FIN - Chap 13

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 less - $63, $6 less - $77, $14 greater - $63, $6 greater

- $77, $14 greater UCL = $110 × (1 - .3) = $77 LEV= $90 × (1 - .3) = $63

The weighted average cost of capital (WACC) formula, for a firm with no debt or preferred stock will have a WACC of: - cost of debt/cost of equity - 1 * cost of equity - Cost of equity/cost of debt - 1 + cost of equity

- 1 * cost of equity Because the weight of debt is 0 in an all equity firm, the WACC for that firm is cost of equity

Suppose a firm has a target debt-equity ratio of 2.5. What is the firm's target capital structure weight for common stock? - 33.33% - 71.43% - 50.00% - 28.57%

- 28.57% 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? - 22% - 6.48% - 6% - 4.68%

- 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% 8% * (1-0.35)

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 - 8 - 4 - 10

- 7 (1-2) * 7% = -7

Flotation costs are costs incurred to ___

- Bring new security issues to the market

For both academics and practitioners, the pendulum has swung over to the _______ for estimating the cost of equity capital. - DDM - CAPM - retention ration - LMN

- CAPM

True or false: If a firm stays in the same industry, its beta will never change.

- False Firm betas can change for reasons such as changes in product line or tech

Which one of the following is true? - Under international tax law, all company interest payments are taxable to the company - Under international tax law, all company interest payments are tax deductible - Under US tax law, a corporations interest payments up to 30% of EBIT are tax deductible - Under US tax law, all company interest payments are taxable to the company

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

If a firm has multiple projects, each project should be discounted using ___. - the firm's overall cost of capital - a discount rate commensurate with the project's risk - the average cost of capital - the marginal cost of capital for the latest project

- a discount rate commensurate with the project's risk

If a firm increases its level of debt, its beta will ___ - also increases - fall - become unstable - remain the same

- also increase

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

- beta

Generally, which is easier to determine? - cost of equity - cost of debt

- cost of debt

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

- cost of equity

One method for estimating the cost of equity is based on the ______ model. - prime growth - prime and LIBOR average - dividend discount

- dividend discount

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

- dividend yield - growth rate

What can we say about the dividends paid to common and preferred stockholders? - dividends to preferred stockholders are fixed - preferred stock dividends change every year based on the earnings of the firm - dividends are guaranteed for both preferred and common stockholders - dividends to common stockholders are not fixed

- dividends to preferred stockholders are fixed - dividends to common stockholders are not fixed

A cyclical firm is one in which revenues go ______ in the contraction phase of the business cycle. - up - sideways - down - all over

- down

A cyclical firm is one in which revenues go ______ in the contraction phase of the business cycle. - down - up - all over - sideways

- down In a cyclical firm, revenues go down in the contraction phase of the business cycle. A counter-cyclical firm has revenues that go up in a contraction

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 ______. - preferred stock - equity - debt - capital

- equity - capital

Which of the following are factors that affect beta? - financial leverage - operating leverage - the cyclical nature of revenues - changes in the market risk premium

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

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

A firm with debt in its capital structure is said to be: - unlevered - operating - levered

- levered

Preferred stock _____ - does not pay dividends - pays dividends in perpetuity - pays a constant dividend - has a fixed maturity

- pays dividends in perpetuity - pays a constant dividend

Dividends and capital gains given to the new shareholders represent ______ to the shareholders. - costs - cash inflows - nothing - returns

- returns

Which of the following variables is NOT required when using the CAPM to compute the cost of equity capital? - the stock's beta - the rate of inflation - the market risk premium - the risk-free rate

- the rate of inflation

To estimate a firm's cost of equity capital, we need to know three things

- the risk-free rate - the market risk premium - the stock beta

The risk free measure for the risk-free rate should be ______ the risk-free rate used for the market risk premium. - greater than - the same as - less than

- the same as

Which of the following variables do we need to compute the beta for a company's stock? - the correlation between the stock's returns and the CPI index - the variance of the market index's return - the covariance between the stocks and the market index's returns - the covariance between the stocks and the industry index's returns

- the variance of the market index's return - the covariance between the stocks and the market index's returns

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?

