FIN 370 Chapter 14
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
Including preferred stock in the WACC adds the term: -(P/V) × RP -(V/P) × RP -[P/(E + D)] × RP
(P/V) × RP
Walker Systems has an issue of preferred stock outstanding with a stated annual dividend of $2.60 that just sold for $23.85 per share. What is the bank's cost of preferred stock?
10.90% Reason: RP = $2.60/$23.85 RP = .1090, or 10.90%
Castillo Corporation common stock is currently priced at $39.75 per share. The company just paid $4.35 per share as its annual dividend. The dividends have been increasing by 7.5 percent annually and are expected to continue doing the same. What is the cost of equity?
19.26% Reason: RE = [$4.35(1.075)]/$39.75 + .075 RE = .1926, or 19.26%
Suppose a corporation issued a 30-year annual, 8 percent bond, 10 years ago. The bond is currently selling for 95 percent of its face value, or $950. What is the corporation's cost of debt?
8.53% Reason: Let's calculate the yield. We can use a financial calculator to calculate the yield. This is an annual bond. N, or the number of years, would be 20, which is 30 years minus the 10 years already passed. The present value or price of the bond is $950. The coupon rate is 8%, so the payment is $80. The future value for most bonds is $1,000, unless otherwise stated.
True or false: The cost of capital depends primarily on the source of the funds, not the use.
False
WACC is used to discount Blank______. -political unrest -news -common stock dividends -cash flows
cash flows
Assume a manager determines the cost of capital for a specific project based on the cost of capital at another firm with a line of business that is similar to the project. Accordingly, the manager is using the ________ approach. -security market line -capital adjustment -subjective risk -pure play -divisional cost of capital
pure play
Mullineaux Corporation has a target capital structure of 46 percent common stock, 5 percent preferred stock, and the balance in debt. Its cost of equity is 15.8 percent, the cost of preferred stock is 8.3 percent, and the aftertax cost of debt is 6.8 percent. What is the WACC given a tax rate of 23 percent?
11.02% Reason: WACC = .46(.158) + .05(.083) + .49(.068) WACC = .1102, or 11.02%
ABC Corporation has 2.8 million shares of stock outstanding. The stock currently sells for $50 per share. The firm's debt is publically traded and was recently quoted at 95 percent of its face value. It has a total face value of $10 million, and it is currently priced to yield 12 percent. The risk-free rate is 5 percent, and the market risk premium is 7 percent. You've estimated that ABC has a beta of 1.25. If the corporate tax rate is 35 percent, what is the WACC of ABC Corporation?
13.38% Reason: EQUITY: Cost of equity capital: .05 + 1.25(.07) = .1375 = 13.75% Total value of equity = 2.8 million × $50 = $140 million DEBT: Cost of debt capital: The pretax cost of debt is the current yield to maturity on the outstanding debt, 12%. Total value of debt: .95 × $10 million = $9.5 million Total market value of equity and debt = $140 million + $9.5 million = $149.5 million WACC=(E/V) × RE + (D/V) × RD × (1 − TC) =(140/149.5) × .1375 + (9.5/149.5) × (.12) × (1 − .35) =(.9365) × .1375 + (.0635)(.12)(1 − .35) =.1288+ .0050 =.1338 = 13.38%
If ABC corporation paid a dividend of $6 per share last year. The stock currently sells for $80 per share. You estimate that the dividend will grow steadily at a rate of 6% per year into the indefinite future. What is the cost of equity?
13.95% Reason: D1=D0 × (1 + g) =$6 × 1.06 =$6.36 RE=D1/P0 + g =$6.36/80 + .06 =13.95%
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? -B and C -A and D -A only -A, B, and C
A and D
Which of the following are components used in the construction of the WACC? Select all that apply: -Cost of preferred stock -Cost of debt -Cost of accounts payable -Cost of common stock
Cost of preferred stock Cost of debt Cost of common stock
What can we say about the dividends paid to common and preferred stockholders? Select all that apply -Dividends to common stockholders are not fixed. -Dividends are guaranteed for both preferred and common stockholders. -Preferred stock dividends change every year based on the earnings of the firm. -Dividends to preferred stockholders are fixed.
