finance 300 chapter 14

Which of the following statements are true. Select one or more correct answers. A. A firm with diverse divisions that uses its WACC to evaluate all projects will potentially make incorrect decisions. B. Firms apply the subjective approach to use a discount rate consistent with capital market history. C. Flotation costs are unimportant because they are irrelevant financing costs. D. Flotation costs are the fees associated with issuing new securities in secondary markets. E. When the firm considers flotation costs, a project that was above the security market line may end up below it. F. None of these statements is true.

a,b,e

If you can borrow all the money you need for a project at 6 percent, doesn't it follow that 6 percent is your cost of capital for the project?

No. The cost of capital depends on the risk of the project, not the source of the money.

In calculating the WACC, if you had to use book values for either debt or equity, which would you choose? Why?

Book values for debt are likely to be much closer to market values than are equity book values.

Both companies estimate that their projects would have a net present value of $1 million at an 18 percent discount rate and a −$1.1 million NPV at a 22 percent discount rate. Dow has a beta of 1.25, whereas Superior has a beta of .75. The expected risk premium on the market is 8 percent, and risk-free bonds are yielding 12 percent. Should either company proceed? Should both?

RSup = .12 + .75(.08) = .1800, or 18.00% Both should proceed. The appropriate discount rate does not depend on which company is investing; it depends on the risk of the project. Since Superior is in the business, it is closer to a pure play. Therefore, its cost of capital should be used. With an 18 percent cost of capital, the project has an NPV of $1 million regardless of who takes it.

On the most basic level, if a firm's WACC is 12 percent, what does this mean?

It is the minimum rate of return the firm must earn overall on its existing assets. If it earns more than this, value is created.

What are the advantages of using the DCF model for determining the cost of equity capital? What are the disadvantages? What specific piece of information do you need to find the cost of equity using this model? What are some of the ways in which you could get this estimate?

- advantages: its simplicity. - disadvantages: (a) the model is applicable only to firms that actually pay dividends; many do not; (b) even if a firm does pay dividends, the DCF model requires a constant dividend growth rate forever; (c) the estimated cost of equity from this method is very sensitive to changes in the growth rate, which is a very uncertain parameter; and (d) the model does not explicitly consider risk, although risk is implicitly considered to the extent that the market has impounded the relevant risk of the stock into its market price, the dividend growth rate must be estimated. - Two common methods of estimating the growth rate are to use analysts' earnings and payout forecasts or to determine some appropriate average historical growth rate from the firm's available data.

What are the advantages of using the SML approach to finding the cost of equity capital? What are the disadvantages? What specific pieces of information are needed to use this method? Are all of these vari- ables observable, or do they need to be estimated? What are some of the ways in which you could get these estimates?

- advantages: the model explicitly incorporates the relevant risk of the stock and the method is more widely applicable than is the dividend discount model, since the SML doesn't make any assumptions about the firm's dividends. - disadvantages of the SML method are (a) three parameters (the risk-free rate, the expected return on the market, and beta) must be estimated, and (b) the method essentially uses historical information to estimate these parameters. The risk-free rate is usually estimated to be the yield on very short maturity T-bills and is, hence, observable; the market risk premium is usually estimated from historical risk premiums and, hence, is not observable. - The stock beta, which is unobservable, is usually estimated either by determining some average historical beta from the firm and the market's return data, or by using beta estimates provided by analysts and investment firms.

Under what circumstances would it be appropriate for a firm to use different costs of capital for its different operating divisions? If the overall firm WACC were used as the hurdle rate for all divisions, would the riskier divisions or the more conservative divisions tend to get most of the investment projects? Why? If you were to try to estimate the appropriate cost of capital for different divisions, what problems might you encounter? What are two techniques you could use to develop a rough estimate for each division's cost of capital?

