FIN: Ch 14 Cost of Capital

Dang's Donut has EBIT of $25,432 depreciation $1,500, and a tax rate of 18%. The company will not be changing it's net working capital, but plans a capital expenditure of $6,324. What is Dant's adjusted cash flow from assets?

$16,030.24

A firm needs to raise $950,000 but will incur flotation costs of 5%. How much will it pay in flotation costs?

$50,000

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

- Cost of debt - Cost of preferred stock - Cost of common stock

The rate used to discount project cash flows is known as the _____.

- Discount rate - Cost of capital - Required return

To apply the dividend discount model to a particular stock, you need to estimate the ______.

- Dividend yield for the next period - Growth rate

Which of the following are true?

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

A firm has a target debt-equity ratio of 0.5, but it plans to finance a new project with all debt. With debt-equity ratio should be used when calculating the project's flotation costs?

0.5

If the firm issued so much debt that its equity was valueless, its average cost of capital would equal __________.

1 x the aftertax cost of debt

The SML approach requires estimates of:

1. Market risk premium 2. Beta coefficient

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

10.5% 15% x (1-.3)

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

15%

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

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 commensurate with the project's risk

Flotation costs are costs incurred to _______________.

Bring new security issues to the market

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 Division's projects, which Division will probably not receive enough resources to fund all of its potentially profitable projects?

Division B

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

It cannot be observed directly

If a firm issues no debt, its average cost of capital will equal ______________.

Its cost of equity

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

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

Required by investors

What does WACC stand for?

Weighted Average cost of Capital

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

B = the market value of a firm's debt; S = the market value of that same firm's equity; Rs = 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)] x Rs + [B/(S+B)] x Rs x (1-Tc)

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

equal to

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

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

too many high-risk

A good source for bond quotes is:

www.finra.org/marketdata

A project's NPV without flotation costs is $1,000,000 and its flotation costs are $50,000. What is the true NPV?

$950,000

A firm has 20% debt, debt flotation costs of 5%, equity flotation costs of 10%, and wants to raise $9,100, not including flotation costs. What are the flotation costs?

$900

To estimate a firm's equity cost of capital using the CAPM, we need to know the _______________.

- Stock's beta - Market risk premium - Risk-free rate

A firms'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?

10%

MNO preferred stock pays a dividend of $2 per year and has a price of $20. If MNO's tax rate is 40percent, the required rate of return on its preferred stock is __________ percent.

10%

The best way to include flotation costs is to ___________.

Add them to the initial investment

Some risk adjustments to a firm's WACC for projects of differing risk, even if it is subjective, is probably:

better than no risk adjustment

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

10% 3%+7%=10%

Preferred stock _______________.

- Pays a constant dividend - Pays dividends in perpetuity

What are the after-tax earnings for HIJ Corporation if it reports $200 in revenue, $90 in operating expenses, has a tax rate of 30%, and pays $20 in interest on its bonds.

$63 ($200-$90-$20) x (1-0.3)

ULC and LEV have earnings before interest and taxes of $110. LEV has $20 of interest expense. Both companies are taxed at 30%, ULC aftertax earnings are _____, which is ______ than LEV's aftertax earnings.

$77; $14 greater

The discount rate for the firm's projects equals the costs of capital for the firm as a whole when ____________.

All projects have the same risk as the current firm

The CAPM can be used to estimate the _______.

required return on equity

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?

$1,571,429 Vo= 110,000/(0.12-0.05)

The WACC is the minimum return a company needs to earn to satisfy ______________.

- Its bondholders - Its stockholders

A firm's cost of debt can be ____________.

- Obtained by checking yields on publicly traded bonds - Obtained by talking to investment bankers - Estimated easier than its cost of equity

To estimate the growth rate of a particular stock, we can _____________.

- Use security analysts forecasts - Use the historical dividend growth rate

Economic Value Added (EVA) uses the weighted average cost of capital to determine if value is:

Being created or destroyed

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

Dividend growth

The CAPM formula is:

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

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

The dividend growth model

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

10%

A firm's capital structure consists of 30% debt and 70% equity. Its bonds yield 10%, pretax, its cost of equity is 16%, and the tax is 40%. What is its WACC?

13% (0.7 x 16%) + (0.3 x 10% x (1 - 0.4)) =

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?

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

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

The rate of inflation