Chapter 14 Cost of Capital
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
The formula for calculating the cost of equity capital that is based on the dividend discount model is:
RE = D1/P0 + g
The best way to include flotation costs is to ___.
add them to the initial investment
Finding a firm's overall cost of equity is ___.
difficult
The underlying key assumption, and oftentimes a key disadvantage, of the dividend growth model is that it assumes the dividend _____.
grows at a constant rate
The cost of capital depends on the _____ of funds, not the _____ of funds.
use; source
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.
Which one of the following is true?
Under U.S. tax law, a corporation's interest payments are deductible for tax purposes.
What does WACC stand for?
Weighted average cost of capital
A project should only be accepted if its return is above what is ___.
required by investors
cost of equity
the return that equity investors require on their investment in the firm
Which of the following methods for calculating the cost of equity ignores risk?
The dividend growth model
Using the SML approach, what is the expected return on a stock if its beta is equal to zero?
The risk-free rate
If a firm has two divisions and one division is riskier than the other, what would be the potential result if the firm used its overall WACC to evaluate the projects in both divisions?
The riskier division's projects will typically receive full funding and the less risky division's projects will often be incorrectly rejected.
If a firm has multiple projects, each project should be discounted using:
a discount rate that commensurates with the project's risk.
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
Flotation costs are costs incurred to ____.
bring new security issues to the market
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
The most well-known approach to company performance evaluation is the _____ method.
economic value added
The return an investor in a security receives is ______ the cost of the security to the company that issued it.
equal to
An important advantage to a firm raising equity internally is not having to pay ___.
flotation costs
The growth rate of dividends can be found using _____.
historical dividend growth rates security analysts' forecasts
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.
in the same risk class
In reality, most firms cover the equity portion of their capital spending with ___.
internally generated cash flow
The most appropriate weights to use in the WACC are the ______ weights.
market value
Preferred stock ___.
pays dividends in perpetuity pays a constant dividend
Other companies that specialize only in projects similar to the project your firm is considering are called ___.
pure plays
cost of debt
the return that lenders require on the firm's debt
MNO preferred stock pays a dividend of $2 per year and has a price of $20. If MNO's tax rate is 21 percent, the required rate of return on its preferred stock is found by which formula?
$2/$20
A firm has a target debt-equity ratio of .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?
.5
Projects should always be discounted at the firm's overall cost of capital.
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
In addition to CAPM, the cost of equity can be determined using the dividend growth model and the _____ approach.
SML
Economic value added (EVA) is a means of evaluating corporate performance.
True
The return an investor in a security receives is equal to the cost of the security to the company that issued it.
True
Capital ___ weights can be interpreted just like portfolio weights.
structure
With the use of the ___ approach to estimating WACC, the firm's WACC may change through time as economic conditions change.
subjective
pure play approach
the use of a WACC that is unique to a particular project, based on companies in similar lines of business
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
Which of the following are true?
Book values are often similar to market values for debt. Ideally, we should use market values in the WACC.
Which of the following are tax-deductible to the firm?
Coupon interest paid on bonds
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 B
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 the current firm
The SML approach requires estimates of ___.
the beta coefficient the market risk premium
weighted average cost of capital (WACC)
the weighted average of the cost of equity and the aftertax cost of debt
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
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 _____.
when economic conditions change quickly
Which of the following are components used in the construction of the WACC?
Cost of preferred stock Cost of debt Cost of common stock
The WACC is the weighted average of the cost of equity and the _____.
aftertax cost of debt
WACC is used to discount ______.
cash flows
The rate used to discount project cash flows is known as the ___.
discount rate required return cost of capital
To apply the dividend growth model to a particular stock, you need to assume that the firm's ___ will grow at a constant rate.
dividend
The ___ ___approach is the use of a WACC that is unique to a particular project, based on companies in similar lines of business.
pure; play
To estimate the expected return on a risky asset, we need to know the ___.
risk-free rate stock's beta market risk premium
The market value cost of debt is often Blank______ the book value cost of debt.
similar to
The formula for the required return from the SML is:
RE = Rf + B(RM − Rf)
The issuance costs of bonds and stocks are referred to as ______ costs.
flotation
Which of the following variables is not required to calculate the expected return on a risky asset?
The rate of inflation
The cost of capital depends primarily on the ___ of funds.
use
Which of the following is true?
A company can deduct interest paid on debt when computing taxable income.
To estimate the growth rate of a particular stock, we can ___.
use the historical dividend growth rate. use security analysts' forecasts
B = the market value of a firm's debt S = the market value of that same firm's equity RB = the before-tax yield on the firm's debt TC = the 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)
A firm's overall cost of capital will include both its cost of ___ and equity capital.
debt
The cost ___ of can be observed because it is the interest rate the firm must pay on new loans.
debt
The cost of capital is an appropriate name since a project must earn enough to pay those who ______ the capital.
supply
Which is true of flotation costs in calculating WACC?
They are relevant cash flows.
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
Including preferred stock in the WACC adds the term:
(P/V) × RP
