Finance Exam 3 LearnSmart
A firm's capital structure consists of 30 percent debt and 70 percent equity. Its bonds yield 10 percent, pretax, its cost of equity is 16 percent, and the tax rate is 40 percent. What is its WACC?
(0.7x.16) + (0.3 x .1 x (1-.4) = 13%
What are the after tax earnings for a corporation if it reports $200 in revenue, $90 in operating expenses, has a tax rate of 30%, and pays $20 in interest on its bonds
(200-90-20) x .7 = 63
The WACC formula, for a firm with no debt or preferred stock will have a WACC of
1 x Cost of equity
If the firm issues so much debt that its equity was valueless, its average cost of capital would equal
1 x aftertax cost of debt
A company has a borrowing rate of 15 percent and a tax rate of 30 percent. What is its after tax cost of debt?
10.5%
Suppose a firm has a target debt-equity ratio of 2.5. What is the firm's target capital structure weight for common stock?
28.57 S/(S+B)= 1/3.5
Historically, the market risk premium has been approximately ___ percent
7
Which of the following can cause a firm's beta to change over time?
Changes in technology Changes in leverage Changes in product line
Which of the following are components used in the construction of WACC?
Cost of debt Cost of common stock Cost of preferred stock
The formula for the dividend discount model when the growth rate is zero is
R = Div/P
True
Under US tax law, a corporation's interest payments are tax deductible
Following are true
Variable costs change with changed in quantity fixed costs do not change as quantity changes fixed costs never change
If a firm has multiple projects, each project should be discounted using ---
a discount rate commensurate with the project's risk
The ___ of the characteristic line of a stock's returns versus those of the market measures the stock's systematic risk
beta, slope
Flotation costs are costs incurred to
bring new security to the market
Firms whose revenues have high standard deviations
can sometimes have low betas can sometimes have high betas
If a point plotted above the security market line (SML) represents a project being considered by an all-equity firm, the project's IRR must be greater than the cost of
capital and equity (the cost of equity is the cost of capital for an all-equity firm)
True
company can deduct interest paid on debt when computing taxable income
U.S. treasury securities considered to be risk-free because they have minimal, if any, ___ risk
default
Two examples of non-cyclical goods
diapers, milk
the issuance costs of bonds and stocks are referred to as ___ costs
flotation
What can we say about dividends?
Dividends to common stockholders are not fixed and dividends to preferred stockholders are fixed
According to the CAPM, what is the expected return on a stock if its beta is equal to zero?
The risk-free rate
Variables we need to compute the beta for a company's stock
The variance of the market index's returns The covariance between the stock and the market index's returns
True about US Treasury instruments
They are not expected to default at this time They have never defaulted
True about security analysts
They are sometimes employees of money management firms; they are sometimes employees of investment banking houses
the growth rate of dividends can be estimated using ___
retention ratio x ROE historical dividend growth rates security analysts' forecasts
To estimate a firm's equity cost of capital using the CAPM, we need to know the ---
risk-free rate, stock's beta, market risk premium
Suppose a firm faces a risk-free rate of 2%, a beta of 1, and a market risk premium of 4%. What is the cost of capital if it is an all-equity firm?
6%
Previously, a firm issues bonds at par with a 6 percent coupon. Today, similar bond yields are 8 percent and the risk-free rate is 3 percent. What is the embedded cost of the firm's debt?
6%- the firms embedded cost of debt is the coupon payment on previously issued debt. it is not related to the firm's cost of new debt.
about ___ percent of US companies use the CAPM in capital budgeting
75
Which of the following are the more likely sources for a firm's forecasts of the market risk premium?
A consensus of forecasts Value Line The firm's own subjective forecast
Cyclical firms
Automakers, Luxury retailers
Which of the following is generally true about firm betas and industry membership?
Betas are likely to change when a firm changes industries; betas can change even when a firm remains in the same industry
What do we know about the stability of the firm's beta?
Betas are more likely to be stable if the firm remains in the same industry Betas can change over time
True statements about Betas
Betas may vary over time A firm's beta may change if the firm increases its debt-equity ratio the sample size used to compute a firm's beta may be inadequate
True
Book values are often similar to market values for debt Ideally, we should use market values in the WACC
For both academics and practitioners, the pendulum has swung over to the ___ for estimating the cost of equity capital
CAPM
True about WACC
It is the expected return a firm must earn on its existing assets to maintain its current value It is also referred to as the discount rate that is used to discount cash flows in capital budgeting problems
The market risk premium is defined as
Return on the market - Risk free rate
Which two risk-free rates are preferred over the life of a project?
The rate that matches the maturity of the project The average one-year rate anticipated over the life of the project
To apply the dividend discount model to a particular stock, you need to estimate the ---
dividend yield growth rate
A cyclical firm is one in which revenues go --- in the contraction phase of the business cycle
down
the beta of a new project may be greater than the beta of existing pure play firms since it is likely to be more responsive to
economywide movements
A firm should only undertake a project if its expected return is ___ that of a financial asset of comparable risk
equal to or greater than
On what time of returns does the CAPM focus?
expected returns
The WACC is the minimum return a company needs to satisfy ___
its stockholders and bondholders
The industry beta may be a better estimate than the firm's own beta due to the ___ standard error of the firm estimate
larger
the CAPM appears to contain less --- than does the DDM
measurement error
A firm's cost of debt can be
obtained by talking to investment bankers; estimated more easily than its cost of equity; obtained by checking yields on publicly traded bonds
When a new project constitutes its own industry, comparing the values of its --- to comparable firms should help determine an appropriate beta.
operating leverage cyclicality of revenues financial leverage
Preferred stock
pays dividends in perpetuity, pays a constant dividend
A point above the SML line represents a project with a ___ NPV for an all-equity firm
positive
A project should only be accepted if its return is above what is
required by investors
the rate used to discount project cash flows is known as the
required return cost of capital discount rate
the CAPM can be used to estimate the
required return on equity
The cost of capital is an apporiate name since a project must earn enough to pay those who --- the capital
supply
When valuing a firm with the WACC, the --- value of the firm can be estimated by assuming a constant perpetual growth rate for cash flows beyond the horizon
terminal
Some academics, in defending the DDM, point out that returns in the long run can only come from ---
the current dividend yield future dividend growth
Factors that affect Beta
the cyclical nature of revenues financial revenues operating leverages
Which of the following securities is generally used most frequently for the risk-free rate?
the one year T-bill rate
the firm's cost of equity capital is --- the required rate of return to shareholders
the same as
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 term premium for long periods is positive because the term structure of interest rates typically slopes ___
upward
to estimate the dividend yield of a particular stock, we can ---
use security analysts' forecasts multiply last year's dividend by (1+g)
THE WACC is the overall expected return the firm must earn on its existing assets to maintain its ---
value
