Valuation Methods and Cost of Capital
Williams, Inc., is interested in measuring its overall cost of capital and has gathered the following data. Under the terms described as follows, the company can sell unlimited amounts of all instruments. Williams can raise cash by selling $1,000, 8%, 20-year bonds with annual interest payments. In selling the issue, an average premium of $30 per bond would be received, and the firm must pay flotation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8%. Williams can sell 8% preferred stock with a par value of $100 for $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share. Williams' common stock is currently selling for $100 per share. The firm expects to pay cash dividends of $7 per share next year, and the dividends are expected to remain constant. The stock will have to be underpriced by $3 per share, and flotation costs are expected to amount to $5 per share. Williams expects to have available $100,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing. Williams' preferred capital structure is Long-term debt 30% Preferred stock 20% Common stock 50% The cost of funds from the sale of common stock for Williams, Inc., is A. 7.6% B. 7.4% C. 7.0% D. 8.1%
Answer A is correct. According to the dividend growth model, the cost of new (external) common equity is the next dividend divided by the net issue proceeds plus the dividend growth rate. Since flotation costs are incurred when issuing new stock, they must be deducted from the market price to arrive at the amount of capital the corporation will actually receive. Accordingly, the $100 selling price is reduced by the $3 discount and the $5 flotation costs to arrive at the $92 to be received for the stock. Because the dividend is not expected to increase in future years, no growth factor is included in the calculation. Thus, the cost of the common stock is 7.6% ($7 dividend ÷ $92 net issue proceeds).
An investor wrote a $45 call option and bought a $50 put option, both of which had the same time to expiration. On the transaction date, the stock price was $45, and the prices for the call and put options were $8 and $10, respectively. Subsequently, the stock price fell by $10, where it remained through the option expiration date. As of the expiration date, the total profit on the combined option position, ignoring commissions and other transactions, is A. $13 B. $17 C. $3 D. $7
Answer A is correct. The amount of gain and loss on a call option for the writer is calculated as the option price minus the excess of the market price over the exercise price, if any. Thus, the call option provides the investor a gain of $8 ($8 - $0). The amount of gain and loss on a put option for the buyer is calculated as the excess of the exercise price over the market price minus the option price. Thus, the put option provides the investor a gain of $5 [($50 - $35) - $10)]. The total profit on the combined option position is $13 ($8 gain + $5 gain).
A company has a weighted-average cost of capital of 12.8%. If the after-tax cost of debt is 8%, and the weight on debt is 20%, what is the company's cost of equity? Assume the company has no preferred stock. A. 14.0% B. 18.0% C. 11.2% D. 26.0%
Answer A is correct. The company's cost of equity can be calculated using the WAAC formula. WACC = Weight on equity × Cost of equity + Weight on debt × Cost of debt 12.8% = 80% × Cost of equity + 20% × 8% 12.8% = 80% × Cost of equity + 1.6% 11.2% = 80% × Cost of equity 14% = Cost of equity
What is the after-tax cost of preferred stock that sells for $5 per share and offers a $0.75 dividend when the tax rate is 35%? A. 15% B. 10.50% C. 9.75% D. 5.25%
Answer A is correct. The component cost of preferred stock is the dividend yield, i.e., the cash dividend divided by the market price of the stock ($.75 ÷ $5.00 = 15%). Preferred dividends are not deductible for tax purposes.
