FIN 320 Chapter 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 is tax-deductible to the firm?
Coupon interest paid on bonds
Which of the following are components used in the construction of the WACC?
Debt/Preferred/ Common Stock
True or false: The primary disadvantage of the dividend growth model approach is its simplicity.
False- The primary advantage of the dividend growth model approach is its simplicity.
True or false: Finding the cost of equity is fairly straightforward.
False-It is difficult because there is no way to directly observe the return that the firm's equity investors require on their investment.
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
What is the equation for finding the cost of preferred stock?
RP=D/P0
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 return an investor in a security receives is equal to the cost of the security to the company that issued it.
Given V = E + D, if we divide both V and D by _________, we can calculate the capital structure weights.
V
Dividends paid to common stockholders ______ be deducted from the payer's taxable income for tax purposes.
cannot-Dividends paid to common shareholders are not tax deductible to the corporation.
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
For a firm with outstanding debt, the cost of debt will be the ________ on that debt.
yield to maturity
The formula for calculating the cost of equity capital that is based on the dividend discount model is:
RE = D1/P0 + g
The formula of the SML is:
RE = Rf + Beta x (RM- Rf)
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
What is the appropriate discount rate to use only if the proposed investment is a replica of the firm's existing operating activities?
WACC
If a firm has multiple projects, each project should be discounted using ___.
a discount rate commensurate with the project's risk-If the overall cost of capital is used, any project whose risk is different from that of the company as a whole could be rejected or accepted in error.
The discount rate for the firm's projects equals the cost of capital for the firm as a whole when:
all projects have the same risk as that of the firm overall
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
The dividend growth model is applicable to companies that pay______.
dividends
The return an investor in a security receives is ______ _____ the cost of the security to the company that issued it.
equal to
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
The WACC of a firm reflects the _________and the target capital structure of the firm's existing assets as a whole.
risk
To estimate a firm's equity cost of capital using the CAPM, we need to know the ___.
stock's beta market risk premium risk-free rate
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
For a firm with outstanding debt, the cost of debt will be the ________ on that debt..
yield to maturity
True or false: Projects should always be discounted at the firm's overall cost of capital
False-Projects' discount rates should reflect their particular level of risk.
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: The discount rate is also known as the expected return.
False-It is known as the required return, appropriate discount rate, and cost of capital.
True or false: Conglomerates are companies that specialize only in projects similar to the project your firm is considering.
False-Pure plays are companies that specialize only in projects similar to the project your firm is considering.
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 it will accept projects that it should have rejected the firm overall will become riskier
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)
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- If the project's beta is less than the firm's overall beta, its cost of capital will be less the the overall cost of capital, and if the overall cost of capital is used, the project's cash flows will be discounted too severely, leading to the possible rejection of a value creating project.
The rate used to discount project cash flows is known as the ___.
required return discount rate cost of capital
It is difficult to establish discount rate for individual projects, so firm's often adopt an approach that involves making _______ adjustments to the overall WACC.
subjective
