Chapter 14 Learnsmart
Including preferred stock in the WACC adds the term:
(P/V) x Rp
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.
0.05 + 2( 0.1 - 0.05) = *015*
A firm has a target debt-equity ratio of 0.5, but it plans to finance a new project with all debt. What debt-equity ratio should be used when calculating the project's flotation costs?
0.5 (When calculating flotation costs, the target debt-equity ratio should be used.)
Dang's Donuts has an EBIT of $25,432, depreciation of $1,500, and a tax rate of 18%. The company will not be changing its net working capital, but plans a capital expenditure of $6,324. What is Dang's adjusted cash flow from assets?
25,432 + 1,500 - 4,777.76 - 6,324 = *16,030.24*
A project's NPV without flotation costs is $1,000,000 and its flotation costs are $50,000. What is the true NPV?
950,000
The CAPM formula is:
E(RE) = R(f) + B(E) x [E(Rm) + R(f)]
The best way to include flotation costs is to _____. add them to the initial investment adjust the WACC upward decrease the WACC and add them to the initial investment
add them to the initial investment
The return an investor in security receives is _____ _____ the cost of the security to the company that issued it. equal to greater than unrelated to less than
equal to
In reality, most firms cover the equity portion of their capital spending with _____. internally generally cash flow a new bond issue a new common stock issue a new preferred stock issue
internally generated cash flow (In reality, most firms cover the equity portion of their capital spending with internally generated cash flow. Preferred stock is considered separately from equity)
The growth rate of dividends can be found using: the perpetuity model s ecurity analysis forecasts historical dividend growth rates the capital asset pricing model
security analysis forecasts historical dividend growth rates
The cost of capital is an appropriate name since a project must earn enough to pay those who _____ the capital. use oversee mandate supply
supply
If a firm uses its overall cost of capital to discount cash flows from higher risk projects, it will accept _____ projects. the optimal number of too many high-risk only profitable
too many high-risk
WACC was used to compute the following project NPVs; Project A = $100, Project B = -$50, Project C = -$10, Project D = $40. Which projects should the firm accept?
A and D (A and D both have positive NPV so both should be chosen)
Which of the following are components used in the construction of the WACC? Cost of debt Cost of preferred stock Cost of common stock Cost of accounts payable
Cost of debt Cost of preferred stock Cost of common stock (A firm's cost of capital will reflect both its cost of debt capital and its cost of equity capital.)
Barry Corporation expects free cash flow of $110 thousand at the end of the year, and steady growth from here on. Its WACC is 12% and its expected growth rate is 5%. What is the value of Barry Corporation today? $2,200,000 $1,571,429 $916,667 $45,833
V(0) = $110,000 / (0.12 - 0.05) = *$1,571,429*
Economic Value Added (EVA) uses the weighted average cost of capital to determine if value is: the stuff that dreams are made of being created or destroyed ephemeral important to shareholders
being created or destroyed
Some risk adjustment to a firm's WACC for projects differing risk, even if it is subjective, is probably: an irreductible absurdity uncalled for preferred over the pure play approach better than no risk adjustment
better than no risk adjustment
The rate used to discount project cash flows is known as the _____. required return market rate discount rate cost of capital
required return discount rate cost of capital
The CAPM can be used to estimate the _____. required return on equity interest rate on loans historical return on equity realized return on equity
required return on equity
If the firm issued so much debt that its equity was valueless, its average cost of capital would equal _____. 1 x the cost of equity 1 x the aftertax cost of debt the cost of debt/cost of equity half of the sum of the cost of equity and the aftertax cost of debt
1 x the aftertax cost of debt
A firm's capital structure consists of 40 percent debt and 60 percent equity. The aftertax 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?
10%
A company has a borrowing rate of 15 percent and a tax rate of 30 percent. What is its aftertax cost of debt?
10.5%
ULC and LEV have earnings before interest and taxes of $110. LEV also has $20 of interest expense. Both companies are taxed at 30 percent, ULC's aftertax earnings are _____, which is _____ than lev's after tax earnings.
ULC = $110 x (1- 0.3) = *$77* LEV = $90 x (1-0.3) = *$63*
Preferred stock _____. does not pay dividends pays dividends in perpetuity pays a constant dividend has a fixed maturity
pays dividends in perpetuity pays a constant dividend
If an all-equity firm's beta is 2, the risk-free rate is 3%, and the historical market risk premium is 7%, what is the firm's cost of capital?
17%
Which of the following are true? 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 equity Book values are often similar to market values for debt
Ideally, we should use market values in the WACC. Book values are often similar to market values for debt.
If the firm is all-equity, the discount rate is equal to the firm's cost of _____ capital. equity government debt derivative
equity
A firm's cost of debt can be _____. estimated easier than its cost of equity obtained by talking to investment bankers calculated using the dividend growth model obtained by checking yields on publicly traded bonds.
estimated easier than its cost of equity obtained by talking to investment bankers obtained by checking yields on publicly traded bonds.
