FINC 3310 - Chapter 12 SmartBook

Which one of the following statements is accurate for a levered firm?

A reduction in the risk level of a firm will tend to decrease the firm's WACC

Empire Plumbing Supply has 100,000 shares of common stock outstanding at a price of $37 a share. It also has 6,000 shares of preferred stock outstanding at a price of $30 a share. There are 5,000 bonds outstanding that have a semiannual coupon payment of $25. The bonds mature in four years, have a face value of $1,000, and sell at 110 percent of par. What is the capital structure weight of the common stock?

Common stock = 100,000 × $37 = $3,700,000 Preferred stock = 6,000 × $30 = $180,000 Debt = 5,000 × (1.1 × $1,000) = $5,500,000 Value = $3,700,000 + 180,000 + 5,500,000 = $9,380,000 Weight of common stock = $3,700,000/$9,380,000 = .3945, or 39.45%

S&W has 21,000 shares of common stock outstanding at a price of $29 a share. It also has 2,000 shares of preferred stock outstanding at a price of $71 a share. The firm has 7 percent, 12-year bonds outstanding with a total market value of $386,000. The bonds are currently quoted at 100.6 percent of face and pay interest semiannually. What is the capital structure weight of the firm's preferred stock if the tax rate is 21 percent?

Common stock = 21,000 × $29 = $609,000 Preferred stock = 2,000 × $71 = $142,000 Debt = $386,000 Value = $609,000 + 142,000 + 386,000 = $1,137,000 Weight of preferred = $142,000/$1,137,000 = .1249, or 12.49%

Select all that apply 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

Select all that apply The growth rate of dividends can be found using Blank______.

security analysts' forecasts historical dividend growth rates

Select all that apply To estimate the dividend yield of a particular stock, we need Blank______.

the current stock price forecasts of the dividend growth rate, g the last dividend paid, D0

The WACC is the minimum required return for Blank______.

the overall firm

The formula of the SML is Blank______.

RE = Rf + β × (RM − Rf)

Which one of the following is the primary determinant of an investment's cost of capital?

The investment's level of risk

According to the CAPM, what is the expected return on a stock if its beta is equal to zero?

The risk-free rate

Which one of the following statements concerning capital structure weights is correct?

The weights are unaffected when a bond issue matures

True or false: RP = D/P0

True

Beta Industries is considering a project with an initial cost of $6.9 million. The project will produce cash inflows of $1.52 million a year for seven years. The firm uses the subjective approach to assign discount rates to projects. For this project, the subjective adjustment is +2.2 percent. The firm has a pretax cost of debt of 9.1 percent and a cost of equity of 17.7 percent. The debt-equity ratio is .57 and the tax rate is 21 percent. What is the net present value of the project?

WACC = (1/1.57)(.177) + (.57/1.57)(.091)(1 − .21) = .138839 Project WACC = .138839 + .022 = .160839, or 16.0839% NPV = −$6.9 million + ($1.52 million)(PVIFA7, 16.0839%) = −$776,522

If D is the market value of a firm's debt, E the market value of that same firm's equity, V the total value of the firm (E + D), RD the yield on the firm's debt, TC is the corporate tax rate, and RE the cost of equity, the weighted average cost of capital is Blank______.

[E/V] × RE + [D/V] × RD ×(1 − TC)

If a firm has multiple projects, each project should be discounted using Blank______.

a discount rate commensurate with the project's risk

It is difficult to establish discount rate for individual projects, so firms often adopt an approach that involves making _____ adjustments to the overall WACC.

subjective

Kate is the CFO of a major firm and has the job of assigning discount rates to each project under consideration. Kate's method of doing this is to assign an incrementally higher rate as the risk level of the project increases and a lower rate as the risk level declines. Kate is applying the _________blank approach.

subjective

SmartKids, a textbook publisher, is considering investing in a software company that collects and stores data. What beta should SmartKids use to assess the risk of the project?

the beta for software companies that collect and store data

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

too many

The cost of capital depends primarily on the Blank______ of funds, not the Blank______.

use; source

The WACC is the overall rate of return the firm must earn on its existing assets to maintain the _______ of its stock.

value or price

What does WACC stand for?

weighted average cost of capital

For a firm with outstanding debt, the cost of debt will be the Blank______ on that debt.

yield to maturity

Including preferred stock in the WACC formula adds which term if P is the market value of preferred stock and RP is the cost of preferred?

(P/V) × RP

Select all that apply Which of the following is true about a firm's cost of debt?

