FRL 3671 - CH. 13 Learn Smart

A company recently paid a dividend of $2 per share. You estimate dividend growth to be 6%. What do you expect next years dividend to be?

$2.12

A firm raises $1,000,000 in equity with flotation costs of 5%. How much will it pay in flotation costs?

$50,000

A firm needs to sell enough equity to raise $950,000 after covering the flotation costs of 5 percent. How much will it pay in flotation costs?

$50,000 $950,000 = Amount Raised × (1 - .05) Amount Raised = $1,000,000 Flotation Costs = $1,000,000 - 950,000 = $50,000

What are the after-tax earnings for HIJ Corporation if it reports $200 in revenue, $90 in operating expenses, has a tax rate of 30%, and pays $20 in interest on its bonds (assume all interest is tax deductible).

$63 ($200 - $90 - $20) × (1 -0.3) = $63

A project's NPV without flotation costs is $750,000 and its flotation costs are $25,000. What is the true NPV?

$725,000

ULC and LEV have earnings before interest and taxes of $110. LEV also has $20 of interest expense. Both companies are taxed at 30%, ULC's aftertax earnings are ___ , which is ___ than LEV's aftertax earnings (assume all interest can be deducted).

$77; $14 greater UCL = $110 × (1 - .3) = $77 LEV= $90 × (1 - .3) = $63

A firm has 45% debt, debt flotation costs of 6%, equity flotation costs of 12%, and wants to raise $7,700, not including flotation costs. What are the flotation costs?

$789.53

A firm has 20 percent debt, debt flotation costs of 5 percent, equity flotation costs of 10 percent, and wants to raise $9,100, not including flotation costs. What are the flotation costs?

$900 f0 = .2 × 5% + .8 × 10% = 9% $9,100/(1 - .09) - $9,100 = $900

A project's NPV without flotation costs is $1,000,000 and its flotation costs are $50,000. What is the true NPV?

$950,000 $1,000,000 - 50,000 = $950,000

A firm's target capital structure weights are evenly split between debt and equity. What is the firm's target debt-equity ratio?

1 Target D/E = .5/.5= 1

The weighted average cost of capital (WACC) formula, for a firm with no debt or preferred stock will have a WACC of:

1 × Cost of equity

If a firm has $10 million of debt with a debt beta of .4 and $30 million of equity with equity beta of 2, then the firm's asset beta is ____.

1.6 ($10/$40)(.4) + ($30/$40)(2) = 1.6

If a firm has $15 million of debt with a debt beta of 0.2 and $40 million of equity with equity beta of 2.2, then the firm's asset beta is ____.

1.65

According to the Wall Street Journal, the average dividend yield for the stocks that comprise the S&P 500 Index was approximately:

1.8%

A company has a borrowing rate of 15% and a tax rate of 30%. What is its aftertax cost of debt (assume all interest is tax deductible)?

10.5% 15% × (1 - .3) = 10.5%

If a preferred stock pays a dividend of $3 per year and is selling for $25, its yield is:

12%

A firm's capital structure consists of 30 percent debt and 70 percent equity. Its bonds yield 10 percent, pretax, its cost of equity is 16 percent, and the tax rate is 40 percent. What is its WACC?

13% (0.7 × .16) + (0.3 × .1 × (1 - 0.4)) = .13 or 13%

Suppose a firm has a target debt-equity ratio of 2.5. What is the firm's target capital structure weight for common stock?

28.57% S/(S + B) = 1/3.5 = 28.57%

Previously, a firm issued bonds at par with a 3% coupon. Today, similar bond yields are 6% and the risk-free rate is 2%. What is the embedded cost of the firm's debt?

3%

If a company has a cost of debt of 8% and a corporate tax rate equal to 35%, what is the after tax cost of debt?

5.2% 8*(1-0.35) ???

Previously, a firm issued bonds at par with a 6 percent coupon. Today, similar bond yields are 8 percent and the risk-free rate is 3 percent. What is the embedded cost of the firm's debt?

6%

Suppose a firm faces a risk-free rate of 2%, a beta of 1, and a market risk premium of 4%. What is its cost of capital if it is an all-equity firm?