A company is projecting an annual growth rate for the foreseeable future of 9%. The most recent dividend paid was $3.00 per share. New common stock can be issued at $36 per share. Using the constant growth model, what is the approximate cost of capital for retained earnings? A. 18.08% B. 19.88% C. 9.08% D. 17.33%
Answer A is correct. The cost of capital can be found using the dividend discount model: Price =Next period dividend ÷ (Cost of capital - Dividend growth rate) Price =[Current period dividend × (1 + growth rate)] ÷ (Cost of capital - Dividend growth rate) $36 =[$3.00 × (1.09)] ÷ (x - 9%) $36x - $3.24 =(3 × 1.09) $36x - $3.24 =3.27 $36x =$6.51 x =18.08333 or 18.08%
An analyst is in the process of determining what the current share price should be for a company. In early January, the analyst collected the following information Dividend at end of current year = $1.00 Yearly dividend increase = 5% Expected investor return = 10% Based on the data provided, the current share price should be A. $20.00 B. $6.67 C. $21.00 D. $7.00
Answer A is correct. The dividend discount model is a method of arriving at the value of a stock by using expected dividends per share and discounting them back to present value. The formula is as follows: dividend per share ÷ (cost of capital - dividend growth rate). Because the dividend at year end is given, the expected dividend does not need to be calculated. Therefore, the current share price should be $20 [$1 ÷ (.10 - .05)]
A publicly traded corporation in an industry with an average price-earnings ratio of 20 has the following summary financial results. Sales $1,000,000 Expenses 500,000 Operating income $500,000 Taxes 300,000 Net income $200,000 Assets $2,500,000 Liabilities 1,000,000 Shareholders' equity 1,500,000 A competitor wishes to make a bid to acquire the stock of the company. What is the current market value? A. $4,000,000 B. $10,000,000 C. $20,000,000 D. $1,500,000
Answer A is correct. The price-earnings ratio is expressed as the market price per share divided by the earnings per share. However, this can also be expressed as the total market price over the total earnings. Earnings (net income) are equal to $200,000, and the price-earnings ratio is equal to 20. Therefore, the market value can be solved for as follows: 20=Market value ÷ $200,000 Market value = 20 × $200,000=$4,000,000
Ten years ago, perpetual preferred shares with a par value of $50 and an annual dividend rate of 6% were issued. Currently, there are no dividends in arrears. Since the issue date, interest rates have risen, and the shares are now selling at $38. The market's current required rate of return on these shares is A. 7.89% B. 6.00% C. 4.56% D. 15.79%
Answer A is correct. The required rate of return on these shares is calculated by dividing the dividend by the issue price. Thus, $3 (6% × $50) must be divided by $38 to yield 7.89%.
The weighted-average cost of capital is equal to the A. Rate of return on assets that covers the costs associated with the funds employed. B. Cost of the firm's equity capital at which the market value of the firm will remain unchanged. C. Minimum rate a firm must earn on high-risk projects. D. Average rate of return a firm earns on its assets.
Answer A is correct. The weighted-average cost of capital represents the minimum rate of return at which a company produces value for its investors. Therefore, it is the return on assets that covers the company's costs.
A manufacturer of printers is attempting to determine its cost of common equity for cost of capital purposes. The manufacturer's long-term debt is rated AA by Standard & Poor's. The manufacturer's common shares trade on the NASDAQ and the current market price is $26.87. The most recent yearly common share dividend paid common shareholders was $1.04. The consensus forecast of security analysts who follow the manufacturer's common shares is that earnings growth will average 12.5% over the long term. The manufacturer's marginal income tax rate is 40%. Using the dividend discount model, what is the manufacturer's cost of equity capital for cost of capital purposes? A. 16.85% B. 10.11% C. 9.82% D. 16.37%
Answer A is correct. Under the dividend growth model, the cost of equity equals the expected growth rate plus the quotient of the next dividend and the current market price. The next dividend is calculated as $1.17 [$1.04 dividend × (1 + .125 growth)]. Thus, the cost of equity capital is 16.85% [12.5% + ($1.17 ÷ $26.87)]. This model assumes that the payout ratio, retention rate, and the earnings per share growth rate are all constant.
During the most recent fiscal year, a company earned net income after tax of $3,288,000. The company paid preferred share dividends of $488,000 and common share dividends of $1,000,000. The current market price of common shares is $56 per share, and the shares are trading at a price-earnings rate of 8. How many common shares does the company have outstanding? A. 400,000 B. 411,000 C. 350,000 D. 469,714
Answer A is correct. Using known relationships, outstanding common stock can be determined as follows: Price-earnings ratio=Market price ÷ Earnings per share 8=$56 per share ÷ Earnings per share Earnings per share=$56 per share ÷ 8=$7 Net income $3,288,000 Less: dividends on preferred stock (488,000) Income available to common shareholders $2,800,000 Earnings per share= Income available to common shareholders ÷ Common shares outstanding $7=$2,800,000 ÷ Common shares outstanding Common shares outstanding =$2,800,000 ÷ $7= 400,000
Which one of the following events will most likely result in a higher price-earnings ratio for a company's common shares? A. The economy is expected to enter a recession. B. Investors' required rate of return on the common shares falls. C. The dividend yield increases when the dividend per share remains unchanged. D. The rate of growth in dividends is expected to decline.
Answer B is correct. A decrease in investors' required rate of return will cause share prices to go up, which will result in a higher P/E ratio.