It is easier to estimate than the cost of equity. Yields can be calculated from observable data.

Select all that apply What will happen over time if a firm uses its overall WACC to evaluate all projects, regardless of each project's risk level?

It will reject projects that it should have accepted. It will accept projects that it should have rejected. The firm overall will become riskier.

Kurt, who is a divisional manager, continually brags that his division's required return for its projects is one percent lower than the return required for any other division of the firm. Which one of the following most likely contributes the most to the lower rate requirement for Kurt's division?

Kurt's division is less risky than the other divisions.

Orchard Farms has a pretax cost of debt of 7.29 percent and a cost of equity of 16.3 percent. The firm uses the subjective approach to determine project discount rates. Currently, the firm is considering a project to which it has assigned an adjustment factor of 1.25 percent. The firm's tax rate is 21 percent, and its debt-equity ratio is .48. The project has an initial cost of $3.9 million and produces cash inflows of $1.26 million a year for 5 years. What is the net present value of the project?

Project cost of capital = [(1/1.48)(.163) + (.48/1.48)(.0729)(1 − .21)] + .0125 = .1413, or 14.13% NPV = −$3.9 million + $1.26 million(PVIFA5, 14.13%) = $412,063

What is the equation for finding the cost of preferred stock?

RP = D/P0

Kelly's uses the firm's WACC as the required return for some of its projects. For other projects, the firm uses a rate equal to WACC plus one percent, while another set of projects is assigned rates equal to WACC minus some amount. Which one of the following factors should be the key factor the firm uses to determine the amount of the adjustment it will make when assigning a discount rate to a specific project?

The perceived risk level of the project

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

Given V = E + D, if we divide both E and D by _____ , we can calculate the capital structure weights.

V or value

What is the appropriate discount rate to use only if the proposed investment is a replica of the firm's existing operating activities?

WACC

Healthy Snacks has a target capital structure of 60 percent common stock, 3 percent preferred stock, and 37 percent debt. Its cost of equity is 16.8 percent, the cost of preferred stock is 11.4 percent, and the pretax cost of debt is 8.3 percent. What is the company's WACC if the applicable tax rate is 21 percent?

WACC = .60(.168) + .03(.114) + .37(.083)(1 − .21) = .1285, or 12.85%

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

equal to

Components of the WACC include funds that come from ______ .

investors

Select all that apply To estimate a firm's equity cost of capital using the SML approach, we need to know the Blank______.

market risk premium stock's beta risk-free rate

The most appropriate weights to use in the WACC are the Blank______ weights.

market value

Select all that apply Preferred stock Blank______.

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 Blank______.

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 Blank______.

rejected, when it should be accepted

Select all that apply The following are disadvantages of the SML approach:

requires estimation of the market risk premium requires estimation of beta

The WACC of a firm reflects the ____ and the target capital structure of the firm's existing assets as a whole.

risk

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

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

RE = D1/P0 + g

The market rate of return is 12.65 percent, and the risk-free rate is 3.1 percent. Galaxy Company has 15 percent more systematic risk than the overall market and has a dividend growth rate of 3.75 percent. The firm's stock is currently selling for $53 a share and has a dividend yield of 4.53 percent. What is the firm's average cost of equity?

RE=Rf + β × (E(RM) − Rf) RE= .031 + 1.15 × (.1265 − .031) RE= .1408, or 14.08% RE=D1/P0 + g RE= $53(.0453)/$53 + .0375 RE= .0828, or 8.28% Average RE= (14.08% + 8.28%)/2 = .1118, or 11.18%

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

its cost of equity

In the WACC calculation, D represents the _____ value of the firm's debt.

market

True or false: The growth rate of dividends can be found using the CAPM.

False The growth rate of dividends can be found using historical dividend growth rates and security analysts' forecasts.

True or false: The primary disadvantage of the dividend growth model approach is its simplicity.

False The primary advantage of the dividend growth model approach is its simplicity.

Select all that apply Which of the following are true?

Ideally, we should use market values in the WACC. The market value of debt and equity are not reliable in case of privately owned company.

Farmer's Supply is considering opening a clothing store, which would be a new line of business for the firm. Management has decided to use the cost of capital of a similar clothing store as the discount rate to evaluate this proposed expansion. Which one of the following terms describes this evaluation approach?

