Chapter 12

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:

10%

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

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

the risk-free rate

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

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

The growth rate of dividends can be found using:

- security analysts' forecasts - historical dividend growth rates

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 WACC is the minimum required return for _____

The overall firm

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

false

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

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

use; source It is the use that determines the risk of the project

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

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

Which of the following is true about a firm's cost of debt?

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

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

- dividend yield - growth rate

To estimate the dividend yield of a particular stock, we need:

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

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.

Preferred stock ____.

- pays a constant dividend - pays dividends in perpetuity

If a firm is funded with $400 in debt and $1200 in equity, the weight of equity is ____ and the weight of debt is __ to be used to compute the WACC

75%; 25%

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 _____.

10% 3%+7%=10%

Suppose a firm's capital structure consists of 30% debt, 10% preferred stock and 60% equity. The firm's bonds yield 10% on average before taxes, the cost of preferred stock is 8% and the cost of equity is 16%. Calculate the firm's WACC assuming a tax rate of 40%

12.20% 0.6 x 16% +.3 x 10% x (1-.4) +.1 x 8% = 12.20

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

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

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:

WACC = (E/V) x Re + (D/V) x Rd x (1-Tc)

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

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