Chapter 13: Reading Tasks/ Homework

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 (assume all interest is tax deductible).

$63 Calc. ($200 - $90 - $20) x (1 - 0.3) = $63

ULC and LEV have earnings before interest and taxes of $110. LEV also has $20 of interest expense. Both companies are taxed at 30%, ULC's aftertax earnings are ___ , which is ___ than LEV's aftertax earnings (assume all interest can be deducted).

$77; $14 greater Calc: ULC = $110 x (1 - 0.3) = $77 LEV = $90 x (1 - 0.3) = $63

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. -Betas can change over time.

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 true?

-Fixed costs do not change as quantity changes. -Variable costs change with changes in quantity.

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.

An increase in ______ will increase beta.

-operating leverage -financial leverage

The cost of equity for RJ Corporation is 8.4 percent and the debt-equity ratio is .6. The expected return on the market is 10.4 percent and the risk-free rate is 3.8 percent. Using the common assumption for the debt beta, what is the asset beta?

0.44

A firm has an equity beta of 1.2, the risk-free rate is 3.4 percent, the market return is 15.7 percent, and the pretax cost of debt is 9.4 percent. The debt-equity ratio is .47. If you apply the common beta assumptions, what is the firm's asset beta?

0.82

Barges has an asset beta of .57, the risk-free rate is 4.3 percent, and the market risk premium is 7.7 percent. What is the equity beta if the firm has a debt-equity ratio of .56?

0.89

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 × Cost of equity

________________ costs do not change as the quantity sold changes, while ______________ costs do change as the quantity sold changes.

1. Fixed 2. Variable

Jack's Construction Co. has 80 bonds outstanding that are selling at their par value of $1,000 each. Bonds with similar characteristics are yielding a pretax 8.6 percent. The firm also has 4,000 shares of common stock outstanding. The stock has a beta of 1.1 and sells for $40 a share. The U.S. T-bill is yielding 4 percent, the market risk premium is 8 percent, and the firm's tax rate is 21 percent. What is the firm's weighted average cost of capital assuming its earnings are sufficient to classify all interest as a tax-deductible expense?

10.80 percent

Suppose Simmons' common stock has a beta of 1.37, the risk-free rate is 3.4 percent, and the market risk premium is 8.2 percent. The yield to maturity on the firm's bonds is 7.6 percent and the debt-equity ratio is .45. What is the WACC if the tax rate is 23 percent and all interest is tax deductible?

11.91 percent

Suppose a firm has a target debt-equity ratio of 2.5. What is the firm's target capital structure weight for common stock?

28.57% Calc. S/(S+B) = 1/3.5 = 28.57%

If a company has a cost of debt of 6% and a corporate tax rate equal to 22%, what is the after tax cost of debt?

4.68%

If a company has a cost of debt of 8% and a corporate tax rate equal to 35%, what is the after tax cost of debt?

5.2% Calc. 8 x (1 - 0.35) = 5.2%

Ladder Works has debt outstanding with a coupon rate of 6 percent and a yield to maturity of 6.8 percent. What is the aftertax cost of debt if the tax rate is 21 percent? Assume all interest is tax deductible.

5.37 percent

If the risk-free rate is 3 percent, the market risk premium is 7 percent, the industry beta is 1, and the firm beta is 2, the cost of equity will be ____ percent less if the industry beta is used instead of the firm beta.

7 Calc.: (1-2) x 7% = -7%

The Shoe Box pays an annual dividend of $3.80 on its preferred stock. What is the cost of preferred if the stock currently sells for $42.70 a share and the tax rate is 21 percent?

8.90 percent

Albert's recently paid its annual dividend of $1.98 per share. At that time, the firm announced that all future dividends will be increased by 2.2 percent annually. What is the firm's cost of equity if the stock is currently selling for $28.40 a share?

9.33 percent

Which of the following is true?

A company can deduct interest paid on debt up to 30 percent of EBIT when computing taxable income.

For both academics and practitioners, the pendulum has swung over to the _______ for estimating the cost of equity capital.

CAPM

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

False

True or false: The CAPM is the only method to compute the cost of equity.

False

______ companies prefer the CAPM to the DDM.

More

What is the CAPM formula?

RS = RF + β × (RM- RF)

True or false: The correct discount rate on a project should be the expected return on a financial asset of comparable risk.

True

True or false: The dividend discount model for a stock can be generalized to the market as a whole.

True

Which one of the following is true?

Under U.S. tax law, a corporation's interest payments up to 30 percent of EBIT are tax-deductible.

The ______ is the overall expected return the firm must earn on its existing assets to maintain its value if the firm is levered.

WACC

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

a discount rate commensurate with the project's risk

When computing WACC, you should use the:

aftertax cost of debt because interest is partially, if not fully, tax deductible.

