Ch. 12 Cost of Capital

Including preferred stock in the WACC formula adds which term if P is the market value of preferred stock and RP is the cost of preferred?

(P/V) × RP

Which of the following are components used in the construction of the WACC?

Cost of preferred stock Cost of common stock Cost of debt

True or false: Finding the cost of equity is fairly straightforward.

False; It is difficult because there is no way to directly observe the return that the firm's equity investors require on their investment.

True or false: According to the CAPM, if the market risk premium is zero, then the expected return on a stock is equal to the required return.

False; It is equal to the risk-free rate.

True or false: The discount rate is also known as the expected return.

False; It is known as the required return, appropriate discount rate, and cost of capital.

True or false: The primary disadvantage of the dividend growth model approach is its simplicity.

False; that is the advantage of the dividend growth model

What is the required return on a stock (RE), according to the constant dividend growth model, if the growth rate (g) is zero?

RE = D1/P0

What is the equation for finding the cost of preferred stock?

RP=D/P0

True or false: RP=D/P0

True

If D is the market value of a firm's debt, E the market value of that same firm's equity, V the total value of the firm (E+D), RD the yield on the firm's debt, TC is the corporate tax rate, and RE the cost of equity, the weighted average cost of capital is:

[E/V] × RE + [D/V] × RD ×(1 - T c)

Dividends paid to common stockholders ______ be deducted from the payer's taxable income for tax purposes.

cannot

The rate used to discount project cash flows is known as the ___.

cost of capital required return discount rate

Components of the WACC include funds that come from ______ .

investors

The most appropriate weights to use in the WACC are the ______ weights.

market value

The WACC of a firm reflects the ____ and the target capital structure of the firm's existing assets as a whole.

risk

To estimate a firm's equity cost of capital using the CAPM, we need to know the ___.

stock's beta risk-free rate market risk premium

Which of the following is tax-deductible to the firm?

Coupon interest paid on bonds

Which of the following is true about a firm's cost of debt?

It is easier to estimate than the cost of equity. Yields can be calculated from observable data

The formula for calculating the cost of equity capital that is based on the dividend discount model is:

RE = D1/P0 + g

The formula of the SML is:

RE = Rf + Beta x (RM- Rf)

According to the CAPM, what is the expected return on a stock if its beta is equal to zero?

The risk-free rate

True or false: The return an investor in a security receives is equal to the cost of the security to the company that issued it.

True

Given V = E + D, if we divide both V and D by _____, we can calculate the capital structure weights.

V

The dividend growth model is applicable to companies that pay _____.

dividends

The return an investor in a security receives is ______ _____ the cost of the security to the company that issued it.

equal to

If an all-equity firm discounts a project's cash flows with the firm's overall weighted average cost of capital even though the project's beta is less than the firm's overall beta, it is possible that the project might be:

rejected, when it should be accepted; If the project's beta is less than the firm's overall beta, its cost of capital will be less the the overall cost of capital, and if the overall cost of capital is used, the project's cash flows will be discounted too severely, leading to the possible rejection of a value creating project.

Finding a firm's overall cost of equity is difficult because:

it cannot be observed directly

For a firm with outstanding debt, the cost of debt will be the ________ on that debt..

yield to maturity