FIN 357 Exam 3 Notes

Aftertax cost of debt =

( 1 - Tax Rate ) * Borrowing Rate

Historically, the market risk premium has been approximately ____ %

7

Which of the following are the more likely sources for a firm's forecasts of the market risk premium

A consensus of forecasts, the firm's own subjective forecast, and the Value Line

New equity beta when all-equity firm changes cap structure to a D2E ratio of # calculation

All-equity firm beta * (1 + Target D2E ratio)

_____________ is the process of buying underpriced securities while selling overpriced substitutes.

Arbitrage

Firm's asset beta calculation

Asset Beta = ((B/B+S)*Debt Beta) + ((S/B+S)*Equity Beta)

Which of the following are the best examples of cyclical firms? Grocery chains Gas stations Automakers Luxury retailers

Automakers and retailers

How to find the avg. one-year interest rate, given the yield of the T-bonds and term premium?

Avg one-year interest rate = T-bond yield - term premium

What do we know about the stability of a firm's beta?

Betas can change over time, and betas are more likely to be stable if the firm remains in the same industry.

Total cashflow to bondholders and stockholders calculation

Cashflow = EBIT * (1-T) + ((Debt*T*Interest rate))

What are the components used in the construction of the WACC?

Cost of debt, cost of common stock, cost of preferred stock

Cost of capital if all-equity firm =

Cost of equity

How to calculate cost of equity (ignoring taxes, MM Prop II), given the D-E ratio, pretax cost of debt, and unlevered cost of equity?

Cost of equity (ignoring taxes) = Cost of unlevered equity + (D-E ratio * (cost of unlevered equity - pretax cost of debt))

Cost of equity calculation without given dollar amounts

Cost of equity = Unlevered cost of equity + ((D-E ratio)*(1-T)*(ULE - cost of debt))

Cost of equity capital formula, given dividend growth rate, average mkt dividend yield, average 1-year T-bill rate and firm's beta?

Cost of equity capital = Avg 1 year T-bill rate + (Firm's Beta * ((Dividend growth rate + avg mkt dividend yield) - Avg 1 year T-bill rate))

A firm can pay out its cash earnings to its shareholders through ____________.

dividends and share repurchase

In a cyclical firm, revenues go _________ in the contraction phase of the biz cycle

down

To apply the DDM to a particular stock, you need to estimate the ______.

growth rate and dividend yield (which is Div/P)

To a tax-paying stockholder, a stock repurchase ______.

has significant tax advantages compared to a cash dividend

One argument against efficient markets is that stocks with high earnings to price ratios (value stocks) have ___________ returns than stocks with low earnings to price ratios (growth stocks).

higher

In a stock split, the number of common shares outstanding _______, but the total owner's equity ___________.

increases; remains unchanged

In reality, most firms cover the equity portion of their capital spending with _________.

internally generated cash flow

Security analysts are sometimes employees of

investment banking houses and money management firms

To test semistrong mkt efficiency, we can compare actively managed mutual funds with ____.

market index funds

To estimate the dividend yield of a particular stock, we can _______.

multiply last year's dividend by (1+g) or use security analysts' forecasts

The serial correlation of a stock's returns is different from the correlation between the returns of two different stocks because it _________.

only involves the returns of one stock

Embedded cost of a firm's debt is found by looking at the __________ % coupon the bond was issued at

previous

Public companies usually pay cash dividends on a _______ basis.

quarterly

The investor trait of _______ occurs when investors draw conclusions from insufficient data.

representativeness

Brokers who sell the stock on margin will protect themselves by ___________.

requiring additional cash contributions from the investor, holding the stock as collateral, or selling the stock to satisfy the loan

The ______ of the characteristic line of a stock's returns vs those of the market measures the stock's systematic risk.

slope; beta

Changes in what can cause a firm's beta to change over time?

technology, product lines, and leverage

The concept that stocks attract certain investors due to a firm's dividend policy and the resulting tax impact is called _____________.

the clientele effect

In defending the DDM, academics point out that returns in the long run can only come from ________.

the current dividend yield and future dividend growth

The growth rate of dividends can be estimated using ___________.

the retention ratio X ROE; historical dividend growth rates; security analysts' forecasts

The firm's cost of equity capital is __________ the required rate of return to the shareholders

the same as

Not everyone believes in efficient markets because ________.

there are anomalies and investors suffer illusions

Rationality implies that investors will ______.

use current and new info to estimate stock prices

A serial correlation coefficient near zero would support _________ form market efficiency

weak

The average beta across all stocks is equal to

1

Steps to calculate the value of a levered firm with perpetual cash flows, in order:

1) Calculate EBIT 2) Multiply EBIT by (1-T) 3) Divide by the cost of equity for an all-equity firm 4) Add the PV of the debt tax shield

According to the WSJ, the average dividend yield is

2.2%

Regression analysis on stock returns against risk premiums on the market can be used to estimate the ________ beta of a levered firm.