A firm has sold 1,000 shares of $100 par, 8% preferred stock at an issue price of $92 per share. Stock issue costs were $5 per share. The firm pays taxes at the rate of 40%. What is the firm's cost of preferred stock capital? A. 8.70% B. 9.20% C. 8.00% D. 8.25%
Answer B is correct. Because the dividends on preferred stock are not deductible for tax purposes, the effect of income taxes is ignored. Thus, the relevant calculation is to divide the $8 annual dividend by the quantity of funds received from the issuance. In this case, the funds received equal $87 ($92 proceeds - $5 issue costs). Thus, the cost of capital is 9.2% ($8 ÷ $87).
In calculating the component costs of long-term funds, the appropriate cost of retained earnings, ignoring flotation costs, is equal to A. The same as the cost of preferred stock. B. The cost of common stock. C. The weighted average cost of capital for the firm. D. Zero, or no cost.
Answer B is correct. Common shareholders expect retained earnings to be paid out in the form of dividends. Thus, the cost of retained earnings is an opportunity cost, i.e., the rate that investors can earn elsewhere on investments of comparable risk.
T Corporation is considering the acquisition of S Company with common stock. The following financial information is available regarding the two companies: T S Net income $8,000,000 $2,000,000 Common shares 4,000,000 1,600,000 outstanding Earnings per $2.00 $1.25 share Price/earnings 12 8 ratio T plans to offer S's shareholders a 20% premium over the market price of the S stock. What would be the earnings per share for the surviving company immediately following the merger? A. $2.143 B. $2.083 C. $1.714 D. $1.667
Answer B is correct. First, calculate how much cash is needed to purchase S. To calculate the price of S stock, the price/earnings ratio of 8 should be multiplied by the earnings per share of $1.25. Thus, the price of S stock is $10 + $2 for the 20% premium ($10 × 20%). $19,200,000 is needed for the acquisition (1,600,000 total shares × $12 price of share). In order to have enough cash to purchase S, T must issue more shares of its own stock. The price of T's stock is $24 (12 price/earnings ratio × $2.00 earnings per share). Therefore, 800,000 additional shares must be issued to have cash to purchase the new stock ($19,200,000 needed cash ÷ $24 T's stock price). The earnings per share for the surviving company is $2.083 ($10,000,000 combined net income ÷ 4,800,000 T's total common shares outstanding).
If a corporation's stock price experiences increased volatility, what would happen to the value of the call options and the put options on the corporation's stock? A. The call options would increase in value, and the put options would decrease in value. B. Both the call options and the put options would increase in value. C. The call options would decrease in value, and the put options would increase in value. D. Both the call options and the put options would decrease in value.
Answer B is correct. Since options protect against volatility in the stock price, the more volatile a stock is, the more owning the options becomes valuable.
A company has the following financial information: Proportion of capital structure Cost of capital Long-term debt 60% 7.1% Preferred stock 20% 10.5% Common stock 20% 14.2% To maximize shareholder wealth, the company should accept projects with returns greater than what percent? A. 14.2% B. 9.2% C. 7.1% D. 10.6%
Answer B is correct. The company should not accept projects that have a lower return than the after-tax weighted-average cost of capital, calculated as follows: Weight*Cost of Capital= Weighted Cost Long-term debt: 60%×7.1%=4.26% Preferred stock: 20%×10.5%=2.10% Common equity: 20%×14.2%=2.84% Total: 9.20%
Current-year earnings are $2.00 per share. Using a discounted cash flow model, the controller determines that the common stock is worth $14 per share. Assuming a 5% long-term growth rate, the required rate of return is which one of the following? A. 7% B. 20% C. 10% D. 15%
Answer B is correct. The current-year earnings per share are $2.00. In order to calculate the correct dividend per share amount when given only the amount of the last annual dividend paid, it is necessary to adjust to the expected dividend using the growth rate of the company. Thus, the dividends per share equal $2.10 [$2 × (1 + .05)]. The dividend discount model (also known as the dividend growth model) is a method of arriving at the value of a stock by using expected dividends per share and discounting them back to present value. The formula is as follows: Dividends per share/(cost of capital-Dividend growth rate) The rate of return can now be solved for as follows: $2.10 ÷ (x - .05)=$14 $2.10=$14x - .70 $2.80=$14x x=20%
A company's capital structure consists entirely of long-term debt and common equity. The cost of capital for each component is shown below. Long-term debt 8% Common equity 15% The company pays taxes at a rate of 40%. If the weighted average cost of capital is 10.41%, what proportion of the company's capital structure is in the form of long-term debt? A. 34% B. 45% C. 66% D. 55%
Answer B is correct. The effective rate for debt is the after-tax cost [8% × (1.0 - .40 tax rate) = 4.8%]. The formula for weighted-average cost of capital can be solved as follows: (Debt weight × Cost of debt) + (Equity weight × Cost of equity) =WACC (Debt weight ×.048) + (Equity weight × .15) =.1041 [(1 - Equity weight) × .048] + (Equity weight × .15) = .1041 .048 - (.048 × Equity weight) + (Equity weight × .15) = .1041- (.048 × Equity weight) + (Equity weight × .15) =.0561 Equity weight × .102 =.0561 Equity weight =.55 Since equity is 55% of the capital structure, debt makes up 45%.