Dividends to common stockholders are not fixed. Dividends to preferred stockholders are fixed.
The most well-known approach to company performance evaluation is the _____ method. -economic value added -value adjusted -economic regressive
economic value added
The return an investor in a security receives is ______ the cost of the security to the company that issued it. -unrelated to -less than -greater than -equal to
equal to
The issuance costs of bonds and stocks are referred to as ______ costs. -market -flotation -sunk -reparation
flotation
An important advantage to a firm raising equity internally is not having to pay ___. -coupons -capital gains -dividends -flotation costs
flotation costs
The percent of investment that the project costs can be referred to as all of the following, except: -free cah flow -required return -cost of money -appropriate discount rate -cost of capital
free cash flow
Assume a firm's flotation costs are 7.8 percent of the funding need. Accordingly, when analyzing capital projects, the firm's managers should?
increase the initial project cost by dividing that cost by (1 − .078).
In reality, most firms cover the equity portion of their capital spending with ___. -a new common stock issue -a new preferred stock issue -a new bond issue -internally generated cash flow
internally generated cash flow
The most appropriate weights to use in the WACC are the ______ weights. -government mandated -book value -market value -salvage value
market value
A firm's cost of debt can be ___. Select all that apply -obtained by talking to investment bankers -obtained by checking yields on publicly traded bonds -estimated easier than its cost of equity -calculated using the dividend growth model
obtained by talking to investment bankers obtained by checking yields on publicly traded bonds estimated easier than its cost of equity
Preferred stock ___. Select all that apply -has a fixed maturity -pays dividends in perpetuity -pays a constant dividend -does not pay dividends
pays dividends in perpetuity pays a constant dividend
Projects that have the same risk are said to be in the same _____. -interest bar -risk party -risk class -classification tree
risk class
Capital __________ weights can be interpreted just like portfolio weights.
structure
Delta Lighting has 24,500 shares of common stock outstanding at a market price of $19 per share. This stock was originally issued at $21 per share. The firm also has a bond issue outstanding with a total face value of $250,000 which is selling for 94 percent of par. The cost of equity is 12.6 percent while the aftertax cost of debt is 5.8 percent. The firm has a beta of 1.33 and a tax rate of 23 percent. What is the weighted average cost of capital?
10.32% Reason: E = 24,500($19) = $465,500 D = .94($250,000) = $235,000 V = $465,500 + 235,000 V = $700,500 WACC = ($465,500/$700,500)(.126) + ($235,000/$700,500)(.058) WACC = .1032, or 10.32%
What is the cost of equity for the TMB Corporation based on the following information? Risk premium = 5% Risk free rate = 4% TMB beta: 1.50
11.50% Reason: RTMB=Rf + ßTMB × (RM - Rf) =4% + 1.50 × 5% =11.50%
Grill Works has 6 percent preferred stock outstanding that is currently selling for $49 per share. The market rate of return is 14 percent and the tax rate is 21 percent. What is the cost of preferred stock if its stated value is $100 per share?
12.24% Reason: (0.06 x $100)/$49 $6/$49 =12.24%
Food Shoppe Galore had the following information: Total market value of a company's stock: $650 million Total market value of the company's debt: $150 million What is the weighted average of the company's debt?
18.75% Reason: Total market value of a company's stock: $650 million Total market value of the company's debt: $150 million The combined market value is $800 million. E/V = 650/800 = 81.25% D/V = 150/800 = 18.75%
Which of the following are true? Select all that apply -Book values are often similar to market values for debt. -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.
True or false: The coupon rate on the firm's outstanding debt can be used as a substitute for the cost of debt.
