Chapter 12

Which of the following are advantages of the CAPM approach

- explicitly adjusts for systematic risk -it is applicable to all companies, as long as beta is available

Which models do we use to estimate the cost of equity?

-The dividend growth model -the capital asset pricing model

For one of our cost of equity models, we need P0, D0, and g. The expected growth rate, g, is difficult to predict. How do we estimate it?

-Use historical growth rates -use analysts forecast of future growth rates

The cost of equity is the return required by equity investors given the risk of the cash flows from the firm. Which of the following are the sources of risk with regard to equity?

Business risk Financial risk

The cost of a capital is a composite cost of a firms long term capital and is calculated as the weighted average cost of the types of financing the firm uses. Which are these sources of financing?

Debt Preferred stock Common stock

Which of the following is the correct way to estimate the firms after-tax cost of debt?

Debt after tax = debt before tax (1-tax rate)

Match the market value of equity(E), the market value of preferred stock (P) and the market value of debt (D) to the correct way of estimating it.

E- p- D-

Which of the following statements regarding the weights used in the weighted average cost capital (WACC) is false?

If target weights are not available, use weights based on book values.

Which of the following is/are true regarding the weighted average cost of capital(WACC)?

It reflects the overall cost of long-term financing. It is the required rate of return for projects that have the same level of risk as the firm

Which of the following is FALSE regarding why the cost of capital is important?

Our cost of capital provides us with an indication of how the market views the return on our assets.

For one of our cost of equity models, we need the risk free rate, the market risk premium, and the firms beta. Which model uses these inputs?

The capital asset pricing model (CAPM)

Which of the following statements is true regarding the cost of capital?

The cost of capital associated with an investment depends on the risk of the investment

For one of our cost of equity models, we need P0, D0, and g. Which model uses these inputs?

The dividend growth model

Which of the following models are used to estimate the cost of preferred stock?

The dividend growth model

Which of the following is NOT a disadvantage of the dividend growth model?

The estimated cost of equity is very sensitive to the estimated dividend. A a 1$ change in the estimated dividend results in a 1% change in the cost of equity

The cost of equity is the most difficult capital cost to estimate. Why?

There is no way of directly observing the return that the firms equity investors require on their investment -we must estimate it.

A firm must earn the required return on the investment just to compensate its investors for the use of the capital needed to finance the project.

True

Which of the following statements about the cost of debt is false?

We can estimate the firms cost of debt as the coupon rate on outstanding bonds