A company's capital structure consists of 30% long-term debt, 25% preferred stock, and 45% common equity. The cost of capital for each component is shown below. Long-term debt 8% Preferred stock 11% Common equity 15% If the company pays taxes at the rate of 40%, what is the company's after-tax weighted average cost of capital? A. 11.90% B. 10.94% C. 9.84% D. 7.14%
Answer B is correct. The effective rate for debt is the after-tax cost [8% × (1.0 - .40 tax rate) = 4.8%]. The weighted-average cost of capital (WACC) can thus be calculated as follows: Weight x Cost of Capital=Weighted Cost Long-term debt: 30%×4.8%=1.44% Preferred stock: 25%×11.0%=2.75% Common equity: 45%×15.0%=6.75% Total: 10.94%
Bull & Bear Investment Banking is working with the management of Clark, Inc., in order to take the company public in an initial public offering. Selected financial information for Clark is as follows. Long-term debt (8% interest rate) $10,000,000 Common equity: Par value ($1 per share) 3,000,000 Additional paid-in-capital 24,000,000 Retained earnings 6,000,000 Total assets 55,000,000 Net income 3,750,000 Dividend (annual) 1,500,000 If public companies in Clark's industry are trading at a market to book ratio of 1.5, what is the estimated value per share of Clark? A. $13.50 B. $27.50 C. $16.50 D. $21.50
Answer C is correct. A firm's book value per share consists of total equity divided by the number of common shares outstanding. Clark's total equity is $33,000,000 ($3,000,000 + $24,000,000 + $6,000,000) and the number of common shares is 3,000,000, making the book value per share $11.00 ($33,000,000 ÷ 3,000,000). Since the industry average market to book ratio is 1.5, Clark's stock price is expected to be $16.50 ($11.00 × 1.5).
A firm's target or optimal capital structure is consistent with which one of the following? A. Minimum cost of debt. B. Minimum risk. C. Minimum weighted-average cost of capital. D. Maximum earnings per share.
Answer C is correct. Ideally, a firm will have a capital structure that minimizes its weighted-average cost of capital. This requires a balancing of both debt and equity capital and their associated risk levels.
An accountant must calculate the weighted average cost of capital of the corporation using the following information. Component Cost Accounts payable $35,000,000 -0- Long-term debt 10,000,000 8% Common stock 10,000,000 15% Retained earnings 5,000,000 18% What is the weighted average cost of capital? A. 6.88% B. 10.25% C. 12.80% D. 8.00%
Answer C is correct. Since the effect of income taxes is ignored in this situation, the stated rate on long-term debt is considered to be its effective rate. The weighted-average cost of capital (WACC) can thus be calculated as follows: Carrying Amount x Weight x Cost of Capital x Weighted Cost Long-term debt $10,000,000/25000000=(40%)×8%=3.2% Common stock 10,000,000/25000000=(40%)×15%=6.0% Retained earnings 5,000,000/25000000=(20%)×18%=3.6% Totals $25,000,000 100% 12.8%
Prometric Emulation Time Remaining: 0:23:27 For the year ended May 31, Year 2, a company had per-share earnings of $4.80. The company's outstanding stock for the Year 1-Year 2 fiscal year consisted of $2,000,000 of 10% preferred with $100 par value and 1,000,000 shares of common. On June 1, Year 2, the common stock split 3 for 1, and the company redeemed one-half of the preferred stock at par value. The company's net income for the year ended May 31, Year 3, was 10% higher than in Year 2. Earnings per share in Year 3 on the company's common stock were A. $5.28 B. $1.76 C. $1.80 D. $5.40
Answer C is correct. The EPS for Year 2 of $4.80 indicates a net income available to common shareholders of $4,800,000. Dividends on preferred stock would have been $200,000 ($2,000,000 × 10%). Thus, the net income must have been $5,000,000. A 10% increase for Year 3 would result in net income of $5,500,000. Only $100,000 ($1,000,000 × 10%) would be required for preferred dividends in Year 3, leaving $5,400,000 for common shareholders. After the 3-for-1 split, EPS would be $1.80 ($5,400,000 ÷ 3,000,000 shares).
