuing additional debt can increase the cost of debt due to elevated perceived default risk and potential impact on credit ratings.
Higher debt levels may lead to a rise in interest rates demanded by lenders.

Payout Ratio and Marginal Cost of Capital

Increasing the payout ratio generally reduces retained earnings, leading to a higher reliance on external financing.
This shift affects the marginal cost of capital, as external funding is often more costly than retained earnings.

Large Issues and Market Pricing

Attempting to issue a large quantity of securities without price adjustments can saturate the market, leading to decreased demand and a potential drop in price.
Poor market reception can negatively impact the firm's financial health and future capital-raising activities.

Management Capability and Capital Suppliers

Granting funds without evidence of management capability undermines investor confidence and can make capital suppliers hesitant.
This lack of trust may lead to stricter financing terms or outright refusal to provide capital.

Marketability and Investor’s Required Return

A security that is readily marketable and maintains stable prices may have a lower required rate of return due to reduced liquidity risk.
Investors seek reliable returns in exchange for the perceived risks associated with the marketability of their investments.

Business and Financial Risk

Business risk (operational performance) and financial risk (debt levels) together influence the investor's required rate of return.
Increased risks can elevate required returns as investors seek compensation for additional uncertainty.

Financing Requirements and Weighted Cost of Capital

The level of financing a firm needs influences the weighted average cost of capital (WACC); higher financing demands can lead to increased costs.
Adjustments in capital structure impact WACC, thus affecting investment decisions and firm valuation.

Description

Test your knowledge on how general economic conditions impact the demand for and supply of capital, as well as the level of expected inflation. This quiz covers topics such as risk-free rate of return and its reflection on economic variables.