Cost of Capital

ULC and LEV have earnings before interest and taxes of $110. LEV also has $20 of interest expense. Both companies are taxed at 21%, ULCs aftertax earnings are _______, which is _______ than LEV's aftertax earnings.

$86.90; $15.80 greater

What are the after-tax earnings for HIJ Corporation if it reports $200 in revenue, $90 in operating expenses, has a tax rate of 21%, and pays $20 in interest on its bonds

(200-90-20) x (1-0.21) = $71.10

WACC equation

(E/V)*Re+(D/V)*Rd*(1-Tc)

WACC equation (preferred stock)

(E/V)*Re+(P/V)*Rp+(D/V)*Rd*(1-Tc)

Including preferred stock in the WACC adds the term:

(P/V)*Rp

A firm's cost of debt can be _____________

*obtained by checking yields on publicly traded bonds *estimated easier than its cost of equity *obtained by talking to investment bankers

The growth rate of dividends can be found using:

-Historical dividend growth rates -Security analysts' forecasts

If the risk free rate is 4%, an all-equity firm's beta is 2, and the market risk premium is 6%, what is the firm's cost of capital?

.04+2*.06=16%

The SML approach requires estimates of:

1. Beta coefficient 2. Market risk premium

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

1. Cost of debt 2. Cost of preferred stock 3. Cost of common stock

Which of the following are true?

1. Ideally, we should use market values in the WACC. 2. Book values are often similar to market values for debt.

Preferred stock _____________

1. pays a constant dividend 2. pays dividends in perpetuity

If an analyst's forecast for a firm's earnings growth is 7%, and its dividend yield is 3%, its cost of equity will be __________________.

10%

A company has a borrowing rate of 15% and a tax rate of 30%. What is its aftertax cost of debt?

15% x (1-.21) = 11.85%

If the market value of debt is $45 million and the market value of equity is $105 million, the total firm value is:

150 million

If a preferred stock pays a dividend of $2 per year and is selling for $20, its yield is:

2/20 = 10%

Suppose the risk-free rate is 5 percent, the market rate of return is 10 percent, and beta is 2. Find the required rate of return using the CAPM

5% + (2*(10%-5%))= 15%

Which of the following is true?

A company can deduct interest paid on debt when computing taxable income.

If a firm has multiple projects, each project should be discounted using ___.

A discount rate that commensurates with the project's risk

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

Cannot

One method for estimating the cost of equity is based on the __________ model.

Dividend growth

CAPM formula is:

E(Re)=Rf+B(E(Rm)-Rf)

SML Approach

Expected return on Equity E(Re)= Risk-free rate+Systematic risk of the asset relative to average * (Market Risk Premium) ________________________ Market risk premium = E(Rm) - Rf

The most appropriate weights to use in the WACC are the _____________ weights

Market value

Dividend Growth Model Approach

Price per share of the stock=(Dividend just paid *(1+growth rate))/(return on equity-growth) = Dividend paid next period/(Return on Equity- growth rate) __________________________ Return on Equity = Dividend paid next period/(price per share of stock+growth)

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

Re = D1/P0

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?

Re= 3% + 2 * 7%= 17%

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

What does WACC stand for?

Weighted average cost of capital

B = the market value of a firm's debt; S= market value of that same firm's equity; Rb= before-tax yield on the firm's debt; Tc= corporate tax rate; Rs= the cost of equity Given the definitions above, the weighted average cost of capital formula can be written as:

[S/(S+B)]*Rs +[B/(S+B)]*Rb*(1-Tc)

The CAPM can be used to estimate the _____________

required return on equity

A good source for bond quotes is:

www.finra.org/marketdata

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?

CFA* = EBIT x (1-Tc) + D Firm value today=V0=CFA∗1WACC−g 110,000/(.12-.05) =110,000/.07 =$1,571,428.57 ~ 1571429

Dang's Donuts has EBIT of $25,432, depreciation of $1,500, and a tax rate of 21%. 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?

CFA*=EBIT+D-EBIT*Tc - Change in NWC- Capital spending =25432+1500-25432*.21-6324 = $15,267.28

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

Equal to

WACC was used to compute the following project NPVs: Project A = $100, Project B = -$50, Project C = -$10, Project D = $40. Which project should the firm accept?

Project A and D

A project should only be accepted if its return is above what is ______.

Required by investors

SML Approach consistent with dividend growth model

Return on equity=Risk free rate+Systematic risk of the asset relative to average * (Rm-Rf)

The market risk premium is defined as:

Rm-Rf Difference between return on market - risk free rate

The cost of capital is an appropriate name since a project must earn enough to pay those who _________________ the capital.

Supply

Which of the following methods for calculating the cost of the equity ignores risk?

The dividend growth model

Which of the following variables is NOT required when using the CAPM to compute the cost of equity capital?

The rate of inflation

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

The risk free rate

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

There is no way of directly observing the return that the firm's equity investors require on their investment.

If a firm uses its overall cost of capital to discount cash flows from higher risk projects, it will accept _____ projects.

Too many high risk

Economic Value Added (EVA) is a mean of evaluating corporate performance

True

A firm's capital structure consists of 30% debt and 70% equity. Its bond yield 10%, pretax, its cost of equity is 16%, and the tax rate is 21%. What is its WACC?

(.07*.16)+(.3*.1*(1-.21))= .1357 or 13.57%

A firm's capital structure consists of 40% debt and 60% equity. The aftertax yield on debt is 2.5% and the cost of equity is 15%. The project is about as risky as the overall firm. What discount rate should be used to estimate the project's net present value?

(.6*.15)+(.4+.025) = .1 or 10%