Principles of Finance - Chapter 14 and Smartbook

MNO preferred stock pays a dividend of $2 per year and has a price of $20. If MNO's tax rate is 21 percent, the required rate of return on its preferred stock is found by which formula?

$2/$20

Including preferred stock in the WACC adds the term:

(P/V) × RP

(Select all that apply) Which of the following are true?

-Book values are often similar to market values for debt. -Ideally, we should use market values in the WACC.

(Select all that apply) The SML approach requires estimates of the _____.

-market risk premium -beta coefficient

(Select all that apply) 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

(Select all that apply) Preferred stock ___.

-pays dividends in perpetuity -pays a constant dividend

(Select all that apply) To estimate the growth rate of a particular stock, we can ___.

-use the historical dividend growth rate. -use security analysts' forecasts

A firm has a target debt-equity ratio of .5, but it plans to finance a new project with all debt. What debt-equity ratio should be used when calculating the project's flotation costs?

.5

WACC was used to compute the following project NPVs: Project A = $100, Project B = -$50, Project C = -$10, Project D = $40. Which projects should the firm accept?

A and D

Which of the following is true?

A company can deduct interest paid on debt when computing taxable income.

(Select all that apply) Which of the following are components used in the construction of the WACC?

Cost of preferred stock Cost of debt Cost of common stock

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

Dividend Growth Model

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

Dividend growth

(Select all that apply) 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.

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 Divisions' projects, which Division will probably not receive enough resources to fund all of its potentially profitable projects?

Division B Reason: Division A is riskier, so its cash flows should be discounted at a higher rate. Because they're not, the projects in Division A will look better than those in Division B. More projects will be accepted in Division A. Division B's cash flows will be discounted using a higher rate than should be used, so they will appear less appealing and will be more often rejected.

The most well-known approach to company performance evaluation is the _____ method.

EVA

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

False

True or false: The cost of debt on the market value basis is typically much higher than the cost of debt on the book value basis.

False They are typically similar

An important advantage to a firm raising equity internally is not having to pay ___.

Flotation Costs

The formula for the required return from the SML is:

RE = Rf + B(RM − Rf)

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/Po

In addition to CAPM, the cost of equity can be determined using the dividend growth model and the _____ approach.

SML

Using the SML approach, what is the expected return on a stock if its beta is equal to zero?

The risk-free rate

If a firm has two divisions and one division is riskier than the other, what would be the potential result if the firm used its overall WACC to evaluate the projects in both divisions?

The riskier division's projects will typically receive full funding and the less risky division's projects will often be incorrectly rejected.

Economic value added (EVA) is a means of evaluating corporate performance.

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

Which one of the following is true?

Under U.S. tax law, a corporation's interest payments are deductible for tax purposes.

The cost of capital depends on the _____ of funds, not the _____ of funds.

Use; Source

B = the market value of a firm's debt S = the market value of that same firm's equity RB = the before-tax yield on the firm's debt TC = the corporate tax rate RS = the cost of equity Given the definitions above, the weighted average cost of capital formula can be written as:

[S/(S + B)] × RS + [B/(S + B)] × RB × (1 − Tc)

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

a discount rate that commensurates with the project's risk

The best way to include flotation costs is to ___.

add them to the initial investment

The WACC is the weighted average of the cost of equity and the _____.

aftertax cost of debt

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

Flotation costs are costs incurred to ____.

bring new security issues to the market

Dividends paid to common stockholders ______ be deducted from the payer's taxable income for tax purposes.

cannot

WACC is used to discount ______.

cash flows

A firm's overall cost of capital will include both its cost of ____________ and equity capital.

debt

The cost of _____ can be observed because it is the interest rate the firm must pay on new loans.

debt

Finding a firm's overall cost of equity is _______________ (straightforward/difficult).

difficult

To apply the dividend growth model to a particular stock, you need to assume that the firm's ___ will grow at a constant rate.

dividend

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

equal to

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

flotation

The underlying key assumption, and oftentimes a key disadvantage, of the dividend growth model is that it assumes the dividend _____.

grows at a constant rate

(Select all that apply) The growth rate of dividends can be found using _____.

historical dividend growth rates security analysts' forecasts

(Select all that apply) The WACC is the minimum return a company needs to earn to satisfy _____.

its stockholders its bondholders

The most appropriate weights to use in the WACC are the ______ weights.

market value

The _____ _____approach is the use of a WACC that is unique to a particular project, based on companies in similar lines of business.

pure play

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

The market value cost of debt is often _____ than the book value cost of debt.

similar

(Select all that apply) To estimate the expected return on a risky asset, we need to know the ___.

stock's beta market risk premium risk-free rate

Capital _________ weights can be interpreted just like portfolio weights.

structure

With the use of the _____ approach to estimating WACC, the firm's WACC may change through time as economic conditions change.

subjective

The cost of capital is an appropriate name since a project must earn enough to pay those who ______ the capital.

supply

If a firm uses its overall cost of capital to discount cash flows from higher risk projects, it will accept ______ projects.

too many high-risk

The cost of capital depends primarily on the ____________ (use/source) of funds.

use

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

Which of the following are tax-deductible to the firm?

Coupon interest paid on bonds

Which of the following variables is not required to calculate the expected return on a risky asset?

The rate of inflation

When discounting the cash flows of a project at the WACC to estimate NPV, we need to find an alternative in the financial markets that is _____ as the given project.

in the same risk class

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 _____.

there is no way of directly observing the return that the firm's equity investors require on their investment