Managerial Finance Ch. 12
Including preferred stock in the WACC formula adds which term if P is the market value of preferred stock and RP is the cost of preferred?
(P/V) × RP
Which of the following are components used in the construction of the WACC?
-Cost of common stock -Cost of debt -Cost of preferred stock
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
The following are advantages of the SML approach:
-Does not require the company to pay a dividend -Adjusts for risk
To estimate the dividend yield of a particular stock, we need ________
-Forecasts of the dividend growth rate, g -The last dividend paid, D0 -The current stock price
The rate used to discount project cash flows is known as the _____
-Required return -Cost of capital -Discount rate
If a firm has multiple projects, each project should be discounted using ______
A discount rate commensurate with the project's risk
Which of the following is tax deductible to the firm?
Coupon interest paid on bonds
True or false: Conglomerates are companies that specialize only in projects similar to the project your firm is considering
False
True or false: Finding the cost of equity is fairly straightforward
False
True or false: In the WACC calculation, V = E − D
False V = E + D
Components of the WACC include funds that come from ______
Investors
Finding a firm's overall cost of equity is difficult because ______
It cannot be observed directly
The formula of the SML is _____
RE = Rf + β × (RM − Rf)
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
The WACC is the minimum required return for _____
The overall firm
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
Free cash flow is better described as ______
Total distributable cash flow
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 ______
[E/V] × RE + [D/V] × RD ×(1 - T c)
True or false: For publicly traded companies, the component of the dividend yield that must be estimated is the dividend
False
True or false: Projects should always be discounted at the firm's overall cost of capital
False
True or false: The expected percentage is the overall rate of return the firm must earn on its existing assets to maintain the value of its stock
False
If a firm issues no debt, its average cost of capital will equal ______
Its cost of equity
The growth rate of dividends can be found using ________
-Historical dividend growth rates -Security analysts' forecasts
Which of the following are true?
-Ideally, we should use market values in the WACC -The market value of debt and equity are not reliable in case of privately owned company
Which of the following is true about a firm's cost of debt?
-It is easier to estimate than the cost of equity -Yields can be calculated from observable data
What will happen over time if a firm uses its overall WACC to evaluate all projects, regardless of each project's risk level?
-It will reject projects that it should have accepted -The firm overall will become riskier -It will accept projects that it should have rejected
Preferred stock _____
-Pays a constant dividend -Pays dividends in perpetuity
The following are disadvantages of the SML approach:
-Requires estimation of the market risk premium -Requires estimation of beta
To estimate a firm's equity cost of capital using the SML approach, we need to know the _______
-Risk-free rate -Market risk premium -Stock's beta
If a firm has multiple projects, each project should be discounted using _______
A discount rate commensurate with the project's risk
Using an analyst's forecast for a firm's earnings growth and a stock's dividend yield, you can find the cost of equity by _______
Adding these two components
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
Dividends paid to common stockholders ______ be deducted from the payer's taxable income for tax purposes
Cannot
The dividend growth model is applicable to companies that pay _______
Dividends
To calculate cash flow from assets, we need to first calculate what the firm's tax bill would have been if it had not used debt financing. What is the expression for the "would-have-been" tax bill?
Earnings before interest and taxes (EBIT) times the firm's tax rate (TC)
The return an investor in a security receives is ______ the cost of the security to the company that issued it
Equal to
If the firm is all-equity, the discount rate is equal to the firm's cost of _____ capital
Equity
True or false: The SML approach is advantageous because all it requires is estimation of beta
False
True or false: The SML approach is advantageous because all it requires is the estimation of beta
False
True or false: The cost of capital depends on the source of the funds
False
True or false: The cost of equity is D1/P0 minus the analysts' estimates of growth
False
True or false: The discount rate is also known as the expected return
False
True or false: The growth rate of dividends can be found using the CAPM
False
True or false: The primary disadvantage of the dividend growth model approach is its simplicity
False
In the WACC calculation, D represents the _______ value of the firm's debt
Market
We should use _______ values in the WACC. Because ______ values are often similar to market values for debt, we often use book value for debt and market value for equity.
Market ; Book
The most appropriate weights to use in the WACC are the _____ weights
Market value
Other companies that specialize only in projects similar to the project your firm is considering are called _____
Pure plays
Other companies that specialize only in projects similar to the project your firm is considering are called _______
Pure plays
What is the required return on a stock (RE), according to the constant dividend growth model, if the growth rate (g) is zero?
RE = D1/P0
The formula for calculating the cost of equity capital that is based on the dividend discount model is _______
RE = D1/P0 + g
What is the equation for finding the cost of preferred stock?
RP=D/P0
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
The WACC of a firm reflects the ________ and the target capital structure of the firm's existing assets as a whole
Risk
It is difficult to establish discount rate for individual projects, so firms often adopt an approach that involves making ______ adjustments to the overall WACC
Subjective
SmartKids, a textbook publisher, is considering investing in a software company that collects and stores data. What beta should SmartKids use to assess the risk of the project?
The beta for software companies that collect and store data
True or false: Free cash flow is very similar to cash flow from assets
True
True or false: Interest paid is a tax-deductible expense, so a company's tax bill is lower than it would have been had the company not used debt financing
True
True or false: RP = D/P0
True
True or false: The return an investor in a security receives is equal to the cost of the security to the company that issued it
True
The cost of capital depends primarily on the ______ of funds, not the ______
Use ; Source
Given V = E + D, if we divide both E and D by ______, we can calculate the capital structure weights
V or Value
The WACC is the overall rate of return the firm must earn on its existing assets to maintain the _______ of its stock
Value or Price
What is the appropriate discount rate to use only if the proposed investment is a replica of the firm's existing operating activities?
WACC
What does WACC stand for?
Weighted Average Cost of Capital
For a firm with outstanding debt, the cost of debt will be the ______ on that debt
Yield to Maturity