FINAN 450 - Chapter 12
the risk-free rate
According to the CAPM, what is the expected return on a stock if its beta is equal to zero?
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 than the overall cost of capital, and if the overall cost of capital is used, the project's cash flows will be discounted too severely, and it will most likely be rejected.
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:
subjective
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.
pure plays
Other companies that specialize only in projects similar to the project your firm is considering are called ___.
value or price
The WACC is the overall rate of return the firm must earn on its existing assets to maintain the ___ of its stock.
required return; discount rate; & cost of capital
The rate used to discount project cash flows is known as the ___.
equal to
The return an investor in a security receives is ______ _____ the cost of the security to the company that issued it.
market risk premium; risk-free rate; stock's beta
To estimate a firm's equity cost of capital using the CAPM, we need to know the ___.
the current stock price; forecasts of the dividend growth rate, g; the last dividend paid, D0
To estimate the dividend yield of a particular stock, we need:
RP=D/P0
What is the equation for finding the cost of preferred stock?
RE = Rf + Beta x (RM- Rf)
the formula of the SML is:
investors
Components of the WACC include funds that come from ______ .
cannot
Dividends paid to common stockholders ______ be deducted from the payer's taxable income for tax purposes.
it cannot be observed directly
Finding a firm's overall cost of equity is difficult because:
yield to maturity (ytm)
For a firm with outstanding debt, the cost of debt will be the ________ on that debt..
V
Given V = E + D, if we divide both V and D by ___ , we can calculate the capital structure weights.
[E/V] × RE + [D/V] × RD ×(1 - T c)
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:
a discount rate commensurate with the project's risk
If a firm has multiple projects, each project should be discounted using ___.
its cost of equity; because the weight of equity in this case is 100%, the weighed average cost of capital is the cost of equity
If a firm issues no debt, its average cost of capital will equal ___.
equity; if the firm is all-equity, the discount rate is equal to the firm's cost of equity capital
If the firm is all-equity, the discount rate is equal to the firm's cost of ______ capital.
(P/V) × RP
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?
the beta for software companies that collect and store data
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?
better than no risk adjustment
Some risk adjustment to a firm's WACC for projects of differing risk, even if it is subjective, is probably:
use; source
The cost of capital depends primarily on the ______ of funds, not the _____.
requires estimation of the market risk premium; requires estimation of beta
The following are disadvantages of the SML approach
RE = D1/P0 + g
The formula for calculating the cost of equity capital that is based on the dividend discount model is:
security analysts' forecasts; historical dividend growth rates
The growth rate of dividends can be found using:
market value
The most appropriate weights to use in the WACC are the ______ weights.
false; it is equal to the risk-free rate
True or false: According to the CAPM, if the market risk premium is zero, then the expected return on a stock is equal to the required return.
false; the primary advantage of the dividend growth model approach is its simplicity
True or false: The primary disadvantage of the dividend growth model approach is its simplicity.
adding these two components
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:
market; book
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.
dividends to preferred stockholders are fixed; dividends to common stockholders are NOT fixed
What can we say about the dividends paid to common and preferred stockholders?
cost of debt; cost of common stock; cost of preferred stock Cost of accounts payable is not included in WACC calculations; WACC is concerned with costs of long-term capital.
Which of the following are components used in the construction of the WACC? a. cost of accounts payable b. cost of debt c. cost of common stock d. cost of preferred stock
coupon interest paid on bonds
Which of the following is tax-deductible to the firm?
it is easier to estimate than the cost of equity; yields can be calculated from observable data
Which of the following is true about a firm's cost of debt?
too many
If a firm uses its overall cost of capital to discount cash flows from projects in higher risk divisions, it will accept ______ projects.
false; the cost of capital depends on the use of the funds
True or false: The cost of capital depends on the source of the funds.
false; the cost of equity is D1/Po plus the analysts' estimates of growth
True or false: The cost of equity is D1/P0 minus the analysts' estimates of growth.
false; it is known as the required return, appropriate discount rate, and cost of capital
True or false: The discount rate is also known as the expected return.
false; the WACC is the overall rate of return the firm must earn on its existing assets to maintain the value of its stock
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; the growth rate of dividends can be found using historical dividend growth rates and security analysts' forecasts
True or false: The growth rate of dividends can be found using the CAPM.
RE = D1/P0
What is the required return on a stock (RE), according to the constant dividend growth model, if the growth rate (g) is zero?
it will reject projects that it should have accepted; it will accept projects that it should have rejected; the firm overall will become riskier
What will happen over time if a firm uses its overall WACC to evaluate all projects, regardless of each project's risk level?
the market value of debt and equity are not reliable in case of privately owned company; ideally, we should use market values in the WACC
Which of the following are true? a. Ideally, we should use book values in the WACC. b. The market value of debt and equity are not reliable in case of privately owned company. c. Book values are often similar to market values for equity. d. Ideally, we should use market values in the WACC.
pays dividends in perpetuity; pays a constant dividend
Preferred stock ___. a. will never be repaid b. pays dividends in perpetuity c. does not pay dividends d. pays a constant dividend
dividends
The dividend growth model is applicable to companies that pay ___.
does not require the company to pay a dividend; adjusts for risk
The following are advantages of the SML approach
false; pure plays are companies that specialize only in projects similar to the project your firm is considering.
True or false: Conglomerates are companies that specialize only in projects similar to the project your firm is considering.
false; it is difficult because there is no way to directly observe the return that the firm's equity investors require on their investment
True or false: Finding the cost of equity is fairly straightforward.
false; the expected growth rate in dividends must be estimated
True or false: For publicly traded companies, the component of the dividend yield that must be estimated is the dividend.
false; projects' discount rates should reflect their particular level of risk
True or false: Projects should always be discounted at the firm's overall cost of capital.
false; estimation of beta is not required for the sml approach
True or false: The SML approach is advantageous because all it requires is estimation of beta.