Chapter 12: Risk, Cost of Capital, and Valuation
ULC and LEV have earnings before interest and taxes of $110. LEV also has $20 of interest expense. Both companies are taxed at 30 percent, ULC's aftertax earnings are ___, which is ___ than LEV's aftertax earnings.
$77; $14 greater ULC = $110 * (1-.3) = $77 LEV = $90 * (1-.3) = $63
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.
($200 - $90 - $20) x (1 - 0.3) = $63
A firm's target capital structure weights are evenly split between debt and equity. What is the firm's target debt-equity ratio?
1
The weighted average cost of capital (WACC) formula, for a firm with no debt or preferred stock will have a WACC of:
1 X Cost of Equity
Suppose a firm faces a risk-free rate of 2%, a beta of 1, and market risk premium of 4%. What is its cost of capital if it is an all-equity firm?
6%
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.
Which of these statements are correct concerning beta?
A firm's beta may change if the firm increases its debt-equity ratio AND The sample size used to compute a firm's beta may be inadequate AND Beta may vary over time.
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.
Which two of these are the best examples of cyclical firms? Automakers Gas Stations Luxury Retailers Grocery Chains
Automakers AND Luxury Retailers
What do we know about the stability of a firm's beta?
Betas are more likely to be stable if the firm remains in the same industry AND Betas can change over time.
Which of the following can cause a firm's beta to change over time?
Changes in leverage, technology, and product line.
U.S. Treasury securities considered to be risk-free because they have minimal, if any, ___ risk.
Default
A cyclical firm is one in which revenues go ____ in the contraction phase of the business cycle.
Down
A firm should only undertake a project if its expected return is ____ that of a financial asset of comparable risk.
Equal to or greater than
If a point plotted above the security market line (SML) represents a project being considered by an all-equity firm, the project's IRR must be greater than the cost of ______.
Equity AND Capital
On what type of returns does the CAPM focus?
Expected Returns
What is the CAPM formula?
Expected return= RF + B(RM-RF)RF means risk free rate.B means betaRM means return on market
When a new project constitutes its own industry, comparing the values of its _____ to comparable firms should help determine an appropriate beta.
Financial leverage, Cyclicality of Revenues, AND Operating Leverage
Which of the following are true?
Fixed costs do not change as quantity changes AND Variable costs change with changes in quanitity.
When valuing a complete business enterprise, the same process that is used for individual projects can be used. However, the analysis is complicated because a ___ must be used, and a terminal firm value must be determined.
Horizon
If the operations of a firm are similar to its industry, the ___ beta should be used to estimate the firm's cost of equity capital.
Industry's
Which of the following is true about the WACC?
It is the expected return a firm must earn on its existing assets to maintain its current value AND It is also referred to as the discount rate that is used to discount cash flows in capital budgeting problems.
The WACC is the minimum return a company needs to earn to satisfy _____.
Its bondholders AND Its stockholders
If a firm issues no debt, its average cost of capital will equal ____.
Its cost of equity.
Which two of the following are the best examples of non cyclical goods? Automobiles Milk Diapers Luxury Handbags
Milk AND Diapers
Which two of the following are the best examples of non cyclical goods? Milk, Diapers, Luxury Handbergs, and Automobiles
Milk AND Diapers
A firm's cost of debt can be ___.
Obtained by checking yields on publicly traded bonds AND Obtained by talking to investment bankers AND Estimated more easily than its cost of equity.
Preferred stock _____.
Pays dividends in perpetuity AND pays a constant dividend
A point above the SML line represents a project with a _____ NPV for an all-equity firm.
Positive
The formula for calculating the cost of equity capital that is based on the dividend discount model is _____.
R = (Div/P) + g
The market risk premium is defined as ___.
Rm-Rf
Suppose a firm has a target debt-equity rate of 2.5. What is the firm's target capital structure weight for common stock?
S/(S+B) = 1/3.5 = 28.57%
The ___ of the characteristic line of a stock's returns versus those of the market measures the stock's systematic risk.
Slope AND Beta
To estimate a firm's equity cost of capital using the CAPM, we need to know the ______.
Stock's Beta, Risk-Free Rate, AND Market Risk Premium
The cost of capital is an appropriate name since a project must earn enough to pay those who ___ the capital.
Supply
When valuing a firm with the weighted average cost of capital, the ______ value of the firm can be estimated by assuming a constant perpetual growth rate for cash flows beyond the horizon.
Terminal
Which of the following variables do we need to compute the beta for a company's stock?
The covariance between the stock and the market index's returns AND The variance of the market index's returns.
Which of the following are true about U.S. Treasury instruments?
They are not expected to default at this time AND They have never defaulted.
Which one of the following is true?
Under US tax law, a corporation's interest payments are tax deductible.
The weighted average cost of capital (Rwacc) is the overall expected return the firm must earn on its existing assets to maintain its _____.
Value
What does WACC stand for?
Weighted average cost of capital