Business Finance: Chapter 12

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

True or false: For publicly traded companies, the component of the dividend yield that must be estimated is the dividend.

False: The expected growth rate in dividends must be estimated.

True or false: The growth rate of dividends can be found using the CAPM.

False: the growth rate of dividends can be found using historical dividend growth rates and security analysts' forecasts.

In the WACC calculation, D represents the _________ value of the firm's debt.

market

Preferred stock ___.

pays dividends in perpetuity pays a constant dividend

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:

adding these two components.

Finding a firm's overall cost of equity is difficult because:

it cannot be observed directly

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

To estimate the dividend yield of a particular stock, we need:

- the last dividend paid, D0 - the current stock price - forecasts of the dividend growth rate, g

The following are advantages of the SML approach

Does not require the company to pay a dividend Adjusts for risk

True or false: Conglomerates are companies that specialize only in projects similar to the project your firm is considering.

False Reason: Pure plays are companies that specialize only in projects similar to the project your firm is considering.

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: It is equal to the risk-free rate.

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.

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)

The following are disadvantages of the SML approach

Requires estimation of the market risk premium Requires estimation of beta

What is the appropriate discount rate to use only if the proposed investment is a replica of the firm's existing operating activities?

WACC

Which of the following is true about a firm's cost of debt? Yields can be calculated from observable data

Yields can be calculated from observable data It is easier to estimate than the cost of equity.

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 Reason: 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 cost of capital depends primarily on the ______ of funds, not the _____.

use; source

What is the equation for finding the cost of preferred stock?

RP=D/P0

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.

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: RP=D/P0

True

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

Other companies that specialize only in projects similar to the project your firm is considering are called ___.

pure plays

The rate used to discount project cash flows is known as the ___.

- required return - discount rate - cost of capital

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 Reason: The WACC is the overall rate of return the firm must earn on its existing assets to maintain the value of its stock.

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 return an investor in a security receives is ______ _____ the cost of the security to the company that issued it.

equal to

The WACC of a firm reflects the ________ and the target capital structure of the firm's existing assets as a whole.

risk

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risk-free rate market risk premium stock's beta

The growth rate of dividends can be found using:

security analysts' forecasts historical dividend growth rates

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

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

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

Cost of preferred stock Cost of common stock Cost of debt

What can we say about the dividends paid to common and preferred stockholders?

- Dividends to common stockholders are not fixed. Reason: - Dividends are generally guaranteed for preferred stock holders, but not for common stock holders. - Dividends to preferred stockholders are fixed.

Which of the following are true?

- 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. Reason: Ideally, we should use market values in the WACC. Because book values are often similar to market values for debt, we often use book value for debt and market value for equity.

Dividends paid to common stockholders ______ be deducted from the payer's taxable income for tax purposes.

- cannot Reason: Dividends paid to common shareholders are not tax deductible to the corporation.

Which of the following is tax-deductible to the firm?

Coupon interest paid on bonds

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 a firm has multiple projects, each project should be discounted using ___.

a discount rate commensurate with the project's risk

If a firm issues no debt, its average cost of capital will equal ___.

its cost of equity Reason: Because the weight of equity in this case is 100%, the weighted average cost of capital is the cost of equity.