Chapter 12 Questions

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

- yields can be calculated from observable data - it is easier to estimate than the cost of equity

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 debt - cost of preferred stock - cost of common stock

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

- discount rate - required return - cost of capital

Which of the following are true?

- the market value of debt and equity are not reliable in case of privately owned company - ideally, we should use market values in the WACC

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

equal to

If the firm is all-equity, the discount rate is equal to the firm's cost of ______ capital.

equity

T/F: The cost of equity is D1/P0 minus the analysts' estimates of growth.

false

T/F: The discount rate is also known as the expected return.

false

Components of the WACC include funds that come from ______ .

investors

T/F: RP=D/P0

true

The following are advantages of the SML approach

- adjusts for risk - does not require the company to pay a dividend

What can we say about the dividends paid to common and preferred stockholders?

- dividends to preferred stockholders are fixed - dividends to common stockholders are not fixed

To estimate the dividend yield of a particular stock, we need:

- forecasts of the dividend growth rate, g - the last dividend paid, D0 - the current stock price

We should use ____ values in the WACC. Because ____ values are often similar to market values for debt, we often use book value for debt and market value for equity.

- market - book

Preferred stock ___.

- pays a constant dividend - pays dividends in perpetuity

The following are disadvantages of the SML approach

- requires estimation of the market risk premium - requires estimation of beta

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

- risk-free rate - stock's beta - market risk premium

The growth rate of dividends can be found using:

- security analysts' forecasts - historical dividend growth rates

The formula of the SML is:

RE = Rf + Beta x (RM- Rf)

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

RP=D/P0

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)

Using an analyst's forecast for a firm's earnings growth and a stock's dividend yield, you can find the cost of equity by:

adding these two components

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

coupon interest paid on bonds

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

dividends

T/F: Finding the cost of equity is fairly straightforward.

false

T/F: For publicly traded companies, the component of the dividend yield that must be estimated is the dividend.

false

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

it cannot be observed directly

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

risk

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

the risk-free rate

T/F: 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 WACC is the overall rate of return the firm must earn on its existing assets to maintain the ____ of its stock.

value or price

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

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

RE = D1/P0 + g

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

cannot

T/F: 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

In the WACC calculation, D represents the ____ value of the firm's debt.

market

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

market value

The cost of capital depends primarily on the ______ of funds, not the _____.

use; source

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

yield to maturity

What is the appropriate discount rate to use only if the proposed investment is a replica of the firm's existing operating activities?

WACC

T/F: The cost of capital depends on the source of the funds.

false

T/F: The expected percentage is the overall rate of return the firm must earn on its existing assets to maintain the value of its stock.

false

T/F: The growth rate of dividends can be found using the CAPM.

false

T/F: The primary disadvantage of the dividend growth model approach is its simplicity.

false

True or false: In the WACC calculation, V = E - D.

false

If a firm issues no debt, its average cost of capital will equal ___.

its cost of equity

T/F: The SML approach is advantageous because all it requires is the estimation of beta.

false

T/F: The SML approach is advantageous because all it requires is estimation of beta.

false