Finance 450 Final (Ch. 12, 13, 14)

Including preferred stock in the WACC adds the term:

(P/V) × RP

Which of the following are true?

*Common stocks may experience negative returns *T-bills sometimes outperform common stocks

In an efficient market:

- All investments have NPV=0 - Assets are priced at the present value of their future cash flows

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

What can we say about the dividends paid to common and preferred stockholders?

- Dividends to preferred stockholders are fixed. - Dividends to common stockholders are not fixed.

Which of the following are examples of a portfolio?

- Investing $100,000 in a combination of stocks and bonds - Investing $100,000 in the stocks of 50 publicly traded corporations - Investing $100,000 in a combination of US and Asian stocks

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

- its stockholders - its bondholders

To estimate the expected return on a risky asset, we need to know the _________

- market risk premium - risk-free rate - stock's beta

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

Studying market risk can reward us by demonstrating that:

- on average, investors will earn a reward for bearing risk - the greater the potential reward is, the greater the risk

Preferred stock _______.

- pays a constant dividend - pays dividends in perpetuity

The risk of owning an asset comes from:

- unanticipated events - surprises

The Ibbotson-Sinquefield data show that over the long-term, _____.

-T-bills, which had the lowest risk, generated the lowest return -small company stocks generated the highest average return -small company stocks had the highest risk level

A firm has a target debt-equity ratio of 0.5, 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?

0.5

The Ibbotson-Sinquefield data shows that:

1. Long-term corporate bonds had less risk or variability than stocks. 2. U.S. T-bills had the lowest risk or variability

The weighted average of the standard deviations of the assets in Portfolio C is 12.9%. Which of the following are possible values for the standard deviation of the portfolio?

10.9% 12.9%

Suppose a stock had an initial price of $82 per share, paid a dividend of $1.20 per share during the year, and had an ending share price of $90. Compute the percentage total return:

11.22% Change in Price = $90-$82 = $8 Dividend = 1.20 Return = (8+1.2)/82*100 = 11.22%

Based on average historical returns shown in the text, small-company stocks increased in value by _____ percent in a typical year.

16%

During the financial crisis of 2008, the S&P 500 Index fell by ____________ percent

37%

WACC was used to compute the following project NPVs: Project A = $100, Project B = -$50, Project C = -$10, Project D = $40. Which project should the firm accept?

A and D

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

If the market changes and stock prices instantly and fully reflect new information, which time path does such a change exhibit?

An efficient market reaction

A stock has had returns of 7 percent, 25 percent, 17 percent, -13 percent, 25 percent, and -6 percent over the last six years. What are the arithmetic and geometric average returns for the stock?

Arithmetic average return: 9.17% Geometric average return: 8.14%

Asset A has an expected return of 17 percent and standard deviation of 5 percent. Asset B has an unexpected return of 15 percent and standard deviation of 5 percent. Which asset would a rational investor choose?

Asset A

Assets A and B each have an expected return of 10 percent. Asset A has a standard deviation of 12 percent while Asset B has a standard deviation of 13 percent. Which asset would a rational investor choose?

Asset A

Which of the following is commonly used to measure inflation?

Consumer Price Index (CPI)

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

Debt

Finding a firm's overall cost of equity is __________

Difficult

Suppose a stock had an initial price of $54 per share, paid a dividend of $1.30 per share during the year, and had an ending share price of $64. What was the dividend yield and the capital gains yield?

Dividend yield: 2.41% Capital gains yield: 18.52% Dividend yield = $1.30 / $54 = 0.0241, or 2.41% Capital gains yield = ($64 - 54) / $54 = 0.1852, or 18.52%

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

The most well-known approach to company performance evaluation is the __________ method

Economic Value Added (EVA)

A stock has a beta of 1.04, the expected return on the market is 10 percent, and the risk- free rate is 3.5 percent. What must the expected return on this stock be?

Expected return: 10.26% E(R) = .035 + (10 - .035 1.04) E(R)= .1026, or 10.26%

True or false: Systematic risk will impact all securities in every portfolio equally:

FALSE

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 variance of a portfolio _________ generally a simple combination of the variances of the assets in the portfolio

Isn't

If a security's expected return is equal to the risk-free rate of return, and the market-risk premium is greater than zero, what can you conclude about the value of the security's beta based on CAPM?

It is equal to 0

What is the definition of expected return?