If the different operating divisions were in much different risk classes, then separate cost of capital figures should be used for the different divisions; the use of a single, overall cost of capital would be inappropriate. If the single hurdle rate were used, riskier divisions would tend to receive more funds for investment projects, since their return would exceed the hurdle rate despite the fact that they may actually plot below the SML and, hence, be unprofitable projects on a risk-adjusted basis. The typical problem encountered in estimating the cost of capital for a division is that it rarely has its own securities traded on the market, so it is difficult to observe the market's valuation of the risk of the division. Two typical ways around this are to use a pure play proxy for the division, or to use subjective adjustments of the overall firm hurdle rate based on the perceived risk of the division.

Why do we use an aftertax figure for cost of debt but not for cost of equity?

Interest expense is tax-deductible. There is no difference between pretax and aftertax equity costs.

All else equal, which of the following will generally cause the weighted average cost of capital to fall? Select one or more correct answers. A. The cost of debt decreases. B. The tax rate decreases. C. The cost of equity increases. D. The market value of equity increases. E. The perceived risk of a project's cash flows falls. F. None of these will cause the WACC to fall.

a,e

The managers of Beryllium Boring Inc. are evaluating a new project and decide it would be best to base the required rate of return for the project on another firm's cost of capital. What strategy are the managers employing? Select one or more correct answers. A. the subjective approach B. a pure play C. weighting the cost of capital D. weighting the divisional cost of capital E. the security market line approach F. None of these is the strategy the managers are employing.

b

If a firm issued its bonds at par, then which of the following statements are true about its current cost of debt? Select one or more correct answers. A. It is equal to its coupon rate. B. It is equal to its yield-to-maturity. C. It is about the same as the yield-to-maturity of similar bonds trading in secondary markets. D. It is the approximate interest rate at which current lenders would lend money to the company. E. It depends on the current tax rate. F. None of these statements is correct.

b,c,d

If market interest rates increase, what will happen to the cost of capital for a leveraged firm? Select the single best answer. A. It will remain unchanged. B. It will decrease. C. It will increase. D. It will change, but the direction of that change depends on the debt-equity level of the firm. E. None of these statements is true.

c

How do you determine the appropriate cost of debt for a company? Does it make a difference if the company's debt is privately placed as opposed to being publicly traded? How would you estimate the cost of debt for a firm whose only debt issues are privately held by institutional investors?

The appropriate after-tax cost of debt to the company is the interest rate it would have to pay if it were to issue new debt today. Hence, if the YTM on outstanding bonds of the company is observed, the company has an accurate estimate of its cost of debt. If the debt is privately placed, the firm could still estimate its cost of debt by (a) looking at the cost of debt for similar firms in similar risk classes, (b) looking at the average debt cost for firms with the same credit rating (assuming the firm's private debt is rated), or (c) consulting analysts and investment bankers. Even if the debt is publicly traded, an additional complication occurs when the firm has more than one issue outstanding; these issues rarely have the same yield because no two issues are ever completely homogeneous.

Which of the following statements are true. Select one or more correct answers. A. WACC must, at a minimum, cover the opportunity costs of the capital providers. B. All else equal, if the government suddenly allowed common stock dividends to be tax-deductible, a firm's WACC would increase. C. The cost of preferred is the same as the dividend yield on a stock. D. The cost of debt is a function of the current market conditions in the fixed income secondary markets. E. Because preferred stock is a hybrid instrument with some of the properties of equity and debt, its dividends are tax-deductible. F. None of these statements is true.

a,c,d

Suppose Tom O'Bedlam, president of Bedlam Products, Inc., has hired you to determine the firm's cost of debt and cost of equity capital. a. The stock currently sells for $50 per share, and the dividend per share will probably be about $5. Tom argues, "It will cost us $5 per share to use the stockholders' money this year, so the cost of equity is equal to 10 percent (= $5/50)." What's wrong with this conclusion? b. Based on the most recent financial statements, Bedlam Products's total liabilities are $8 million. Total interest expense for the coming year will be about $1 million. Tom therefore reasons, "We owe $8 million, and we will pay $1 mil- lion interest. Therefore, our cost of debt is obviously $1 million/8 million = .125, or 12.5%." What's wrong with this conclusion? c. Based on his own analysis, Tom is recommending that the company increase its use of equity financing because "Debt costs 12.5 percent, but equity costs only 10 percent; thus equity is cheaper." Ignoring all the other issues, what do you think about the conclusion that the cost of equity is less than the cost of debt?