If a firm increases its level of debt, its beta will ___.

also increase

The covariance between the stock and the market index's returns divided by the variance of the market index's returns represents the ____________ for a company's stock.

beta

The slope of the characteristic line of a firm's returns versus those of the market is the ___.

beta

Flotation costs are costs incurred to ____.

bring new security issues to the market

U.S. Treasury securities are considered to be risk-free because they have minimal, if any, ____ risk.

default

The __________ discount model for a stock can be generalized to the market as a whole.

dividend

One method for estimating the cost of equity is based on the ______ model.

dividend discount

When estimating the cost of equity using the DDM, the factor that is the most apt to add error to this estimate is the:

dividend growth rate

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

The asset beta is the beta of common stock had the firm been all ____________.

equity

An increase in a firm' s level of debt is an example of ___.

financial leverage

The issuance costs of bonds and stocks are referred to as ______ costs.

flotation

Comparing two otherwise equivalent firms, the beta of the common stock of the levered firm is _____ the beta of the common stock of the unlevered firm.

greater than

A firm's WACC can be correctly used to discount the expected cash flows of a new project when that project will:

have the same level of risk as the firm's current operations.

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

The use of leverage:

increases the equity beta but does not affect the asset beta.

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

its cost of equity

The industry beta may be a better estimate than the firm's own beta due to the ______ standard error of the firm estimate.

larger

A firm with debt in its capital structure is said to be ______.

levered

The sales of cyclical firms are ______ sensitive to the business cycle than are the sales of non-cyclical firms.

more

The weighted average cost of capital for a firm is the:

overall rate which the firm must earn on its existing assets to maintain the value of its stock.

A point above the SML line represents a project with a ______ NPV for an all-equity firm.

positive

The difference between the expected return on the market portfolio and the risk-free rate is the market risk ____________.

premium

If the expected return of a project is below that of a financial asset of comparable risk, the firm should ______ the project.

reject

The CAPM can be used to estimate the ___.

required return on equity

The correct discount rate on a project ______ the expected return on a financial asset of comparable risk.

should be

For debt, book values and market values are typically ______.

similar

Lesco's is evaluating a project that has a different level of risk than the overall firm. This project should be evaluated:

using a beta commensurate with the project's risks.

The weighted average cost of capital (RWACC) is the overall expected return the firm must earn on its existing assets to maintain its ___.

value

The beta of the portfolio is a ______ average of the betas of the individual items in the portfolio.

weighted

What does WACC stand for?

weighted average cost of capital

The beta of debt is commonly considered to be:

zero

Which of the following is true about the WACC?

-It is also referred to as the discount rate that is used to discount cash flows in capital budgeting problems. -It represents the marginal cost of capital.

Which of the following are true about U.S. Treasury instruments?

-They are not expected to default at this time. -They have never defaulted.

The ____ of the characteristic line of a stock's returns versus those of the market measures the stock's systematic risk.

-beta -slope

Which of the following can cause a firm's beta to change over time?

-changes in technology -changes in product line -changes in leverage

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

-dividend yield -growth rate

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 -capital

Changes in ____________ leverage and ______________ leverage will affect beta. (Enter only one word per blank.)

-financial -operating or operational

Which of the following are factors that affect beta?

-financial leverage -the cyclical nature of revenues -operating leverage

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

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

A firm's cost of debt can be ___.

-obtained by checking yields on publicly traded bonds -estimated more easily than its cost of equity -obtained by talking to investment bankers

Preferred stock ______.

-pays dividends in perpetuity -pays a constant dividend

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. -the variance of the market index's returns.

The ___________ discount model requires estimation of the dividend yield and ___________ rate.

1. dividend 2. growth

Southern Imports is an all-equity firm with a beta of 1.32. The firm is considering a new project that entails less risk than its current operations and thus management feels that the firm's beta should be lowered by .18 when assigning a discount rate to this project. The market rate of return is 9.4 percent and the risk-free rate is 2.8 percent. What discount rate should be assigned to this project?

10.32 percent

Consolidated Transfer is an all-equity financed firm. The beta is .75, the market risk premium is 7.78 percent, and the risk-free rate is 3.84 percent. What is the expected rate of return on this stock?

9.68 percent

The ________ _________ _________ model can be used to estimate the required return on equity.

capital asset pricing

Dividends and capital gains given to the new shareholders is ___ that cannot be paid to the old shareholders.

cash

Generally, which is easier to determine?

cost of debt

Dividends and capital gains given to the new shareholders represent ___ to the firm.

costs

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 is NOT required when using the CAPM to compute the cost of equity capital?

the rate of inflation

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

the risk-free rate

The risk free measure for the risk-free rate should be ______ the risk-free rate used for the market risk premium.

the same as