It is the return that an investor expects to earn on a risky asset in the future

Greater return volatility produces a ___________ difference between the arithmetic and geometric averages

Larger

You own a stock portfolio invested 30 percent in Stock Q, 25 percent in Stock R, 25 percent in Stock S, and 20 percent in Stock T. The betas for these four stocks are .95, 112, 113, and 1.30, respectively. What is the portfolio beta?

Portfolio Beta: 1.11 ßp= .30(.95) + .25(1.12) + .25(1.13) + .20(1.30) Bp=1.11

You own a portfolio that has $3,700 invested in Stock A and $4,700 invested in Stock B. If the expected returns on these stocks are 9 percent and 12 percent, respectively, what is the expected return on the portfolio?

Portfolio expected return: 10.68% Total portfolio value = $8,400 ER =($3.700/$8.400(.09) + ($4.700/$8,400/12) ER =.1068. or 10.68%

The percentage of a portfolio's total value invested in a particular asset is called the ___________

Portfolio weight

The principle of diversification tells us that spreading an investment across a number of assets will eliminate _____________ of the risk

Some

Forms of Market Efficiency

Strong form efficiency: it implies that all information of every kind is reflected in stock prices Semi strong form efficiency: it is the most controversial, and all public information is reflected in the stock price Weak form efficiency: it suggests that at a minimum, the current price of a stock reflects the stock's own past prices

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.

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

The best way to include flotation costs is to ___________.

add them to the initial investment

The capital structure weights used in computing a company's weighted average cost of capital:

are based on the market values of the outstanding securities.

The dividend yield for a 1-year period is equal to the annual dividend amount divided by the

beginning stock price

The _____________ coefficient is the amount of systematic risk present in a particular risky asset relative to that in an average asset

beta

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

When a company declares a dividend, shareholders generally receive ___________

cash

WACC is used to discount _______________.

cash flows

The geometric rate of return takes _______________ into account

compounding

Capital ___________ weights can be interpreted just like portfolio weights

structure

Which type of risk is unaffected by adding securities to a portfolio?

systematic risk

The standard deviation is:

the square root of the variance

The efficient markets hypothesis contends that ______________ capital markets such as the NASDAQ are efficient

well-organized

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

$2/$20 .10

As more securities are added to a portfolio, what will happen to the portfolio's total unsystematic risk?

- It may eventually be almost eliminated - It is likely to decrease

If you are forecasting a few decades in the future (as you might do for retirement planning) you should calculate the expected return using:

Blume's formula

An efficient market is one in which any change in available information will be reflected in the company's stock price ____________

Immediately

Based on the historical returns shown in the text, the average ____________________ , was 2.9 percent per year over the 94-year span depicted

Inflation rate

What is systematic risk?

It is a risk that pertains to a large number of assets.

The second lesson from studying capital market history is that there is a direct link between _____________ and reward

Risk

The _________ ratio is calculated as the risk premium of the asset divided by the standard deviation

Sharpe

The weighted average cost of capital for a firm can depend on all of the following except:

Standard deviation of the firm's common stock.

Suppose a stock had an initial price of $84 per share, paid a dividend of $1.50 per share during the year, and had an ending share price of $73. Compute the percentage total return, dividend yield, and capital gains yield.

Total return %: -11.31% Dividend yield: 1.79% Capital gains yield: -13.10% Return on shares in %: (return on share/initial price) * 100 (-9.50/84) * 100 = -11.31% Dividend yield: (dividend income/initial price) * 100 (1.50/84) * 100= 1.79% Capital gains yield: (Ending price - initial price) / initial price * 100= -13.10%

True or False: The existence of traders attempting to beat the market is a necessary precondition for markets to become efficient

True

True or false: Economic value added (EVA) is a means of evaluating corporate performance.

True

The minimum required return on a new project when its risk is similar to that of projects the firm currently owns is known as the ______________

cost of capital

The cost of _______ can be observed because it is the interest rate the firm must pay on new loans

debt

The cost of _______ can be observed because it is the interest rate the firm must pay on new loans.

debt

The increase in the number of stocks in a portfolio results in a ______________ in the average standard deviation of annual portfolio returns

decrease

When we _________ an announcement or a news item, we say that is has less of an impact on price because the market already factored it in.