.44 .084 = .038 + βEquity(.104 − .038)βEquity = .697 βAsset = (1/1.6)(.697)βAsset = .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?

.82 βAsset = (1/1.47)(1.2)βAsset = .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?

.89 βEquity = .57/(1/1.56)βEquity = .89

A firm's target capital structure weights are evenly split between debt and equity. What is the firm's target debt-equity ratio? - 2 - 1 - 0.5 - 1.5

1 Target D/E = 0.5/0.5 = 1

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% RProject = .028 + (1.32 − .18)(.094 − .028) RProject = .1032, or 10.32%

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?

10.8% Re = .04 + 1.1(.08) Re = .128 Debt = 80($1,000)Debt = $80,000 Common stock = 4,000($40) Common stock = $160,000 Total debt and equity = $80,000 + 160,000 Total debt and equity = $240,000 WACC = ($160,000/$240,000)(.128) + ($80,000/$240,000)(.086)(1 − .21) WACC = .1080, or 10.80%

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% Rs = .034 + 1.37(.082)Rs = .14634, or 14.634% WACC = (1/1.45)(.14634) + (.45/1.45)(.076)(1 − .23)WACC = .1191, or 11.91%

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% RD = .068(1 − .21)RD = .0537, or 5.37%

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?

8.9% RP = $3.80/$42.70 RP = .0890, or 8.90%

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% Rs = [$1.98(1.022)]/$28.40 + .022Rs = .0933, or 9.33%

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% RS = .0384 + .75(.0778)RS = .0968, or 9.68%

The _____ can be used to estimate the required return on equity

CAPM

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

False. Projects discount rates should reflect their particular level of risk

Capital gains represent a cost to the firm

If part of capital gain goes to new stockholders, only the remainder can be captured by old shareholders...which dilutes capital gain of old shareholders.

When a firm has extra cash, what is the two actions it can take?

Pay out cash directly to investors or invest the extra cash into a project, paying out future cash flows of the project

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

The sales of DEFENSIVE firms are less sensitive to the business cycle than are the sales of non-cyclical firms

The ______ is the overall expected return the firm must earn on its existing assets to maintain its value if the firm is levered. - WACC - cost of equity - cost of debt

WACC

When computing WACC, you should use the

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

As an increase in operating leverage increases beta...

an increase in financial leverage (i.e an increase in debt) increases beta

Capital Asset Pricing Model (CAPM)

can be used to estimate the required return

An all-equity firm should accept a project whose internal rate of return is greater than

cost of equity capital and reject a project whose IRR is less than cost of equity capital

Dividends and capital gains given to the new shareholders represent ______ to the firm. - returns - nothing - cash inflows - costs

costs

U.S. Treasury securities 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

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 firm should only undertake a project if its expected return is _____ that of a financial asset of comparable risk. - equal to or greater than - equal to or less than

equal to or greater than

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

equity

The diagonal line (security market line)

graphical depiction of the CAPM and represents the relationship between the cost of equity capital and the firm's beta.

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.

The use of leverage

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

The sales of cyclical firms are _____ sensitive to the business cycle than are the sales of non-cyclical firms. - less - more

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

The correct discount rate on a project ____ the expected return on a financial asset of comparable risk. - should not be - should be

should be

For debt, book values and market values are typically: - similar - different

similar

The discount rate

the expected return on a financial asset of comparable risk

Financial leverage is ...

the extent to which a firm relies on debt. refers to a firm's fixed cost of finance

What is WACC?

the minimal return a company needs to earn to satisfy all of its investors, including stockholders, bondholders, and preferred stockholders

Discount rate is also known as

the required return on a project or cost of capital

market risk premium

the risk free measure should be the same for the risk-free rate and for the market risk premium

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.

WACC

weighted average cost of capital

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 - when economic conditions are relatively stable

when economic conditions change quickly

The beta of debt is commonly considered to be:

zero