Pure play approach

1 Regulation Insurance has a beta of .90, a dividend growth rate of 2.5 percent for the foreseeable future, a stock price of $47 per share, and an expected annual dividend of $.60 per share next year. The market rate of return is 13.9 percent, and the risk-free rate is 3.4 percent. What is the firm's average cost of equity?

RE=Rf + β × (E(RM) − Rf) RE= .034 + .9 × (.139 − .034) RE= .1285, or 12.85% RE=D1/P0 + g RE= $.6/$47 + .025 RE= .0378, or 3.78% Average RE= (12.85% + 3.78%)/2 = .0831, or 8.31%

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

False Projects' discount rates should reflect their particular level of risk.

True or false: Conglomerates are companies that specialize only in projects similar to the project your firm is considering.

False Pure plays are companies that specialize only in projects similar to the project your firm is considering.

True or false: The cost of capital depends on the source of the funds.

False The cost of capital depends on the use of the funds.

True or false: In the WACC calculation, V = E − D.

False V = E + D

Commercial Construction Builders has a beta of 1.34, a dividend growth rate of 2.1 percent for the foreseeable future, a stock price of $15 per share, and an expected annual dividend of $.45 per share next year. The market rate of return is 12.8 percent, and the risk-free rate is 4.2 percent. What is the firm's average cost of equity?

RE=Rf + β × (E(RM) − Rf) RE= .042 + 1.34 × (.128 − .042) RE= .1572, or 15.72% RE=D1/P0 + g RE= $.45/$15 + .021 RE= .0510, or 5.10% Average RE= (15.72% + 5.10%)/2 = .1041, or 10.41%

Traditional Bank has an issue of preferred stock with an annual dividend of $7.50 that just sold for $62 a share. What is the bank's cost of preferred stock?

RP = $7.50/$62 = .1210, or 12.10%

Ted is trying to decide what cost of capital he should assign to a project. Which one of the following should be his primary consideration in this decision?

Risk level of the project

The 7 percent preferred stock of Midwest Muffler and Towing is selling for $65 per share. What is the firm's cost of preferred stock if the tax rate is 21 percent and the par value per share is $100?

Rp = (.07 × $100)/$65 = .1077, or 10.77%

Three years ago, the Fairchildress Company issued 20-year, 7.75 percent semiannual coupon bonds at par. Today, the bonds are quoted at 102.6. What is this firm's pretax cost of debt?

YTM = 3.73865% × 2 = 7.48%

True or false: The SML approach is advantageous because all it requires is the estimation of beta.

False

True or false: The discount rate is also known as the expected return.

False

True or false: The expected percentage is the overall rate of return the firm must earn on its existing assets to maintain the value of its stock.

False

True or false: The SML approach is advantageous because all it requires is estimation of beta.

False Estimation of beta is not required for the SML approach.

True or false: Finding the cost of equity is fairly straightforward.

False It is difficult because there is no way to directly observe the return that the firm's equity investors require on their investment.

True or false: The cost of equity is D1/P0 minus the analysts' estimates of growth.

False The cost of equity is D1/P0 plus the analysts' estimates of growth.

True or false: For publicly traded companies, the component of the dividend yield that must be estimated is the dividend.

False The expected growth rate in dividends must be estimated.

Which one of the following will decrease the aftertax cost of debt for a firm?

Increase in tax rates

Which one of the following will increase the cost of equity, all else held constant?

Increase in the dividend growth rate

We should use ________, values in the WACC. Because ________ values are often similar to market values for debt, we often use book value for debt and market value for equity.

Blank 1: market Blank 2: book

Which of the following is tax-deductible to the firm?

Coupon interest paid on bonds

Using an analyst's forecast for a firm's earnings growth and a stock's dividend yield, you can find the cost of equity by Blank______.

adding these two components

Select all that apply The following are advantages of the SML approach:

adjusts for risk does not require the company to pay a dividend

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

all projects have the same risk as that of the firm overall

Some risk adjustment to a firm's WACC for projects of differing risk, even if it is subjective, is probably Blank______.

better than no risk adjustment

Dividends paid to common stockholders Blank______ be deducted from the payer's taxable income for tax purposes.

cannot

WACC is used to discount Blank______.

cash flows

Select all that apply Which of the following are components used in the construction of the WACC?

cost of preferred stock cost of common stock cost of debt

Select all that apply The rate used to discount project cash flows is known as the Blank______.

discount rate cost of capital required return

The dividend growth model is applicable to companies that pay ____.

dividends

True or false: According to the CAPM, if the market risk premium is zero, then the expected return on a stock is equal to the required return.