6% 2% + 1 × 4% = 6%

A company has a borrowing rate of 8% and a tax rate of 22%. What is its after tax cost of debt (assume all interest is tax deductible)?

6.2%

About _______ percent of U.S. companies use the CAPM in capital budgeting.

75

What do we know about the stability of a firm's beta? Multiple select question. Betas are more likely to be stable if the firm remains in the same industry. Betas can change over time. Betas are more likely to change if the firm remains in the same industry. Betas do not change over time.

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

The _______ can be used to estimate the required return on equity.

CAPM

Which of the following can cause a firm's beta to change over time? Multiple select question. Changes in product line Changes in technology Changes in the betas of other companies Changes in leverage

Changes in product line Changes in technology Changes in leverage

The primary advantage of the ______ is its simplicity.

DDM

What can we say about the dividends paid to common and preferred stockholders? Multiple select question. Dividends are guaranteed for both preferred and common stockholders. Dividends to preferred stockholders are fixed. Preferred stock dividends change every year based on the earnings of the firm. Dividends to common stockholders are not fixed.

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

True or false: If a firm stays in the same industry, its beta will never change.

False

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

False

True or false: The CAPM is the only method to compute the cost of equity.

False

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

False There is no fixed relationship between standard deviation and beta.

Which of the following are true? Multiple select question. Fixed costs do not change as quantity changes. Fixed costs never change. Variable costs never change. Variable costs change with changes in quantity.

Fixed costs do not change as quantity changes. Variable costs change with changes in quantity.

Which of the following are true? Multiple select question. Ideally, we should use market values in the WACC. Book values are often similar to market values for equity. Book values are often similar to market values for debt. Ideally, we should use book values in the WACC.

Ideally, we should use market values in the WACC. Book values are often similar to market values for debt.

______ companies prefer the CAPM to the DDM.

More

The market risk premium is defined as ___.

RM - RF

What is the CAPM formula?

RS = RF + β× (RM- RF)

Which of the following are factors that affect beta? Multiple select question. Changes in the market risk premium The cyclical nature of revenues Operating leverage Financial leverage

The cyclical nature of revenues Operating leverage Financial leverage

Which of the following are the more likely sources for a firm's forecasts of the market risk premium? Multiple select question. The firm's own subjective forecast A consensus of forecasts The Wall Street Journal Value Line

The firm's own subjective forecast A consensus of forecasts Value Line

Which of the following variables is NOT required when using the CAPM to compute the cost of equity capital?

The rate of inflation

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

The risk-free rate

Suppose Bill's Burgers is considering acquiring Ken's Kampground. Ken's is not publicly traded, so Bill's estimates Ken's future cash flows and calculates the value of Ken's using its own (Bill's) WACC. What assumption of the WACC method is Bill's violating?

The use of Bill's WACC assumes Ken's has the same business risk as Bill's.

Which of the following variables do we need to compute the beta for a company's stock? Multiple select question. The variance of the market index's returns. The correlation between the stock's returns and the CPI index. The covariance between the stock and the industry index's returns. The covariance between the stock and the market index's returns.

The variance of the market index's returns. The covariance between the stock and the market index's returns.

Which of the following is true about security analysts? Multiple select question. They only study bonds. They only study individual securities. They are sometimes employees of investment banking houses. They are sometimes employees of money management firms.

They are sometimes employees of investment banking houses. They are sometimes employees of money management firms.

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

True

True or false: The correct discount rate on a project should be the expected return on a financial asset of comparable risk.

True

True or false: The rate of return required by shareholders is the same as the firm's cost of equity capital.

True

Which one of the following is true?

Under U.S. tax law, a corporation's interest payments up to 30% of EBIT are tax deductible.

The ______ is the overall expected return the firm must earn on its existing assets to maintain its value if the firm is levered.

