Chapter 14: Cost of Capital

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

The SML approach requires estimates of the _____.

- market risk premium - beta coefficient

Which of the following are components used in the construction of the WACC?

-Cost of common stock -Cost of preferred stock -Cost of debt

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 growth rate of dividends can be found using _____.

-historical dividend growth rates -security analysts' forecasts

To estimate the expected return on a risky asset, we need to know the ___.

-market risk premium -risk-free rate -stock's beta

Preferred stock ___.

-pays dividends in perpetuity -pays a constant dividend

The WACC is the minimum return a company needs to earn to satisfy _____.

-the bondholders -stockholders

To estimate the growth rate of a particular stock, we can ___.

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

The formula for calculating the cost of equity capital that is based on the dividend discount model is:

RE = D1/P0 + g

The formula for the required return from the SML is:

RE = Rf + B(RM − Rf)

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

The dividend growth model

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

The rate of inflation

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

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

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

grows at a constant rate

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

risk free rate

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

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

use

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

use; source

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