Finance Chapter 12
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
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 common stockholders are not fixed - dividends to preferred stockholders are fixed
Preferred stock _____.
- Pays dividends in perpetuity - pays a constant dividend
Which of the following are components used in the construction of the WACC?
- cost of debt - cost of preferred stock - cost of common stock
To estimate the dividend yield of a particular stock, we need:
- forecasting od the dividend growth rate, g - the last dividend paid, D0 - the current stock price
Which of the following is true about a firm's cost of debt?
- it is easier to estimate than the cost of equity - yields can be calculated from observable data
What will happen over time if a firm uses its overall WACC to evaluate all projects, regardless of each project's risk level?
- it will accept projects that it should have rejected - it will reject projects that it should have accepted - the firm overall will become riskier
The rate used to discount project cash flows is known as the ____.
- required return - discount rate - cost of capital
The following are disadvantages of the SML approach.
- retires estimation of beta - requires estimation of the market risk premium
Which of the following is tax-deductible to the firm?
Coupon interest paid on bonds
T/F: Accordion to the CAPM, if the market risk premium is zero, then the expected return on a stock is equal to the required return.
False
T/F: In the WACC calculation, V = E - D.
False
T/F: The cost of capital depends on the source of the funds.
False
T/F: The cost of equity is D1/P0 minus the analysts' estimates of growth.
False
T/F: The growth rate of dividends can be found using the CAPM.
False
T/F: for publicly traded companies, the component of the dividend yield that must be estimated is the dividend.
False
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 values for equity.
Market, book
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 formal for calculating the cost of equity capital that is based on the dividend discount model is:
RE = D1/P0 + g
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
T/F: RP=D/P0
True
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
T/F: The return an investor in a security recipes is equal to the cost of the security to the company that issues it.
True
Given V=E+D, if we divide both V and D by ____, we can calcite the capital structure weights.
V
What is the appropriate discount rate to use only if the proposed investment is a replica of the firm's existing operating activities?
WACC
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)
If a firm has multiple projects, each project should be discounted using ____.
a discount rate commensurate with the project's risk
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
The discount rate for the firm's projects equals the cost of capital for the firm as a whole when:
all projects have the same risk as that of the firm overall
Some risk adjustment to a firm's WACC for projects of differing risk, even if it is subjective, is probably:
better than no risk adjustment
The dividend growth model is applicable to companies that pay ____.
dividends
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) Projects should always be discounted at the firm's overall cost of capital.
false
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
T/F: Conglomerates are companies that specialize only in projects similar to the project your firm is considering.
false
T/F: Finding the cost of equity is fairly straightforward.
false
T/F: Projects should always be discounted at the firm's overall cost of capital.
false
Components of the WACC include funds that come from _____.
investors
Finding a firm's overall cost of equity is difficult because:
it cannot be observed directly
The most appropriate weights to use in the WACC are the ___ weights.
market value
Other companies that specialize only in projects similar to the project your firm is considering are called _____.
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:
rejected, when it should be accepted
The WACC of a firm reflects the _____ and the target capital structure of the firm's existing assets as a whole.
risk
It is difficult to establish discount rate for individual projects, so firm's often adopt an approach that involves making _____ adjustments to the overall WACC.
subjective
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 software companies that collect and store data
According to the CAPM, what is the expected return on a stock if its beta is equal to zero?
the risk-free rate
If a firm uses its overall cost of capital to discount cash flows from projects in higher risk divisions, it will accept ____ projects.
too many
The cost of capital depends primarily on the ___ of funds, not the ____.
use; source
The WACC is the overall rate of return the firm mist earn on its existing assets to maintain ____ of its stock.
value
To estimate a firm's equity cost of capital using the CAPM, we ne
- 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 growth rate of dividends can be found using:
- security analysts' forecasts - historical dividend growth rates
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
T/F: the discount rate is also known as the expected return.
False
Dividends paid to common stockholders ____ be deducted from the payer's taxable income for tax purposes.
cannot
T/F: The SML approach is advantageous because all it requires is estimation of beta.
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 primary disadvantage of the dividend growth model approach is its simplicity.
false
T/F: The primary disadvantage of the dividend growth model approach is the simplicity.
false
T/F: finding the cost of equity is fairly straightforward.
false
T/F: the SML approach is advantageous because all it requires is the estimation of beta
false
T/F: the growth rate of dividends can be found using the CAPM.
false
If a firm issues no debt, its average cost of capital will equal ____.
its cost of equity
In the WACC calculation, D represents the _____ value of the firm's debt.
market
For a firm with outstanding debt, the cost of debt will be the ____________ on that debt.
yield to maturity