Chapter 12
o The dividend growth model is applicable to companies that pay _________
Dividends
o True or False: Projects should always be discounted at the firm's overall cost of capital.
False
o The WACC is the overall _______ the firm must earn on its existing assets to maintain _______ of its stocks
Return; value
o To estimate the dividend yield of a particular stock, we need:(3) The last dividend paid, D0 Beta from the Wall Street Journal The current stock price Forecasts of the dividend growth rate, g The risk-free rate from a bank's CD rates
• The last dividend paid, D0 • The current stock price • Forecasts of the dividend growth rate, g
o What does WACC stand for? Weighted average cost of capital Weighted average company cost Working amount of corporate cash Working amount of corporate cost
• Weighted average cost of capital
o Which of the following are components used in the construction of the WACC? (3) Cost of commons tock Cost of preferred stock Cost of accounts payable Cost of debt
• Cost of common stock • Cost of preferred stock • Cost of debt
o The rate used to discount project cash flows is known as the ______.(3) Discount rate Cost of capital Market rate Required return
• Discount rate • Cost of capital • Required return
Some risk adjustments to a firm's WACC for projects of differing risk, even if its subjective, is probably: Preferred over the pure play approach An irreducible absurdity Better than no risk adjustment Uncalled for
• Better than no risk adjustment
o The cost of capital depends primarily on the ______ of funds, not the _______ Source; use Source; cost Use; cost Use; source
• Use; source
o A firm's capital structure consists of 40 percent and 60 percent equity. The after-tax yield on debt is 2.5 percent and the cost of equity is 15 percent. The project is about as risky as the overall firm. What discount rate should be used to estimate the project's net present value? 8.75% 10% 2.5% 11.43%
• 10%
o If a preferred stock pays a dividend of $2 per year and is selling for $20, its yield is: 22% 20% 18% 10%
• 10%
o If an analyst's forecast for a firm's earnings growth is 7 percent, and its dividend yield is 3 percent, its cost of equity will be _____. 10% 2.5% 21% 4%
• 10%
o Suppose the risk-free rate is 5 percent, the market rate of return is 10 percent, and the beta is 2. Find the required rate of return using the CAPM. 20% 5% 15% 10%
• 15%
o For a firm with outstanding debt, the cost of debt will be the ______ on that debt Average yield Yield to maturity Coupon rate Current yield
• Yield to maturity
o If the firm is all-equity, the discount rate is equal to the firm's cost of ______ capital Government Derivative Debt Equity
• Equity
o Which of the following is true about a firm's cost of debt?(2) It is easier to estimate that the cost of equity Yields can be calculated from the observable data Yields can be checked by using the DDE model
• It is easier to estimate that the cost of equity • Yields can be calculated from the observable data
o If a firm issues no debt, its average cost of capital will equal ______. Its dividend yield Its cost of debt Half the sum of the cost of debt and equity Its cost of equity
• Its cost of equity
o Other companies that specialize only in project's similar to the project your firm is considering are called _______ Knock-offs Conglomerates Pure plays Matched pairs
• Pure plays
o The following are disadvantages of the SML approach (2) Adjusts for risk Requires estimation of the market risk premium Does not require the company to pay a dividend Requires estimation of beta
• Requires estimation of the market risk premium • Requires estimation of beta
o Ted is trying to decide what cost of capital he should assign to a project. Which one of the following should be his primary consideration in this decision? Amount of debt used to finance the project Use, or lack, of preferred stock as a financing option Mix of funds used to finance the project Risk level of the project Length of the project's life
• Risk level of the project
o To estimate a firm's equity cost of capital using the CAPM, we need to know the______ (3) Risk-free rate Annual dividend amount Market risk premium Stock's beta
• Risk-free rate • Market risk premium • Stock's beta
o The growth rate of dividends can be found using:(2) Security analysts' forecasts The capital asset pricing model The perpetuity model Historical dividend growth rate
• Security analysts' forecasts • Historical dividend growth rates
o Which one of the following is the primary determinant of an investment's cost of capital? Life of the investment Amount of the initial cash outlay The investment's level of risk The source of funds used for the investment The investment's net present value
• The investment's level of risk
o What can we say about the dividends paid to common and preferred stockholders?(2) Dividends to common stockholders are not fixed Dividends are guaranteed foe both preferred and commons stockholders Preferred stock dividends change every year based on the earnings of the firm Dividends to preferred stockholders are fixed
• Dividends to common stockholders are not fixed • Dividends to preferred stockholders are fixed
o The following are advantages of the SML approach(2) Requires estimation of beta Does not require the company to pay a dividend Adjusts for risk Requires estimation of the market risk premium
• Does not require the company to pay a dividend • Adjusts for risk
o The return an investor in a security receives is ______ _______ the cost of the security to the company that issued it Equal to Less than Greater than Unrelated to
• Equal to
o The cost of capital for a project depends primarily on which one of the following? Source of funds used for the project Division within the firm that undertakes the project Project's modified internal rate of return How the project uses its funds Project's fixed costs
• How the project uses its funds
o Components of the WACC include funds that come from_____. Investors Non-cash expenses Accruals
• Investors
o Finding a firm's overall cost of equity is difficult because: It requires the use of differential equations It cannot be observed directly The federal government refuses to disclose equity costs It can only be guessed at
• It cannot be observed directly
o Which one of the following is most apt to cause a wise manager to increase a project's cost of capital? Assume the firm is levered. Management decides to issue new stock to finance the project. The initial cash outlay requirement is reduced. She learns the project is riskier than previously believed. The aftertax cost of debt just decreased. The project's life is shortened.