The management of a company has been reviewing the company's financing arrangements. The current financing mix is $750,000 of common stock, $200,000 of preferred stock ($50 par) and $300,000 of debt. The company currently pays a common stock cash dividend of $2. The common stock sells for $38, and dividends have been growing at about 10% per year. Debt currently provides a yield to maturity to the investor of 12%, and preferred stock pays a dividend of 9% to yield 11%. Any new issue of securities will have a flotation cost of approximately 3%. The company has retained earnings available for the equity requirement. The company's effective income tax rate is 40%. Based on this information, the cost of capital for retained earnings is A. 16.0% B. 14.2% C. 15.8% D. 9.5%
Answer C is correct. The cost of new common stock is the next dividend ($2.20) divided by the net proceeds of the stock. If this were to involve a new sale of stock, the flotation costs would be deducted from the selling price to get the net proceeds. However, this was for retained earnings, so there is no deduction. The calculation is to divide the $2.20 dividend by the $38 selling price to get 5.8%. Add the 10% growth rate and the answer is 15.8%.
Joint Products, Inc., a corporation with a 40% marginal tax rate, plans to issue $1,000,000 of 8% preferred stock in exchange for $1,000,000 of its 8% bonds currently outstanding. The firm's total liabilities and equity are equal to $10,000,000. The effect of this exchange on the firm's weighted average cost of capital is likely to be A. No change, since it involves equal amounts of capital in the exchange and both instruments have the same rate. B. A decrease, since preferred stock payments do not need to be made each year, whereas debt payments must be made. C. An increase, since a portion of the debt payments are tax deductible. D. A decrease, since a portion of the debt payments are tax deductible.
Answer C is correct. The payment of interest on bonds is tax-deductible, whereas dividends on preferred stock must be paid out of after-tax earnings. Thus, when bonds are replaced in the capital structure with preferred stock, an increase in the cost of capital is likely because there is no longer a tax shield.
The type of option that does not have the backing of stock is called a(n) A. Covered option. B. Unsecured option. C. Put option. D. Naked option.
Answer D is correct. A naked or uncovered option is a call option that does not have the backing of stock. Thus, the option writer will have to purchase the underlying stock if the call option is exercised.
Williams, Inc., is interested in measuring its overall cost of capital and has gathered the following data. Under the terms described as follows, the company can sell unlimited amounts of all instruments. Williams can raise cash by selling $1,000, 8%, 20-year bonds with annual interest payments. In selling the issue, an average premium of $30 per bond would be received, and the firm must pay flotation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8%. Williams can sell 8% preferred stock with a par value of $100 for $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share. Williams' common stock is currently selling for $100 per share. The firm expects to pay cash dividends of $7 per share next year, and the dividends are expected to remain constant. The stock will have to be underpriced by $3 per share, and flotation costs are expected to amount to $5 per share. Williams expects to have available $100,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing. Williams' preferred capital structure is Long-term debt 30% Preferred stock 20% Common stock 50% If Williams, Inc., needs a total of $1,000,000, the firm's weighted-average cost of capital would be A. 27.4% B. 4.8% C. 6.5% D. 6.8%
Answer D is correct. Because Williams can sell unlimited amounts of all of its instruments, it can maintain its preferred capital structure. The cost of new debt is given as 4.8%. The cost of new preferred stock is 8.0% ($8 dividend ÷ $100 net issue proceeds). The common equity component will amount to $500,000 ($1,000,000 capital needed × 50% common stock). Retained earnings are available to cover $100,000 (10% of the total), so new common stock will have to be issued to cover the other 40%. The cost of new common stock is 7.6% ($7 dividend ÷ $92 net issue proceeds). Weight*cost of capital=Weighted cost
How much must the stock be worth at expiration in order for a call holder to break even if the exercise price is $60 and the call premium was $3? A. $60.00 B. $61.50 C. $57.00 D. $63.00
Answer D is correct. Because the call premium is $3, the stock price must be at least $63 ($60 exercise price + $3 call premium).
A major homebuilder will use lumber to build a large development of homes next year. If the homebuilder plans to buy the lumber next year, it can hedge its future costs if it A. Buys a lumber futures contract next year. B. Sells a lumber futures contract today that expires next year. C. Buys and sells lumber futures contracts today that expire next year. D. Buys a lumber futures contract today that expires next year.