What can we say about the dividends paid to common and preferred stockholders? Preferred stock dividends change every year based on the earnings of the firm. Dividends to common stockholders are not fixed. Dividends are guaranteed for both preferred and common stockholders. Dividends to preferred stockholders are fixed.
Dividends to common stockholders are not fixed.. Dividends to preferred stockholders are fixed. (Preferred stock dividends generally stay the same. Common stock dividends are often a function of earnings.)
A firm has 20 percent debt, debt flotation costs of 5 percent, equity flotation costs of 10 percent, and wants to raise $9,100, not including flotation costs. What are the flotation costs?
f(0) = (0.2 x 0.05) + (0.8 x 0.1) = 9% $9,100/(1-.09) - 9,100 = *$900*
The issuance of costs of bonds and stocks are referred to as _____ costs. market reparation sunk floatation
floatation
What does WACC stand for?
Weighted average cost of capital
B = the market value of a firm's debt; S = the market value of that same firm's equity; R(B) = the before-tax yield on the firm's debt T(C) = the corporate tax rate; R(B) = the cost of equity Given the definitions above, the weighted average cost of capital formula can be written as:
[S/(S+B)] x R(B) + [B/(S+B)] x (1 - T(C))
If a firm has multiple projects, each project should be discounted using _____. the firms overall cost of capital the marginal cost of capital for the latest project a discount rate commensurate with the project's risk the average cost of capital
a discount rate commensurate with the project's risk
Dividends paid to common stockholders ______ be deducted from the payer's taxable income for tax purposes. can cannot should may
cannot
One method for estimating the cost of equity is based on the ______ model. dividend growth prime and LIBOR average bond plus equity premium prime growth
dividend growth
The most appropriate weights to use in the WACC are the _____ weights. salvage value book value market value government mandated
market value
Preferred stock _____. has fixed maturity pays a constant dividend pays dividends in perpetuity does not pay dividends
pays a constant dividend pays dividends in perpetuity
Other companies that specialize only in projects similar to the project your firm is considering are called _____. pure plays comparables knock-offs matched pairs
pure plays
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: accepted, when it should be rejected rejected, as it should be accepted, as it should be rejected, when it should be accepted
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 than the overall cost of capital, and if the overall cost of capital is used, the project's cash flows will be discounted too severely, and it will most likely be rejected.)
Finding a firm's overall cost of equity is difficult because the federal government refuses to disclose equity costs there is no way to estimate it it cannot be observed directly it requires the use of differential equiations
it cannot be observed directly
What can we say about the dividends paid to common and preferred stockholders? Preferred stock dividends change every year based on the earnings of the firm. Dividends to preferred stockholders are fixed. Dividends are guaranteed for both preferred and common stockholders. Dividends to common stockholders are not fixed.
Dividends to preferred stockholders are fixed Dividends to common stockholders are not fixed
To estimate a firm's equity cost of capital using the CAPM, we need to know the _____. annual dividend amount market risk premium stock's beta risk-free rate
market risk premium stock's beta risk-free rate
The WACC is the minimum return a company needs to earn to satisfy _____. the exchange on which its stock is traded its bondholders its stockholders the SEC
its bondholders its stockholders
Which of the following is true? A company cannot deduct interest paid on debt when computing taxable income. A company can deduct interest paid on debt when computing taxable income. A company can deduct dividends paid to shareholders when computing taxable income.
A company can deduct interest paid on debt when computing taxable income.
The formula for calculating the cost of equity capital that is based on the dividend discount model is:
R(E) = D(1)/P(0) + g
The SML approach requires estimates of: the cost of debt capital the beta coefficient the market risk premium the cost of equity capital
the beta coefficient the market risk premium
Which of the following methods for calculating the cost of equity ignores risk? yeild to maturity the dividend growth model the CAPM
the dividend growth model
One of the disadvantages of using historical returns to estimate the market risk premium is that the past may not be a good guide to the future: ever when the economic conditions are relatively stable when economic conditions change quickly
when economic conditions change quickly
A good source for bond quotes is: www.sec.gov www.finra.org/marketdata www.goodbondinfor.org www.bond.edu
www.finra.org/marketdata
Sigma Corporation consists of two divisions: A and B. Division A is riskier than Division B. If Sigma Corporation uses the firm's overall WACC to evaluate both Divisions' projects, which Division will probably not receive enough resources to fund all of its potentially profitable projects? Division A Division B Both Divisions Neither will be harmed
Division B (Division A is riskier, so its cash flows should be discounted at a higher rate. Because they're not, the projects Division A will look better than those in Division B. More projects will be accepted in Division A, Division B's cash flows will be discounted using a higher rate than should be used, so they will appear less appealing and will be more rejected.
The discount rate for the firm's projects equals the cost of capital for the firm as a whole when _____. all projects have a "bell curve" of risks all projects have the same risk as the current firm the average risk of the firm's projects is constant
all projects have the same risk as the current firm