False
Which of the following statements regarding the cost of preferred stock is accurate? -It equals the yield to maturity. -It decreases when tax rates increase. -It is highly dependent on the dividend growth rate. -It is independent of the preferred stock's price. -It equals the dividend yield.
It equals the dividend yield
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
For the Dividend Growth Model, the equation can be written as follows: P0 = =D1/(RE - g). How can this equation be rearranged?
RE = D1/P0 + g
True or false: Since preferred stock has a fixed dividend paid every period forever, it is essentially a perpetuity.
True
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
Flotation costs for a levered firm should be: -considered only when two projects are mutually exclusive. -ignored when analyzing a project because they are a sunk cost. -spread over the life of a project thereby reducing the cash flows for each year of the project. -totally ignored when internal equity funding is utilized. -weighted and included in the initial cash flow.
Weighted and included in the initial cash flow.
If a firm has multiple projects, each project should be discounted using: -the average cost of capital. -the marginal cost of capital for the latest project. -the firm's overall cost of capital. -a discount rate that commensurates with the project's risk.
a discount rate that commensurates with the project's risk.
A firm's target capital structure represents: -the cost of debt to achieve the desired NPV. -a fixed debt-equity ratio that the company attempts to maintain. -a fixed cost of capital that the company maintains. -the cost of equity to achieve the desired NPV. -the required return for the project with the highest NPV.
a fixed debt-equity ratio that the company attempts to maintain
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 -the average risk of the firm's projects is constant -all projects have the same risk as the current firm
all projects have the same risk as the current firm
Flotation costs are costs incurred to ____. -insure the payment due to bondholders -obtain a bank loan -keep a firm in business -bring new security issues to the market
bring new security issues to the market
When evaluating capital project proposals, assume a firm assigns unique discount rates based on the risk level of each project. Accordingly the: -firm will be unable to maximize value for its shareholders. -company's overall cost of capital will decrease over time. -company's overall cost of capital may increase or decrease over time. -company's overall cost of capital will not change over time. -value of the company will decrease over time.
company's overall cost of capital may increase or decrease over time
A firm's overall cost of capital will include both its cost of _________________ capital and equity capital.
debt
The cost of _________________ can be observed because it is the interest rate the firm must pay on new loans.
debt
Finding a firm's overall cost of equity is ___________________ (straightforward/difficult).
difficult
To apply the dividend growth model to a particular stock, you need to assume that the firm's ___ will grow at a constant rate. -debts -beta -profitability -dividend
dividend
The required return of preferred stock is equal to the ________ ________ on the preferred stock. -dividend yield -bond rating -current price -perpetuity rating -fixed dividend
dividend yield
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 -rejected, when it should be accepted -accepted, as it should be
rejected, when it should be accepted
The market value cost of debt is often ______ the book value cost of debt. -similar to -higher than -lower than
similar to
To estimate the expected return on a risky asset, we need to know the ___. Select all that apply -stock's beta -risk-free rate -market risk premium -annual dividend amount
stock's beta risk-free rate market risk premium
Which of the following variables is not required to calculate the expected return on a risky asset? -The stock's beta -The rate of inflation -The risk-free rate -The market risk premium
the rate of inflation Reason: The CAPM equation is: E(RE) = Rf + Beta * (E(RM) − Rf)
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 -it extensively requires the use of differential equations -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
If a firm uses its overall cost of capital to discount cash flows from higher risk projects, it will accept ______ projects. -only profitable -the optimal number of -too many high-risk
too many high-risk
True or false: Economic value added (EVA) is a means of evaluating corporate performance.
true
The cost of capital depends primarily on the ____________________ (use/source) of funds.
use
The cost of capital depends on the _____ of funds, not the _____ of funds. -use; inflation -source; use -use; source
use; source
What does WACC stand for? -Working amount of corporate cost -Weighted average company cost -Working amount of corporate cash -Weighted average cost of capital
weighted average cost of capital
