Chapter 14 FIN 3400

A firm's cost of debt can be

*obtained by checking yields on publicly traded bonds *estimated easier than its cost of equity *obtained by talking to investment bankers

CAPM Formula

-Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)

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% Cost of equity=Dividend yield + growth rate.

If the risk free rate is 4 percent, an all-equity firms beta is 2, and the market risk premium is 6 percent, what is the firms cost of capital.

16%

A project's NPV without flotation costs is $1,000,000 and its flotation costs are $50,000. What is the true NPV?

950,000

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

Flotation costs are incurred to

Bring new security issues to the market

which of the following are components used in the construction of the WACC

Cost of debt, cost of common stock, and cost of preferred stock

Which of the following are tax deductable to a firm

Coupon interest paid on bonds

The rate used to discount project cash flows is known as

Discount rate, Cost of capital, and Required return

To apply the dividend growth model to a particular stock, you need to assume that the firms __ will grow at a constant rate.

Dividend

one method for estimating cost of equity is based on the __ model

Dividend growth

What can we say about the dividends paid to common and preferred stockholders

Dividends to Common stockholders are not fixed. Dividends to preferred stockholders are fixed

True or false Book values are often similar to market values for equity

False

Other companies that specialize only in projects similar to the project your firm is considering are called _____.

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:

Rejected, when it should be accepted

a project should only be accepted if its return is above what is

Required by investors

To estimate a firms equity cost of Capital using CAPM we need to know____

Risk-free rate, Stocks beta, and market risk premium

WACC can be written as

S/(s+b) *Rs +{b/(b+s)}*Rb*(1-Tc)}

the cost of capital is an appropriate name since the project must earn enough to pay those who ___ the capital

Supply

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

a discount rate commensurate with the projects risk

the best way to include flotation costs is to

add them to the initial investment

Economic value added uses the weighted average cost of capital to determine if value is

being created or destroyed

WACC is used to discount ______ _________.

cash flows

In reality, most firms cover the equity portion of their capital spending with _________.

internally generated cash flow

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

it cannot be observed directly

The CAPM can be used to estimate the _______.

required return on equity

Which of the following methods for calculating the cost of equity ignores risk

the dividend growth model

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

What does WACC stand for?

weighted average cost of capital

a firm has a target debt of equity ratio of .5, but plans to finance a new project with all debt. what debt equity ratio should be used when calculating the projects flotation costs

.5

According to the WACC formula, a firm with no debt or perferred stock will have a WACC of

1*cost of equity

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

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

Flotation

The discount rate for the firms projects equal the cost of capital for the firm as a whole when_.

all projects have the same risk as the current firm

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

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 of interest to its bonds

$71.1

The growth rate of dividends can be found using:

- security analysts' forecasts - historical dividend growth rates

Barry Corporation expects free cash flow of $110 thousand at end of year, and a steady from here on. Its WACC is 12% and its expected growth rate is 5%. What is the value of Barrys Corporation today?

1,571,429 CFA/(wacc-g)=Value

A firms Capital structure consists of 40%debt and 60% equity. the after-tax yield is 2.5%, and the cost of equity is 15%. the project is about as risky as the overall firm. What discount rate should be used to estimate the projects net present value

10% .6*.15+{.025*.4}=.01+.09

MNO perferred stock pays a dividend of 2 per year and has a stock price of $20. Tax rate is 21%, the required rate of return on this stock is __ percent.

10% 2/20

A company that has a borrowing rate of 15% and a tax rate of 21%. what is the after tax rate of debt

11.85

A firms Capital structure consists of 30% debt and 70% equity. its bond yield 10%, pretax, its cost of equity is 16% and tax rate is 21%. What is the WACC

13.57% .7*.16+(.3*.1*(1-.21))= .0237+.1120 =.1357

if the market value of debt is 45 million and the market value of equity is 105 million, the total firm value is _____ million

150 million

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?

17%

a firm needs to sell enough equity to raise 950,000 after covering the flotation costs of 5%. how much will it pay in flotation costs?

50,000 950,000/(1-.05)=1,000,000 1,000,000-950,000=50,000

A firm has 20% debt, debt flotation costs of 5%, equity flotation costs of 10%, and wants to raise capital by 9,1000, not including flotation costs.

900 =.2* .05+ .8* .10= .09 9,100/(1-.09) - 9,100=900

Dividends paid to common stockholders ___ be deducted from the payers taxable income for tax purposes

Cannot

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

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

Equal TOo

An important advantage to a firm raising equity internally is not having to pay___

Flotation costs

The SML approach requires estimates of

Market risk premium, and beta coefficient

The most appropriate weights to use in WACC are the ___ weights

Market value

The formula for calculation the cost of equity capital that is based on a dividend discount model is

RE=D1/(Po+g)

True or False? Under U.S. tax law, a corporations interest payments are tax deductable

True

True or false Book values are often similar to market values for debt

True

True or false Ideally we should use market values in the WACC

True

True or false? A company can deduct interest paid on debt when computing taxable income.

True

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

equity

Dangs 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 dangs adjusted cash flow from assets

15,267.28 ebit*(1-tax rate)+1500-6324

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

15%