Chapter 12: Cost of Capital LearnSmart

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

1. 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

1. True

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

Cost of debt Cost of common stock Cost of preferred stock

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

Coupon interest paid on bonds

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

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

The formula of the SML is:

RE = Rf + Beta x (RM- Rf)

According to the CAPM, what is the expected return on a stock if its beta is equal to zero?

The risk-free rate

Given V = E + D, if we divide both V and D by , we can calculate the capital structure weights.

V

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

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

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

cannot

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

it cannot be observed directly

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

its cost of equity

The most appropriate weights to use in the WACC are the ______ weights.

market value

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

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

required return cost of capital discount rate

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

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

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

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

2. True or false: The discount rate is also known as the expected return.

2. False

For a firm with outstanding debt, the cost of debt will be the ________ on that debt..

yield to maturity

3. True or false: Finding the cost of equity is fairly straightforward

3. False

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

4.False

5. True or false: The primary disadvantage of the dividend growth model approach is its simplicity.

5. False

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

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

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

If the firm is all-equity, the discount rate is equal to the firm's cost of ______ capital.

equity

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

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

pure plays

6. 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.

6. False

7. True or false: Projects should always be discounted at the firm's overall cost of capital.

7. False

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

8. False

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

RE = D1/P0 + g