Answer D is correct. Buying the futures contract allows the homebuilder to buy the lumber next year at a stated rate. This will hedge the future costs.
Which of the following, when considered individually, would generally have the effect of increasing a firm's cost of capital? I. The firm reduces its operating leverage. II. The corporate tax rate is increased. III. The firm pays off its only outstanding debt. IV. The Treasury Bond yield increases. A. I and III. B. II and IV. C. I, III and IV. D. III and IV.
Answer D is correct. Debt generally has a lower initial cost than equity. By removing debt from the firm's financing structure, the cost of capital is thereby increased. Similarly, the increase in yield on Treasury bonds, a risk-free rate, would cause the yield on all other bonds to also increase
A stock began the month with a stock price of $50 per share, paid a dividend of $2 per share during the month, and ended the month with a price of $52 per share. What total return did investors earn on the stock during this month? A. 7.69% B. 4.00% C. 0.00% D. 8.00%
Answer D is correct. Investors earned $2 in dividends and $2 in stock appreciation. Therefore, they made $4 on the beginning price of $50, or 8%.
A gold-mining company expects to sell 10,000 ounces of gold 6 months from today. The revenue risk of selling the gold can be hedged by A. Buying a gold futures contract for 5,000 ounces today that expires in 6 months and selling a gold futures contract for 5,000 ounces today that expires in 6 months. B. Buying a gold futures contract for 10,000 ounces today that expires in 6 months. C. Selling the gold in the spot market 6 months from today. D. Selling a gold futures contract for 10,000 ounces today that expires in 6 months.
Answer D is correct. Selling a gold futures contract for 10,000 ounces today that expires in 6 months would allow the gold-mining company to lock in a selling price today for the sale of the 10,000 ounces in 6 months when the contract expires. This will hedge the revenue risk as the company pre-determined what it will get for the contract in 6 months.
Selected information regarding a corporation's outstanding equity is show below. Common stock, $10 par value, 350,000 shares outstanding $3,500,000 Preferred stock, $100 par value, 10,000 shares outstanding 1,000,000 Preferred stock dividend paid 60,000 Common stock dividend paid 700,000 Earnings per common share 3 Market price per common share 18 The corporation's yield on common stock is A. 16.88% B. 16.66% C. 20.00% D. 11.11%
Answer D is correct. The corporation's yield on common stock is 11.11% as shown below. Dividend yield =Dividends per common share ÷ Market price per common share =($700,000 ÷ 350,000) ÷ $18 =11.11%
A corporation just paid a dividend of $2.00 per common share. Historical data indicate that dividends grow at a steady rate of 5% per year. The required rate of return for investing in such stock is 18%. The current value of one share of common stock is A. $11.11 B. $15.38 C. $11.67 D. $16.15
Answer D is correct. The dividend discount model (also known as the dividend growth model) is a method of arriving at the value of a stock by using expected dividends per share and discounting them back to present value. The next dividend is calculated as $2.10 [$2.00 dividend × (1 + .05 growth rate)]. Thus, the current value of one share of common stock is calculated as $16.15 [$2.10 next dividend ÷ (18% cost of capital - 5% dividend growth rate)].
A corporation paid a dividend of $3 per share last year. If investors expected the dividend per share to grow by 5% per year forever, what required return of investors is consistent with a current share price of $63 per share? A. 15% B. 3% C. 5% D. 10%
Answer D is correct. The dividend growth model estimates the cost of retained earnings using the dividends per share, the market price, and the expected growth rate. The current dividend yield is 5% ($3.15 ÷ $63). Adding the growth rate of 5% to the yield of 5% results in a required return of 10%.
A company is planning an expansion program estimated to cost $100 million. The company is going to raise funds according to its target capital structure shown below. Debt .30 Preferred stock .24 Equity .46 The company had net income available to common shareholders of $184 million last year of which 75% was paid out in dividends. The company has a marginal tax rate of 40%. Additional data: The before-tax cost of debt is estimated to be 11%. The market yield of preferred stock is estimated to be 12%. The after-tax cost of common stock is estimated to be 16%. What is the company's weighted average cost of capital? A. 14.00% B. 13.54% C. 13.00% D. 12.22%
Answer D is correct. The effective rate for the company's debt is the after-tax cost [11% × (1.0 - .40 tax rate) = 6.6%] The weighted average cost of capital (WACC) can thus be calculated as follows: Carrying Amount Weight Cost of Capital Weighted Cost Debt $ 30,000,000/100000000=30% 30%×6.6%=1.98% Preferred stock 24,000,000/100mil=24% 24%×12.0%=2.88% Common equity 46,000,000/100000000=46% 46%×16.0%=7.36% Totals $100,000,000 100% 12.22%
The firm's marginal cost of capital A. Is unaffected by the firm's capital structure. B. Is inversely related to the firm's required rate of return used in capital budgeting. C. Should be the same as the firm's rate of return on equity. D. Is a weighted average of the investors' required returns on debt and equity.