WACC

Which of the following are advantages of the CAPM over the DDM?

adjusts for risk applicable to companies with no dividends

The weighted-average cost of capital requires the ______-tax cost of debt.

after

Through standard regression technique, the intercept is commonly called _______

alpha

If a firm increases its level of debt, its beta will ___.

also increase

If the operations of a firm are different than its industry, the firm's ________ should be used to estimate the firm's cost of equity capital.

beta

The covariance between the stock and the market index's returns divided by the variance of the market index's returns represents the _______ for a company's stock.

beta

The ____ of the characteristic line of a stock's returns versus those of the market measures the stock's systematic risk. Multiple select question. length width beta slope

beta slope

Flotation costs are costs incurred to ____.

bring new security issues to the market

A complication in selecting the right industry beta is ___.

classifying the firm's industry

The discount rate of a project is said to be its ________ of capital.

cost

Generally, which is easier to determine?

cost of debt

U.S. Treasury securities considered to be risk-free because they have minimal, if any, ____ risk.

default

The ________ discount model for a stock can be generalized to the market as a whole.

dividend

One method for estimating the cost of equity is based on the ______ model.

dividend discount

The ________ discount model requires estimation of the dividend yield and _________ rate

dividend; growth

Security analysts typically forecast: Multiple select question. earnings ownership structure dividends debt

earnings dividends

A firm should only undertake a project if its expected return is ______ that of a financial asset of comparable risk.

equal to or greater than

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

equity

The asset beta is the beta of common stock had the firm been all _______.

equity

When using regression analysis with stock returns as inputs, the ________ beta is estimated.

equity

If a point plotted above the security market line (SML) represents a project being considered by an all-equity firm, the project's IRR must be greater than the cost of ______. Multiple select question. equity capital debt preferred stock

equity capital

An increase in a firm' s level of debt is an example of ___.

financial leverage

An increase in ______ will increase beta.

financial leverage operating leverage

Changes in _______ leverage and ________ leverage will affect beta.

financial; operating or operational

________ costs do not change as the quantity sold changes while ________ costs do change as the quantity sold changes.

fixed; variable

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

flotation

The equity beta of a levered firm will always be ______ the equity beta of an otherwise identical all-equity firm.

greater than

To apply the dividend discount model to a particular stock, you need to estimate the ___. Multiple select question. growth rate dividend yield risk-free rate stock's beta

growth rate dividend yield

When valuing a complete business enterprise, the same process that is used for individual projects can be used. However, the analysis is complicated because a _________ must be used, and a terminal firm value must be determined.

horizon

Financial leverage _____ risk to the firm's equity.

increases

Alpha is the ______ of the characteristic line of a stock's returns versus those of the market.

intercept

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

internally generated cash flow

There ______ a fixed relationship between standard deviation and beta.

is not

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

its cost of equity

The industry beta may be a better estimate than the firm's own beta due to the ______ standard error of the firm estimate.

larger

A firm with debt in its capital structure is said to be:

levered

Which two of the following are the best examples of non cyclical goods?

milk diapers

The sales of cyclical firms are ______ sensitive to the business cycle than are the sales of non-cyclical firms.

more

A firm's cost of debt can be ___. Multiple select question. obtained by checking yields on publicly traded bonds estimated more easily than its cost of equity Taking the present value of the tax shields from fixed assets obtained by talking to investment bankers

obtained by checking yields on publicly traded bonds estimated more easily than its cost of equity obtained by talking to investment bankers

Preferred stock ___. Multiple select question. does not pay dividends pays a constant dividend pays dividends in perpetuity has a fixed maturity

pays a constant dividend pays dividends in perpetuity

The difference between the expected return on the market portfolio and the risk-free rate is the market risk _______

premium

When using the WACC to value an acquisition, one assumes debt-equity ratio will:

remain constant

A project should only be accepted if its return is above what is ___.

required by investors

Dividends and capital gains given to the new shareholders represent ______ to the shareholders.

returns

For debt, book values and market values are typically:

similar

The cost of capital is an appropriate name since a project must earn enough to pay those who ______ the capital.

supply

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

the same as

If a firm uses its overall cost of capital to discount cash flows from higher risk projects, it will reject ______ projects.

too many low-risk

There is often a trade-off between a firm's fixed costs and its ______ costs.

variable

The beta of the portfolio is a ______ average of the betas of the individual items in the portfolio.

weighted