discount

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

equal to

The _________ rate of return is the difference between risky returns and risk-free returns

excess

The issuance costs of bonds and stocks are referred to as __________ costs

flotation

An important advantage to a firm raising equity internally is not having to pay __________

flotation costs

Dividends are the ______ component of the total return from investing in a stock

income

An efficient market is one that fully reflects all available

information

Stock prices fluctuate from day to day because of:

information flow

The most appropriate weights to use in the WACC are the _________ weights

market value

The year 2008 was:

one of the worst years for stock market investors in US history

-Normally, the excess rate of return on risky assets is _____.

positive

Other companies that specialize only in projects similar to the project your firm is considering are called ___.

pure plays

Which of the following variables is not required to calculate the expected return on a risky asset?

rate of inflation

The Sharpe ratio measures

reward to risk

Geometric averages are ______________ arithmetic averages

smaller than

Kate corporation has discovered a very secret new product, but hasn't yet announced the discover to the public. If the stock price reacts before the announcements (assuming no corporate "leaks"), the market is:

strong form efficient

With the use of the _____ approach to estimating WACC, the firm's WACC may change through time as economic conditions change.

subjective

A normal distribution has a __________ shape

symmetrical

The _______________ risk principle argues that the market does not reward unnecessary risk that is taken on by the investor

systematic

The portfolio weight is _________

the percentage of the total value that is invested in an asset

A projected IRR on a risky investment in the _____ percent range is not unusual.

10-20

Stock in Jansen Industries has a beta of 1.3. The market risk premium is 6 percent, and T- bills are currently yielding 4.3 percent. The company's most recent dividend was $1.50 per share, and dividends are expected to grow at an annual rate of 8 percent indefinitely. If the stock sells for $45 per share, what is your best estimate of the company's cost of equity?

Cost of equity= 11.85% RE= .043 + 1.30(.06) RE= 1210, or 12.10% Dividend growth model: RE= [$1.50(1.08/$451 + 08 RE= .1160, or 11.60% RE=(1210+.1160)/2 RE= 1185, or 11.85%

Savers has an issue of preferred stock with a $6.25 stated dividend that just sold for $99 per share. What is the bank's cost of preferred stock?

Cost of preferred stock= 6.31% The cost of preferred stock is the dividend payment divided by the price, so: Rp=$6.25/$99 Rp= 0631, or 6.31%

The ___________ the risk, the greater the required return

Greater

In general, the arithmetic average return is probably too __________ for longer periods and the geometric average is probably too __________ for shorter periods

High; Low

Dani Corporation has 9 million shares of common stock outstanding. The current share price is $81, and the book value per share is $7. The company also has two bond issues outstanding. The first bond issue has a face value of $130 million, a coupon rate of 6 percent, and sells for 92 percent of par. The second issue has a face value of $115 million, a coupon rate of 5 percent, and sells for 103 percent of par. The first issue matures in 24 years, the second in 10 years. Suppose the most recent dividend was $4.85 and the dividend growth rate is 5.2 percent. Assume that the overall cost of debt is the weighted average of that implied by the two outstanding debt issues. The tax rate is 22 percent. What is the company's WACC?

WACC: 9.75% The market value of equity is the share price times the number of shares, so: MVE=9,000,000(581) MVE=$729,000,000 Using the relationship that the total market value of debt is the price quote times the par value of the bond, we find the market value of debt is: MVD = 92($130,000,000) + 1.03($115,000,000) MVD=$238,050,000 This makes the total market value of the company: V= $729,000,000 + 238,050,000 V= $967,050,000 And the market value weights of equity and debt are: E/V=$729.000,000/S967,050,000 EN=.7538 DV=1-EN=.2462 Next, we will find the cost of equity for the company. The information provided allows us to solve for the cost of equity using the dividend growth model, so: RE=[$4.85(1.052)/$81] + .052 RE= 1150, or 11.50% Next, we need to find the YTM on both bond issues. Doing so, we find: P, = $920 = $30(PVIFA%.48) + $1,000(PVIF R%,48) R= 3.337% YTM = 3.337% x 2 = 6.67% P2 = $1,030 = $25(PVIFA p%, 20) + $1,000(PVIF R%,20) R= 2 311% YTM = 2.311% x 2 = 4.62% To find the weighted average aftertax cost of debt, we need the weight of each bond as percentage of the total debt. We find: *D1=.92($130,000,000)/$238,050,000 *D1 = .5024 *D2 = 1.03($115,000,000 /$238.050,000 *D2 = .4976 Now we can multiply the weighted average cost of debt times one minus the tax rate to find the weighted average aftertax cost of debt. This gives us: RD= (1 - 22)(.5024) .0667) + (.4976)/.0462)] Rn= .0441, or 4.41% Using these costs and the weight of debt we calculated earlier, the WACC is: WACC = 7538(1150) + 2462(0441) WACC = 0975, or 9.75%

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

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 high-risk

Average returns can be calculated ______________

two different ways: arithmetic & geometric

Arrange the following investments from highest to lowest return based on what our study of capital market history has revealed about risk premiums

• Small-company common stock • Long-term corporate bonds • U.S. Treasury bills

Which of the following yields on a stock can be negative?