Answer D is correct. The marginal cost of capital is the cost of the next dollar of capital. The marginal cost continually increases because the lower cost sources of funds are used first. The marginal cost represents a weighted average of both debt and equity capital.
By using the dividend growth model, estimate the cost of equity capital for a firm with a stock price of $30.00, an estimated dividend at the end of the first year of $3.00 per share, and an expected growth rate of 10%. A. 21.1% B. 12.2% C. 11.0% D. 20.0%
Answer D is correct. Under the dividend growth model, the cost of equity equals the expected growth rate plus the quotient of the next dividend and the current market price. Thus, the cost of equity capital is 20% [10% + ($3 ÷ $30)]. This model assumes that the payout ratio, retention rate, and the earnings per share growth rate are all constant.
The owner of a call option wants to know the respective effects on the call's price of a decrease in stock-return volatility and a decrease in time to expiration. The respective effects on the call's price are which of the following? A. Decrease in Stock-Return Volatility: Increase Decrease in Time to Expiration: Decrease B. Decrease in Stock-Return Volatility: Increase Decrease in Time to Expiration: Increase C. Decrease in Stock-Return Volatility: Decrease Decrease in Time to Expiration: Increase D. Decrease in Stock-Return Volatility: Decrease Decrease in Time to Expiration: Decrease
Answer d is correct. A decrease in stock-return volatility will cause the call's price to decrease. A decrease in the time to expiration will also cause the call's price to decrease. Thus, both of these effects will cause a decrease in the call's price.
An advantage of using EBITDA is that it distorts reality. T/F
False A disadvantage of EBITDA is that it distorts reality.
A distinguishing feature of forward contracts is that they are marked to market every day. T/F
False A distinguishing feature of futures contracts is that their prices are marked to market every day at the close of the day to each person's account.
As tax rates rise, the deductibility of interest makes debt a less attractive financing option. T/F
False As tax rates rise, the deductibility of interest makes debt a more attractive financing option.
The value of a put option will decrease as the price of the underlying decreases. T/F
False As the price of the underlying increases, the value of a call option also will increase; the exercise price is more and more of a bargain with each additional dollar in the price of the underlying. By the same token, the value of a put option will decrease as the price of the underlying increases since there is no advantage in selling at a lower-than-market price.
Book value per share equals the amount of net assets available to the shareholders of a given type of stock divided by the total number of shares issued. T/F
False Book value per share equals the amount of net assets available to the shareholders of a given type of stock divided by the number of those shares outstanding.
Dividends always grow at a constant rate. T/F
False Dividends do not always grow at a constant rate
Futures contracts are restricted to the trading of certain assets because they provide much less flexibility than do forward contracts. T/F
False Futures contracts are actively traded on futures exchanges. Because futures contracts are for delivery during a given month, not a specific day, they are more flexible arrangements than forward contracts. Because futures contracts are actively traded, the result is a liquid market in futures that permits buyers and sellers to net out their positions.
The model provided by standard financial theory focuses management effort on minimizing the marginal cost of capital rather than maximizing earnings per share. T/F
False Standard financial theory provides a model for the optimal capital structure of every firm. This model holds that shareholder wealth-maximization results from minimizing the weighted-average cost of capital. Thus, the focus of management should not be on maximizing earnings per share. (EPS can be increased by taking on more debt, but debt increases risk.)
The computation of the cost of new capital is eased by the fact that the cost of new common stock and the cost of retained earnings are identical. T/F
False The component costs of common stock and retained earnings are identical. The cost of new common stock is higher than the cost of retained earnings.
The price-earnings ratio equals the market price per share of common stock divided by diluted earnings per share. T/F
False The price-earnings ratio equals the market price per share of common stock divided by earnings per share.
The seller of a put option is taking a short position. T/F
False The seller (writer) of a put option hopes the price of the underlying will remain above the exercise price, since (s)he must buy from the holder at the strike price regardless of the fact that the same underlying can be obtained for less in the open market. The seller of a put option is thus taking a long position.