False It is equal to the risk-free rate.

Swizer Industries has two separate divisions. Division X has less risk, so its projects are assigned a discount rate equal to the firm's WACC minus .75 percent. Division Y has more risk, and its projects are assigned a rate equal to the firm's WACC plus 1 percent. The company has a debt-equity ratio of .48 and a tax rate of 21 percent. The cost of equity is 15.4 percent and the aftertax cost of debt is 5.4 percent. Presently, each division is considering a new project. Division Y's project provides a return of 12.9 percent while Division X's project is expected to earn 11.5 percent. Which project(s), if any, should the company accept?

Accept X and reject Y WACC = (1/1.48)(.154) + (.48/1.48)(.054) = .1216 Division X: Required return =.1216− .0075 = .1141, or 11.41% Division X's return of 11.5 percent exceeds the required rate of 11.41 percent, so its project should be accepted. Division Y: Required return = .1216 + .01 = .1316, or 13.16% Division Y's return of 12.9 percent is less than the required rate of 13.16 percent, so its project should be rejected.

City Rentals has 44,000 shares of common stock outstanding at a market price of $32 a share. The common stock just paid a $1.50 annual dividend and has a dividend growth rate of 2.5 percent. There are 7,500 shares of $9 preferred stock outstanding at a market price of $72 a share. The outstanding bonds mature in 11 years, have a total face value of $825,000, a face value per bond of $1,000, a market price of $989 each, and a pretax yield to maturity of 8.3 percent. The tax rate is 21 percent. What is the firm's weighted average cost of capital?

Common stock: 44,000 × $32 = $1,408,000 Preferred stock: 7,500 × $72 = $540,000 Debt: $989/$1,000 × $825,000 = $815,925 Value = $1,408,000 + 540,000 + 815,925 = $2,763,925 RE = [($1.50 × 1.025)/$32] + .025 = .073047 Rp = $9/$72 = .125 WACC = ($1,408,000/$2,763,925)(.073047) + ($540,000/$2,763,925)(.125) + ($815,925/$2,763,925)(.083)(1 − .21) = .0810, or 8.10%

Casper's is analyzing a proposed expansion project that is much riskier than the firm's current operations. Thus, the project will be assigned a discount rate equal to the firm's cost of capital plus 2.5 percent. The proposed project has an initial cost of $18.1 million that will be depreciated on a straight-line basis to a zero book value over 20 years. The project also requires additional inventory of $428,000 over the project's life. Management estimates the facility will generate cash inflows of $2.46 million a year over its 20-year life. After 20 years, the company plans to sell the facility for an aftertax amount of $1.4 million. The company has 58,000 shares of common stock outstanding at a market price of $52 a share. This stock just paid an annual dividend of $2.84 a share. The dividend is expected to increase by 3.6 percent annually. The firm also has 15,000 shares of 9 percent preferred stock with a market value of $87 a share. The preferred stock has a par value of $100. The company has $1.2 million of face value bonds with semiannual payments and a coupon rate of 9 percent. The bonds are currently priced at 102 percent of face value and mature in 13 years. The tax rate is 21 percent. Should the firm pursue the expansion project at this point in time? Why or why not?

Common: 58,000 × $52 = $3,016,000 Preferred = 15,000 × $87 = $1,305,000 Debt: 1.02 × $1.2 million = $1,224,000 Value = $3,016,000 + 1,305,000 + 1,224,000 = $5,545,000 RE = [($2.84 × 1.036)/$52] + .036 = .0926 Rp = (.09 × $100)/$87 = .1034 $1,020 = [(.09 × $1,000)/2] × {1−1/[1 + (r/2)]26}/(r/2) + $1,000/[1 + (r/2)]26 r = 8.74% Project cost of capital = ($3,016,000/$5,545,000)(.0926) + ($1,305,000/$5,545,000)(.1034) + ($1,224,000/$5,545,000)(.0874)(1 − .21) + .025 = .1149, or 11.49% NPV = −$18.1 million− $428,000 + $2.46 million(PVIFA20, 11.49%) + ($1.4 million + 428,000)/(1.1149)20 = $.7 million The firm should proceed with the expansion project because the NPV is positive. Accept; 0,7 million

Which one of the following is most apt to cause a wise manager to increase a project's cost of capital? Assume the firm is levered.

She learns the project is riskier than previously believed.

If the firm is all-equity, the discount rate is equal to the firm's cost of Blank______ capital.

equity

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

it cannot be observed directly