Final Exam (Chapter 12)
disadvantages of dividend growth model
-only applicable to companies currently paying dividends -not applicable if dividends aren't growing at a reasonably constant rate -extremely sensitive to the estimated growth rate -does not explicitly consider risk
2 methods of determining cost of debt
1. compute YTM on existing debt 2. use estimates of current rates based on the bond rating expected on new debt
what is the equation for finding the cost of preferred stock?
Dividend/Po
dividends to preferred stock holders are/are not fixed
are
dividends to common stock holders are/are not fixed
are not
a firm's WACC reflects the risk of an _____ project undertaken by the firm
average ("average" -> risk = the firm's current operations)
dividends paid to common stockholders ____ be deducted form the payer's taxable income for tax purposes
cannot
the WACC is defined as the weighted average of a firm's
cost of equity and its aftertax cost of debt
advantage of dividend growth model
easy to understand and use
firms with riskier projects generally have a _____ WACC
higher
ideally, we should use ___ values in the WACC
market
D/V (WACC)
percent financed with debt
E/V (WACC)
percent financed with equity
weights (for WACC) =
percentages of the firm that will be financed by each component
preferred stock is a _____
perpetuity
___ ____ companies can be difficult to find
pure play
a firm must earn at least the ___ ___ to compensate investors for the financing they have provided
required return
different divisions/projects may have different
risks
the cost to a firm for capital funding =
the return to the providers of those funds -the return earned on assets depends on the risk of those assets
according to CAPM, what is the expected return on a stock of its beta is equal to zero?
the risk-free rate
book values are often similar to _____ values for debt
market
D (WACC)
market value of debt = # outstanding bonds x bond price
E (WACC)
market value of equity = # outstanding shares x price per share
V (WACC)
market value of the firm = D + E
two major methods for determing the cost of equity
-dividend growth model -SML or CAPM
advantages of SML approach to determining cost of equity
-explicitly adjusts for systematic risk -applicable to all companies, as long as beta is available
pure play approach
-find one or more companies that specialized in the product or service being considered -compute the beat for each company -take an average -use that beta along with CAPM to find the appropriate return for a project of that risk
the growth rate of dividends can be found using...
-historical dividend growth rates -security analysts' forecasts
factors that influence a company's WACC
-market conditions, especially interest rates, tax rates, and the market risk premium -the firm's capital structure and dividend policy -the firm's investment policy
disadvantages of SML approach to determining cost of equity
-must estimate the expected market risk premium, which does vary over time -must estimate beta, which also varies over time -relies on the past to predict the future, which is not always reliable
a division's or project's _____ should be adjusted to reflect the appropriate risk and capital structure
WACC
WACC =
WACC = (E/V) x RE + (P/V) x RP + (D/V) x RD x (1- TC)
for a firm with outstanding debt, the cost of debt will be the ____ on that debt
YTM
use the ____ on the firm's debt
YTM
some risk adjustments to a firm's WACC for projects of differing risk, even if it is subjective, is probably...
better than no risk adjustment
WACC is used to discount ____ ____
cash flows
subjective approach
consider the project's risk relative to the firm overall -if the project is riskier than the firm, use a discount rate greater than the WACC -if the project is less risky than the firm, use a discount rate less than the WACC
what is tax-deductible to the firm?
coupon interest paid on bonds
the required return is the same as the appropriate...
discount rate
the rate used to discount project cash flows is known as the...
discount rate/cost of capital/required return
preferred stock pays a constant _____ every period
dividend (dividends expected to be paid forever)
finding a firm's overall cost of equity is difficult because
it cannot be observed directly
what is the primary determinant of an investment's cost of capital?
level of risk
if an all-equity firm discounts a project's cash flows with the firm's overall WACC 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
dividend model approach for determining cost of equity
start with the dividend growth model formula and rearrange to solve for Re Po = D1/Re-g so Re = (D1/Po) + g
always use the ___ weights (for WACC). If not available, use _____ values
target; market
interest is...
tax deductible (1-Tc)
a firm's cost of debt is easier to estimate than..
the cost of equity
the cost of debt is NOT
the coupon rate
use what to compute a weighted "average" cost of capital for the firm
the individual costs of capital
a firm's cost of capital indicates how...
the market views the risk of the firm's assets
cost of debt =
the required return on a company's debt
weighted "average" cost of capital for the firm =
the required return on the firm's assets, based on the market's perception of the risk of those assets -the weights are determined by how much of each type of financing is used
SML approach to determining cost of equity
use the following information to compute the cost of equity: -risk-free rate, Rf -market risk premium, E(Rm) - Rf -systematic risk of asset, beta Re = Risk free + beta(E(Rm) - risk free)
what is the pretax cost of debt?
weighted average yield to maturity on the firm's outstanding debt
cost of equity
the return required by equity investors given the risk of the cash flows from the firm
if a firm uses its overall cost of capital to discount cash flows from projects in higher risk divisions, it will accept...
too many projects
