Finance Chapter 14

Disadvantages of SML approach

Have to estimate the expected market risk premium, which does vary over time Have to estimate beta, which also varies over time We are using the past to predict the future, which is not always reliable

economic values added

means of evaluating corporate performance based on creating value

what is the firm's overall cost of equity?

no way of directly observing the return that investors require on their investments. Must estimate it.

Preferred stock ___. Multiple select question. pays a constant dividend has a fixed maturity pays dividends in perpetuity does not pay dividends

pays a constant dividend pays dividends in perpetuity

capital structure weights

the percentage of money raised from each source of capital, which in this class is stockholders and bondholders. The capital structure weights must some to one in order to account for all the financing.

cost of preferred stock

the ratio of the preferred stock dividend to the firm's net proceeds from the sale of preferred stock

cost of equity

the return that equity investors require on their investment in the firm.

cost of debt

the return that lenders require on the firm's debt

what is the cost of capital for a risk-free investment?

the risk-free rate

pure play appraoch

the use of WACC that is unique to a particular project, based on companies in similar lines of business (same risk class)

what is the primary determinant of the cost of capital for an investment?

the use of funds, not the source.

what does the cost of capital depend on?

the use of the funds, not the source (risk of the investment, not how or where capital is raised)

True or false: The return an investor in a security receives is equal to the cost of the security to the company that issued it. True false question.TrueFalse

true

What can we say about the dividends paid to common and preferred stockholders? Multiple select question. 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.

The formula for calculating the cost of equity capital that is based on the dividend discount model is: Multiple choice question. RE = (D1/P0)/g RE = D1/P0 - g RE = D0/P1 + g RE = D1/P0 + g

RE = D1/P0 + g

Weighted Average Cost of Capital (WACC)

the weighted average of the cost of equity and the after tax cost of debt. It is the overall return the firm must earn on its existing assets to maintain the value of its stock.

Finding a firm's overall cost of equity is difficult because _____. Multiple choice question. the federal government refuses to disclose equity costs unless the firm is in the real estate sector there is no way to estimate it there is no way of directly observing the return that the firm's equity investors require on their investment it extensively requires the use of differential equations

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

The cost of capital depends on the _____ of funds, not the _____ of funds. use; inflation use; source source; use

use; source

disadvantage of dividend growth model

-only applicable to companies currently paying dividends -not applicable if dividends aren't growing at a reasonably constant rate -extremely sensitive to the estimated growth rate -does not explicitly consider risk

Which of the following are components used in the construction of the WACC? Multiple select question. Cost of common stock Cost of debt Cost of preferred stock Cost of accounts payable

Cost of common stock Cost of debt Cost of preferred stock

Which of the following are true? Multiple select question. 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.

What is the required return on a stock (RE), according to the constant dividend growth model, if the growth rate (g) is zero? Multiple choice question. RE = D1/P0 RE = D0 + P1 RE = D0 − P1 RE = P0/D1

RE = D1/P0

target capital structure

The mix of debt, preferred stock, and common equity the firm plans to raise to fund its future projects.

A firm's overall cost of capital will include both its cost of _______ capital and equity capital.

debt

True or false: The cost of debt on the market value basis is typically much higher than the cost of debt on the book value basis.

false

The most appropriate weights to use in the WACC are the ______ weights. Multiple choice question. book value government mandated market value salvage value

market value

Weighted Average Cost of Capital (WACC)

the cost of capital for the firm as a whole, and it can be interpreted as the required return on the overall firm.

floatation costs

the costs associated with issuing new stocks or bonds

what is irrelevant when determining cost of debt?

the coupon rate on the firm's outstanding debt

Why is the coupon rate a bad estimate of a firm's cost of debt?

the coupon rate tells us what the firm's cost of debt was back when the bonds were issued, not what it is today.

two approaches in determining cost of equity

the dividend growth model approach and the security market line (SML) approach.

what is the cost of debt?

the interest rate the firm must pay on new borrowing (loans)

cost of capital

the rate of return a company must earn in order to meet the demands of its lenders and expectations of its equity holders

When discounting the cash flows of a project at the WACC to estimate NPV, we need to find an alternative in the financial markets that is _____ as the given project. Multiple choice question. in the same risk class twice as risky the exact same half as risky

in the same risk class

To estimate the expected return on a risky asset, we need to know the ___. Multiple select question. market risk premium stock's beta risk-free rate annual dividend amount

market risk premium stock's beta risk-free rate

market value added?

market value of the firm minus the book value of the capital investment in the firm

Advantages of SML approach

1. It explicitly adjusts for risk 2. It is applicable to other companies other than just those with steady dividend growth.

Which of the following variables is not required to calculate the expected return on a risky asset? Multiple choice question. The risk-free rate The market risk premium The rate of inflation The stock's beta

The rate of inflation

Advantage of Dividend Growth Model

easy to understand and use

The most well-known approach to company performance evaluation is the _____ method. Multiple choice question. economic regressive value adjusted economic value added

economic value added

WACC is used to discount Blank______. Multiple choice question. political unrest cash flows news common stock dividends

cash flows