• She learns the project is riskier than previously believed.
o SmartKids, a textbook publisher, is considering investing in a software company that collects and stores data. What beta should SmartKids use to assess the risk of the project? The beta for SmartKids The beta for software companies that collect and store data The beta for software companies as a whole The beta for the textbook industry as a whole
• The beta for software companies that collect and store data
o Suppose a firm's capital structure consists of 30% debt, 10% preferred stock and 60% equity. The firm's bonds yield 10% on average before taxes, the cost of preferred stock is 8% and the cost of equity is 16%. Calculate the firm's WACC assuming a tax rate of 40% 12% 12.2% 13.2% 12.5%
• 12.2%
o A firm's capital structure of 30 percent debt and 70 percent equity. Its bonds yield 10 percent, pretax, its cost of equity is 16 percent, and the tax rate is 40 percent. What is its WACC? 12.5% 13% 12% 13.5%
• 13%
o Judy's Boutique just paid an annual dividend of $1.48 on its common stock and increases its dividend by 2.2 percent annually. What is the rate of return on this stock if the current stock price is $29.60 a share? 7.31 percent 8.37 percent 7.54 percent 8.19 percent 8.33 percent
• 7.31 Percent
o If a firm is funded with $400 in debt and $1,200 in equity, the weight of equity in the capital structure is _________% and the weight of debt is ________%. 75; 25 35; 65 50; 50 25; 75
• 75; 25
o WACC was used to compute the following project NPV's: Project A= $100, Project B= -$50, Project C- -$10, Project D - $40. Which projects should the firm accept? B and C A only A,B, and c A and D
• A and D
o Which of the following are true?(2) Book values are often similar to market values for equity Book values are often similar to market values for debt Ideally, we should use market values in the WACC Ideally, we should use book values in the WACC.
• Book values are often similar to market values for debt • Ideally, we should use market values in the WACC
o Dividends paid to common stockholders _______ be deducted from the payer's taxable income for tax purposes Can Cannot Should May
• Cannot
Katie owns 100 shares of ABC stock. Which one of the following terms is used to refer to the return that Katie and the other shareholders require on their investment in ABC? Weighted average cost of capital Pure play cost Cost of equity Subjective cost Cost of debt
• Cost of Equity
o Lester lent money to The Corner Store by purchasing bonds issued by the store. The rate of return that he and the other lenders require is referred to as the: Pure play cost. Cost of debt. Weighted average cost of capital. Subjective cost. Cost of equity.
• Cost of debt
o The weighted average cost of capital is defined as the weighted average of a firm's: Return on all of its investments. Cost of equity, cost of preferred, and its aftertax cost of debt. Pretax cost of debt and its preferred and common equity securities. Bond coupon rates. Common and preferred stock.
• Cost of equity, cost of preferred, and its aftertax cost of debt.
o What will happen over time if a firm uses its overall WACC to evaluate all projects, regardless of each project's risk level? (3) Using the firm's WACC to evaluate all projects is appropriate The firm's risk will not change over time The firm overall will become riskier It will reject projects that it should have accepted It will accept projects that is should have rejected
• The firm overall will become riskier • It will reject projects that it should have accepted • It will accept projects that is should have rejected
o Which one of the following represents the minimum rate of return a firm must earn on its assets if it is to maintain the current value of its securities? Cost of equity Pretax cost of debt Aftertax cost of debt Weighted average cost of capital Weighted average cost of preferred and common stock
• Weighted average cost of capital
o All else constant, an increase in a firm's cost of debt: Could be caused by an increase in the firm's tax rate. Will result in an increase in the firm's cost of capital. Will lower the firm's weighted average cost of capital. Will lower the firm's cost of equity. Will increase the firm's capital structure weight of debt.
• Will lower the firm's weighted average cost of capital.