a. This only considers the dividend yield component of the required return on equity. b. This is the current yield only, not the promised yield to maturity. In addition, it is based on the book value of the liability, and it ignores taxes. c. Equity is inherently more risky than debt (except, perhaps, in the unusual case where a firm's assets have a negative beta). For this reason, the cost of equity exceeds the cost of debt. If taxes are considered in this case, it can be seen that at reasonable tax rates, the cost of equity does exceed the cost of debt.

All else equal, what will result if the corporate tax rate increases. Select one or more correct answers. A. The WACC of a firm with debt and equity in its capital structure will increase. B. The WACC of a firm with debt in its capital structure will decrease. C. It will not affect the WACC of a firm with debt in its capital structure. D. The WACC of a firm with only equity in its capital structure will decrease. E. The WACC of a firm with debt in its capital structure will change, but you cannot determine the direction of the change without more information. F. None of these statements is correct.

b

If a firm uses its overall weighted average cost of capital as the discount rate for all of its proposed projects, then which of the following will tend to occur? A. The firm will correctly accept and reject projects. B. The firm will become riskier over time. C. The firm will reject high-risk winners. D. The firm will reject the riskiest projects, as it should. E. The firm will accept low-risk winners. F. None of these will tend to occur.

b

Which of the following statements are true? Select one or more correct answers. A. Market participants' perceived risk of a firm influences its cash flows from assets. B. To estimate the firm's cost of capital, one cannot look only at the coupon rate on the firm's existing debt. C. The cost of equity is the return that equity investors require on their investment in the firm. D. One method of computing a divisional cost of capital is to use the pure-play approach. E. The subjective approach is flawed because it ignores the reward-to-risk tradeoff. F. None of the above is true.

b,c,d

Which of the following are disadvantages of the dividend growth model for estimating the cost of equity? Select one or more correct answers. A. The dividend growth model only applies to firms whose dividend growth rate fluctuates widely. B. The dividend growth model only applies to companies that are not currently paying any dividends. C. The dividend growth model does not explicitly consider risk. D. The estimated cost of equity computed using the dividend growth model is highly sensitive to the estimated growth rate. E. Historical dividends can be used as a basis for future dividends unless they have undergone a significant change or revised their dividend policy. F. None of the above is correct.

c,d

What strategy is Magnesium Mining employing when it is appropriate to add a risk premium to its WACC when evaluating a project in a division it perceives as riskier than the overall company? Select one or more correct answers. A. It is using a pure play. B. It is applying the security market line approach. C. It is using the subjective approach. D. It is trying not to ignore capital market history. E. It is trying to avoid mistakenly accepting high-risk losers. F. None of these statements correctly completes the sentence.

c,d,e

Which of the following statements are true about the security market line approach? Select one or more correct answers. A. You can only use it for firms that pay regular dividends. B. It considers both the total risk associated with a stock and the risk-free rate of return. C. It considers the systematic risk of a stock as compared to that of the overall market. D. It values a security based on the risk-free rate and the amount of unsystematic risk inherent in a security. E. It applies to stocks that do not pay dividends. F. None of these statements is true.

c,e

Which of the following will tend to increase a leveraged firm's cost of capital? Select one or more correct answers. A. A decrease in interest rates by the Federal Reserve. B. An increase in the tax rate. C. An increase in the price of the firm's bonds outstanding in secondary markets. D. A decrease in the cost of preferred stock. E. A falling stock beta. F. None of the above is correct.

f