Corporate Finance - Chapter 12

True or false: In the WACC calculation, V = E - D.

False Reason: V = E + D

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

Which of the following is true about a firm's cost of debt?

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

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

equity Reason: If the firm is all-equity, the discount rate is equal to the firm's cost of equity capital, as the firm has no debt.

The cost of preferred stock:

is equal to the stock's dividend yield.

Preferred stock ___.

pays dividends in perpetuity pays a constant dividend

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 one of the following statements is accurate for a levered firm?

A reduction in the risk level of a firm will tend to decrease the firm's WACC.

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.

Blank 1: market Blank 2: book

Lester lent money to The Corner Store by purchasing bonds issued by the store. The rate of return that he and the other lenders require is referred to as the:

Cost of debt

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

Coupon interest paid on bonds

Bermuda Cruises issues only common stock and coupon bonds. The firm has a debt-equity ratio of .45. The cost of equity is 17.6 percent and the pretax cost of debt is 8.9 percent. What is the capital structure weight of the firm's equity if the firm's tax rate is 35 percent?

Weight of equity = 1/1.45 = .6897, or 68.97 percent

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.

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

A firm uses its weighted average cost of capital to evaluate the proposed projects for all of its varying divisions. By doing so, the firm:

automatically gives preferential treatment in the allocation of funds to its riskiest division.

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

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

Components of the WACC include funds that come from ______ .

investors

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

pure plays

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 WACC is the overall rate of return the firm must earn on its existing assets to maintain the _____ of its stock.

value or price

Madison Square Stores has a $20 million bond issue outstanding that currently has a market value of $19.4 million. The bonds mature in 6.5 years and pay semiannual interest payments of $35 each. What is the firm's pretax cost of debt?

Current bond price = (19.4 /20) ×$1,000 = $970 $970 = $35 ×({1 - 1 / [1 + (RD / 2)]13} / (RD / 2))+ $1,000 / [1 + (RD / 2)]13 RD = 7.59 percent

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

It's 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.

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

RE = D1/P0 + g

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

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

equal to

Assume a firm has a beta of 1.2. All else held constant, the cost of equity for this firm will increase if the:

risk-free rate decreases.

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

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

use; source

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

Cost of preferred stock Cost of common stock Cost of debt Reason: WACC is concerned with costs of long-term capital.

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 Reason: It is equal to the risk-free rate.

True or false: The cost of equity is D1/P0 minus the analysts' estimates of growth.

False Reason: The cost of equity is D1/P0 plus the analysts' estimates of growth.

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

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

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

False Reason: True or false: The primary advantage of the dividend growth model approach is its simplicity.

Stock in ABC Enterprises has a beta of 1.28. The market risk premium is 7.4 percent, and T-bills are currently yielding 3.6 percent. ABC's most recently paid dividend was $1.62 per share, and dividends are expected to grow at an annual rate of 2 percent indefinitely. If the stock sells for $38 a share, what is your best estimate of ABC's cost of equity?

RE= .036 +1.28(.074) = .13072 RE = ($1.62 ×1.02)/$38 + .02 = .06348 Average = (.13072 + .06348)/2 = .0971, or 9.71 percent

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

V

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

WACC

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

market

International Exchange has three divisions: A, B, and C. Division A has the least risk and Division C has the most risk. The firm has an aftertax cost of debt of 6.1percent and a cost of equity of 14.3 percent. The firm is financed with 37 percent debt and 63 percent equity. Division A's projects are assigned a discount rate that is 2.2 percent less than the firm's weighted average cost of capital. What is the discount rate applicable to Division A?

Division A cost of capital = (.63)(.143) + (.37)(.061) -.022 = .0907, or 9.07 percent

True or false: RP=D/P0

True

Which one of the following statements is correct? Assume the pretax cost of debt is less than the cost of equity.

A firm may change its capital structure if the government changes its tax policies.

Derek's is a brick-and-mortar toy store. The firm is considering expanding its operations to include Internet sales. Which one of the following would be the best firm to use in a pure play approach to analyzing this proposed expansion?

A toy store that sells online only

The following are advantages of the SML approach

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

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.

True or false: The SML approach is advantageous because all it requires is the estimation of beta.

False. Reason: Beta is not required for the SML approach.

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

False. Reason: It is difficult because there is no way to directly observe the return that the firm's equity investors require on their investment.

The Green Balloon just paid its first annual dividend of $.87 a share. The firm plans to increase the dividend by 3.2 percent per year indefinitely. What is the firm's cost of equity if the current stock price is $4.75 a share?

