Ch.14
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.
A firm has a target debt-equity ration 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
If a preferred stock pays a dividend of $2 per year and is selling for $20, its yield is:
2 / 0.20 = 10%
If the market value of debt is $45 million and the market value of equity is $105 million, the total firm value is ____ million.
45 + 105 = $150
Suppose the risk-free rate is 5 percent, the market rate of return is 10 percent, and beta is 2. Find the required rate of return using the CAPM.
5% + (2 x (10%-5%)) = 15%
If an analyst's forecast for a firm's earnings growth is 7%, and its dividend yield is 3%, its cost of equity will be _____.
7% + 3% = 10%
WACC was used to compute the following project NPVs: Project A = $100, Project B = -$50, Project C = -$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.
Which of the following are tax-deductible to the firm?
Coupon interest paid on bonds
The CAPM formula is:
E(Re)=Rf+B(E(Rm)-Rf)
If a firm issues no debt, its average cost of capital will equal ____.
Its cost of equity
Economic Value Added (EVA) is a mean of evaluating corporate performance.
True
Barry Corporation expects free cash flow of $110 thousand at the end of the year, and steady growth from here on. Its WAC is 12% and its expected growth rate is 5%. What is the value of Barry Corporation today?
Vo= 110,000/(0.12-0.05) $1,571,429
What does WACC stand for?
Weighted average cost of capital
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)] x Rs + [B/(S+B)] x Rs x (1-Tc)
If a firm has multiple projects, each project should be discounted using ___.
a discount rate commensurate with the project's risk
The best way to include flotation costs is to ___________.
add them to the initial investment
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
One method for estimating the cost of equity is based on the ______ model.
dividend growth
The return an investor in a security receives is ____ ______ the cost of the security to the company that issued it.
equal to
A firm has 20 percent debt, debt flotation costs of 5 percent, equity flotation costs of 10 percent, and wants to raise $9,100, not including flotation costs. What are the flotation costs?
f(0) = (0.2 x 0.05) + (0.8 x 0.1) = 9% $9,100/(1-.09) - 9,100 = $900
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
Other companies that specialize only in projects similar to the project your firm is considering are called _____.
pure plays
A project should only be accepted if its return is above what is ______.
required by investors
Which of the following methods for calculating the cost of equity ignores risk?
the dividend growth model
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 projects in higher risk divisions, 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
A good source for bond quotes is:
www.finra.org/marketdata
Suppose a firm faces a risk-free rate of 2%, a beta of 1, and a market risk premium of 4%. What is its cost of capital if it is an all-equity firm?
(2% + 1*4%) = 6%
A company has a borrowing rate of 15 percent and a tax rate of 21 percent. What is its aftertax cost of debt?
15%*(1-0.21) = 11.85%
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) x Rp
The rate used to discount project cash flows is known as the _____.
- Required return - Cost of capital - Discount rate
Preferred stock _____.
- pays a constant dividend - pays dividends in perpetuity
Which of the following are components used in the construction of the WACC?
- cost of debt - cost of preferred stock - cost of common stock
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?
Re= 3% + 2 x 7% = 17%
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
A project's NPV without flotation costs is $1,000,000 and its flotation costs are $50,000. What is the true NPV?
$1,000,000 - $50,000 = $950,000
The WACC is the minimum return a company needs to earn to satisfy ____.
- Its bondholders - Its stockholders
Flotation costs are costs incurred to ____.
bring new security issues to the market
A firm's cost of debt can be _____.
- estimated easier than its cost of equity - obtained by talking to investment bankers - obtained by checking yields on publicly traded bonds
Dang's Donuts has EBIT of $25,432, depreciation of $1,500, and a tax rate of 21%. The company will not be changing its net working capital, but plans a capital expenditure of $6,324. What is Dang's adjusted cash flow from assets?
$25,432 * (1-.21) + $1,500 - 0 - $6,324 = $15,267.28
A firm's capital structure consists of 40 percent debt and 60 percent equity. The aftertax yield on debt is 2.5 percent and the cost of equity is 15 percent. The project is about as risky as the overall firm. What discount rate should be used to estimate the project's net present value?
((.60/.40+.60)x.15) + ((.40/.40+.60)x.025) = 10%
A firm's capital structure consists of 30 percent debt and 70 percent equity. Its bonds yield 10 percent, pretax, its costs of equity is 16 percent, and the tax rate is 21 percent. What is its WACC?
(0.7 x .16) + (0.3 x .1 x (1 - 0.21)) = 0.135 or 13.57%
What are the after-tax earnings for HIJ Corporation if it reports $200 in revenue, $90 in operating expenses, has a tax rate of 21%, and pays $20 in interest on its bonds.
(200-90-20) x (1-0.21) = $71.1
To estimate a firms equity cost of capital using CAPM we need to know the _____.
- risk-free rate - stock's beta - market risk premium
The SML approach requires estimates of:
- the market risk premium - the beta coefficient
To estimate the growth rate of a particular stock, we can ______.
- use security analysts' forecasts - use the historical dividend growth rate
A firm needs to sell enough equity to raise $950,000 after covering the flotation costs of 5 percent. How much will it pay in flotation costs?
Amount raised: $950,000 * (1-0.05)= $1,000,000 Flotation Costs: $1,000,000-950,000 = $50,000
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
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
An important advantage to a firm raising equity internally is not having to pay _____.
flotation costs
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