A well-managed firm should sell at low multiples of its book value. T/F
False Well-managed firms should sell at high multiples of its book value, which reflects historical cost.
Since internally generated capital is the least expensive form of capital, a firm can rely solely on retained earnings to fund new projects. T/F
False While internally generated capital is the least expensive form of capital, a firm cannot rely solely on retained earnings to fund new projects.
The dividend discount model is calculated as follows: Dividend Growth Rate/(Cost of Capital - Dividends Per Share) T/F
False The model dividend discount model is Dividends per Share/(Cost of Capital - Dividend Growth Rate)
If the price of the underlying asset is substantially higher than the exercise price of a call option, the holder will have an incentive to exercise the option. T/F
True A call option gives the buyer (holder) the right to purchase (i.e., the right to "call" for) the underlying asset (stock, currency, commodity, etc.) at a fixed price. If the price of the underlying rises above the exercise price, the option is said to be "in-the-money." The holder can exercise his/her option and buy the underlying at a bargain price.
Derivative instruments can be used to either incur or hedge against risk. T/F
True A derivative is defined informally as an investment transaction in which the buyer purchases the right to a potential gain with a commitment for a potential loss. It is a wager on whether the value of something will go up or down. The purpose of the transaction is either to speculate (incur risk) or to hedge (avoid risk).
A dividend rate higher than the market average will result in the preferred stock selling at a premium. T/F
True A dividend rate higher than the market average will result in the preferred stock selling at a premium.
An option that grants the buyer the right to exercise any time on or before expiration is an American option T/F
True An option that grants the buyer the right to exercise any time on or before expiration is an American option.
Earnings per share equals net income available to common shareholders divided by the average number of shares outstanding for the period. T/F
True Earnings per share equals net income available to common shareholders divided by the average number of shares outstanding for the period.
Earnings yield equals earnings per share divided by market price per share. T/F
True Earnings yield equals earnings per share divided by market price per share.
In a simple forward contract to exchange merchandise for money at a future date, one party has adopted a long position and the other has adopted a short position T/F
True In a simple forward contract, the party that has contracted to buy the underlying at a future date has taken a long position (protection against a rise in price), and the party that has contracted to deliver the underlying has taken a short position (protection against a fall in price
In general, the buyer of a call option benefits from a low exercise price. T/F
True In general, the buyer of a call option benefits from a low exercise price. Likewise, the buyer of a put option generally benefits from a high exercise price. Thus, an increase in the exercise price of an option results in a decrease in the value of a call option and an increase in the value of a put option.
A distinguishing feature of swaps is that they are designed to be at-the-money at inception. T/F
True Most swaps are priced to be at-the-money at inception, meaning that the value of the two sets of cash flows being exchanged is the same. Naturally, as interest rates, currency exchange rates, and credit risks change, the values of the swaps will change.
Potential common stock is said to be dilutive if its inclusion in the calculation of EPS results in a reduction of EPS. T/F
True Potential common stock is said to be dilutive if its inclusion in the calculation of EPS results in a reduction of EPS.
The component cost of debt can be calculated by multiplying the effective rate by 1.0 minus the firm's marginal tax rate. T/F
True The component cost of debt is the after-tax interest rate on the debt (interest payments are tax deductible by the firm).
The component costs of preferred stock and common stock are calculated using the same formula. However, the formulas for new preferred and common stock are different. T/F
True The component costs of both preferred and common stock are computed using the dividend yield ratio (cash dividend ÷ market price of stock). The cost of new preferred stock is next dividend ÷ net issue proceeds. The cost of new common stock is (next dividend ÷ net issue proceeds) + dividend growth rate.
The marginal cost of capital is the cost to the firm of the next dollar of new capital raised after existing internal sources are exhausted. T/F
True The marginal cost of capital is the cost to the firm of the next dollar of new capital raised after existing internal sources are exhausted.
The longer the term of a put option, the higher the option price. T/F
True The more time that passes, the riskier any investment is. Thus, an increase in the term of an option (both calls and puts) will result in an increase in the value of the option.
The value of preferred stock can be calculated as dividend per share ÷ cost of capital T/F
True The value of preferred stock can be calculated as dividend per share ÷ cost of capital.
The put-call parity theorem holds that a risk-free return can be obtained by the combination of buying a put option, buying the underlying, and selling a call option. T/F
True. The combination of buying a put option, buying the underlying, and selling a call option provides the same return as investing the present value of the exercise price at the risk-free rate. Knowledge of these relationships can help investors devise appropriate option strategies.