Re = ($.87× 1.032) / $4.75 + .032 = .2210, or 22.10 percent

The following are disadvantages of the SML approach

Requires estimation of beta Requires estimation of the market risk premium

To estimate a firm's equity cost of capital using the CAPM, we need to know the ___.

stock's beta risk-free rate market risk premium

Given the following information for Electric Transport, find the WACC. Assume the company's tax rate is 35 percent. Debt:8,100, 6.9 percent coupon bonds outstanding. $1,000 par value, 17 years to maturity, selling for 101 percent of par, the bonds make semiannual payments. Common stock: 175,000 shares outstanding, selling for $77 per share, beta is 1.32. Preferred stock:9,000 shares of $7.50 preferred stock outstanding, currently selling for $73 per share. Market: 7.9 percent market risk premium and 3.6 percent risk-free rate.

Common: 175,000 ×$77 = $13,475,000 Preferred: 9,000 × $73 = $657,000 Debt: 8,100 × 1.01 × $1,000 = $8,181,000 Value = $13,475,000 + 657,000 + 8,181,000 = $22,313,000 RE = .036 + 1.32(.079) = .1403 RP = $7.50 /$73= .1027 $1,010 = [(.069 × $1,000) / 2] × ({1- 1 / [1 + (r/ 2)]34} / (r / 2)) + $1,000 / [1 + (r / 2)]34 r = 6.80 percent WACC = ($13,475,000/$22,313,000)(.1403) + ($657,000/$22,313,000)(.1027) + ($8,181,000/$22,313,000)(.0680)(1 -.35) = .104, or 10.4 percent

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.

Which of the following are true?

Ideally, we should use market values in the WACC. The market value of debt and equity are not reliable in case of privately owned company.

The common stock of Mill Stones has a beta that is 8 percent greater than the overall market beta. Currently, the market risk premium is 7.65 percent while the U.S. Treasury bill is yielding 4.3 percent. What is the cost of equity for this firm?

RE= .043 + 1.08(.0765) = .1256, or 12.56 percent

The 6.5 percent preferred stock of Home Town Brewers is selling for $42 a share. What is the firm's cost of preferred stock if the tax rate is 35 percent and the par value per share is $100?

Rp = (.065 ×$100)/$42 = .1548, or 15.48 percent

The formula of the SML is:

RE = Rf + Beta x (RM- Rf)

Judy's Boutique just paid an annual dividend of $1.48 on its common stock and increases its dividend by 2.2 percent annually. What is the rate of return on this stock if the current stock price is $29.60 a share?

Re = [($1.48× 1.022) / $29.60] + .022 = .0731, or 7.31 percent

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

The risk-free rate

What will happen over time if a firm uses its overall WACC to evaluate all projects, regardless of each project's risk level?

the firm overall will become riskier it will accept projects that it should have rejected It will reject projects that it should have accepted

True or false: The cost of capital depends on the source of the funds.

False Reason: The cost of capital depends on the use of the funds.

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

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

True or false: The SML approach is advantageous because all it requires is estimation of beta.

False Reason:Estimation of beta is not required for the SML approach.

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

cost of capital required return discount rate

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

False Reason: Projects' discount rates should reflect their particular level of risk.

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

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

False Reason: It is known as the required return, appropriate discount rate, and cost of capital.

The 7.5 percent preferred stock of Rock Bottom Floors is selling for $84 a share. What is the firm's cost of preferred stock if the tax rate is 35 percent and the par value per share is $100?

Rp = (.075 ×$100)/$84 = .0893, or 8.93 percent

Which one of the following is used as the pretax cost of debt? Average coupon rate on the firm's outstanding bonds Coupon rate on the firm's latest bond issue Weighted average yield to maturity on the firm's outstanding debt Average current yield on the firm's outstanding debt Annual interest divided by the market price per bond for the latest bond issue

Weighted average yield to maturity on the firm's outstanding debt

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)

The growth rate of dividends can be found using:

-Historical dividend growth rates -Security analysts' forecasts

The weighted average cost of capital is defined as the weighted average of a firm's:

cost of equity, cost of preferred, and its aftertax cost of debt.

The dividend growth model is applicable to companies that pay _____.

dividends

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

it cannot be observed directly

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

market value

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 Reason: It is necessary to evaluate project risk by using a beta with risk similar to the project.

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

Dividends to preferred stockholders are fixed. Dividends to common stockholders are not fixed.

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

risk

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

yield to maturity