Equity

_________ studies examine whether or not the release of information on one day influences stock returns on other days.

Event

CAPM focuses on what kind of returns?

Expected returns

True or False: A high beta always goes along with a high standard deviation

False

Cost of equity, given forecasted earnings growth and dividend yield?

Firm's earnings growth % + Dividend yield % = Cost of equity

The issuance costs of bonds and stocks are referred to as ___________ costs.

Flotation

An important advantage to a firm raising equity internally is not having to pay __________.

Flotation costs

An important advantage to a firm raising equity internally is not having to pay ___________.

Flotation costs

How to find how much will be paid in flotation costs

Funds Needed = Amount Raised x ( 1 - flotation costs %)

If managers who want to issue equity believe the company's stock is overpriced, they are likely to _____.

Issue equity immediately

If a firm issues no debt, its avg cost of capital will equal ___________.

Its cost of equity

The WACC is the minimum return a company needs to earn to satisfy ______.

Its stockholders and its bondholders

Why are mutual funds extremely popular?

Mutual funds provide valuable diversification benefits and are professionally managed

Dividends to common stockholders are _____________, whereas dividends to preferred stockholders are __________.

NOT fixed; fixed.

According to the EMH ________.

New info is immediately reflected in stock prices, stock prices adjust to new info before the typical investor has time to trade on them and investors should expect only a normal return

These things usually occur with a stock dividend:

No cash leaves the firm; the number of shares increase (Stock split) and therefore the price per share falls

A firm's cost of debt can be ________.

Obtained by checking yields on publicly traded bonds; estimated easier than its cost of equity; obtained by talking to investment bankers

Factors that affect beta:

Operating leverage, financial leverage, and the cyclical nature of revenues

A point above the SML line represents a project with a ________ NPV for an all-equity firm

Positive

Companies that specialize only in projects similar to the project your firm is considering are called ________.

Pure plays

Dividend Discount Model formula w/ growth rate of zero:

R = Div/P

Cost of equity =

Risk Free Rate + Beta*(Mkt Risk Premium)

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

Risk free rate Market risk premium Stock's beta

What types of serial correlation would be consistent with market inefficiency?

Significantly negative or positive serial correlation

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

Which of the following variables do we need to compute the beta for a company's stock?

The COVARIANCE between the stock and the market index's returns and the VARIANCE of the market index's returns.

The two risk-free rates that are preferred over the life of a project are:

The rate that matches the maturity of the project and the average one-year rate anticipated over the life of the project

True or False: A firm can use its extra cash to either pay a dividend or invest in a project.

True

True or False: An increase in operating and financial leverage (i.e., an increase in debt) increases beta

True

True or False: Dividends are NOT tax-deductible

True

True or False: The firm should use the target weights, even if it can finance the entire cost of the project with either debt or equity

True

True or False: Under US tax law, a corporation's interest payments are tax deductible

True

True or false: the DDM for a stock can be generalized to the market as a whole

True

U.S. Treasury instruments have never defaulted, and are not expected to default at this time, TRUE or FALSE?

True

A company can deduct interest paid on debt when computing taxable income, TRUE or FALSE?

True.

The WACC is the overall expected return the firm must earn on its existing assets to maintain its ___________.

Value

Value of a firm calculation

Value of a firm = (EBIT * (1-T))/(unlevered cost of capital)

Value of levered firm calculations

Value of levered = Value of unlevered + B*Tc

There is often a trade-off between a firm's FC and its ___________ costs.

Variable

The market return used in the abnormal return definition is based on _________.

a broad-based stock market index

Preferred stock pays

a constant dividend, and pays dividends in perpetuity

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

a discount rate commensurate with the project's risk

The best way to include flotation costs is to ____________.

add them to the initial investment

The discount rate for the firm's projects = the cost of capital for the firm as a whole when ___________.

all projects have the same risk as the current firm

The EMH tells us which of the following a) Investors are foolish b) Prices correctly reflect value c) There is no upward trend in stock prices d) Financial managers cannot time bond and stock sales

b) and d)

The higher returns from value stocks could be due to _______________.

biases in commercial databases and differences in risk

Which of the following are implications of the efficient markets hypothesis? a) Efficient trading techniques make for supernormal profits. b) A firm will make supernormal profits if it is efficient. c) Investors should expect only a normal rate of return d) Securities sellers will receive a fair price that reflects the PV of the security

c) and d)

If a point plotted above the SML represents a project being considered by an ell-equity firm, the project's IRR must be greater than the cost of ____________.

capital/equity (same thing in an all-equity firm)

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

cost of capital; required return; discount rate (terms are all interchangeable)

Even with efficient markets, investors must worry about their ________.

degree of diversification and level of risk exposure