Capital gains yield and total return

True or false: Projects should always be discounted at the firm's overall cost of capital.

False

What does the security market line depict?

It is a graphical depiction of the capital asset pricing model.

There is ____________ correlation between the unsystematic risk of two companies from different industries

No

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

The formula for calculating the cost of equity capital that is based on the dividend discount model is:

RE = D1/P0 + g

The market value cost of debt us often _______ the book value cost of debt.

Similar to

What are the portfolio weights for a portfolio that has 144 shares of Stock A that sell for $40 per share and 100 shares of Stock B that sell for $20 per share?

Stock A: 0.7423 Stock B: 0.2577 Total value = 144($40) + 100($20) Total value = $7.760 WeightA = 144($40)/$7,760 WeightB = 100($20)/$7,760

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

True

The cost of capital depends primarily on the ______ of funds

Use

In reality, most firms cover the equity portion of their capital spending with _________.

internally generated cash flow

A company's pretax cost of debt:

is based on the current yield to maturity of the company's outstanding bonds.

More volatility in returns produces ______ difference between the arithmetic and geometric averages.

larger

Variance is measured in _____________ , while standard deviation is measured in ______________

percent squared; percent

Projects that have the same risk are said to be in the same ___________

risk class

The standard deviation is the ________ of the variance

square root

When an investor is diversified only ______________ risk matters

systematic

What are the two components of unexpected return (U) in the total return equation?

systematic portion and unsystematic portion

To determine whether an investment has a positive NPV, you can compare the expected return on that new investment to what the financial market offers on an investment with _________

the same beta

A distribution tends to have a smooth shape when the number of observations is

very large

Which of the following are examples of information that may impact the risky return of a stock?

- The Fed's decision on interest rates at their meeting next week - The outcome of an application currently pending with the Food and Drug Administration.

True or false: The process to calculate a portfolio's beta is opposite of the process to calculate a portfolio s expected return

False

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

Sunrise, Incorporated, is trying to determine its cost of debt. The firm has a debt issue outstanding with 23 years to maturity that is quoted at 93 percent of face value. The issue makes semiannual payments and has an embedded cost of 7 percent annually. a. What is the company's pretax cost of debt? b.If the tax rate is 22 percent, what is the aftertax cost of debt?

Pretax cost of debt: 7.65% Aftertax cost of debt: 5.97% The pretax cost of debt is the YTM of the company's bonds, so: Po = $930 = $35(PVIFA R%.46) + $1,000(PVIF R%, 46) R= 3.826% YTM = 2 × 3.826% = 7.65% And the aftertax cost of debt is: RD=.0765(1- .22) RD= .0597, or 5.97%

What is the required return of a stock, according to the constant dividend growth model, if the growth rate is zero?

RE= D1/P0

Mona Corporation has a variance of returns of 343, while Scott Corporation has a variance of returns of 898. Which company's actual returns vary more from their mean return?

Scott Corporation

The ____________ is the squared standard deviation

Variance

Ninecent Corporation has a target capital structure of 65 percent common stock, 10 percent preferred stock, and 25 percent debt. Its cost of equity is 11 percent, the cost of preferred stock is 7 percent, and the pretax cost of debt is 8 percent. The relevant tax rate is 23 percent. a. What is the company's WACC? b. What is the aftertax cost of debt?

WACC: 9.39% Cost of debt: 6.16% Using the equation to calculate the WACC, we find: WACC= .65(11) + 10(.07) + .25(.08)(1 - .23) WACC = .0939, or 9.39% The aftertax cost of debt is: R0= .08(1 - 23) RD= .0616, or 6.16% Hence, on an aftertax basis, debt is cheaper than the preferred stock.

The geometric average rate of return is approximately equal to

the arithmetic mean minus half of the variance