FRL3000: Smartbook: CH14-Cost of Capital

Including preferred stock in the WACC adds the term:

(P/V) × RP

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

Coupon interest paid on bonds

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

dividend growth

The most well-known approach to company performance evaluation is the _____ method.

economic value added (EVA)

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

equal to

Select all that apply A firm's cost of debt can be ___. estimated easier than its cost of equity calculated using the dividend growth model obtained by talking to investment bankers obtained by checking yields on publicly traded bonds

estimated easier than its cost of equity obtained by talking to investment bankers obtained by checking yields on publicly traded bonds Reason: The dividend growth model is used for the cost of equity calculation.

When discounting the cash flows of a project at the WACC to estimate NPV, we need to find an alternative in the financial markets that is _____ as the given project.

in the same risk class

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

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

required by investors

The market value cost of debt is often Blank______ the book value cost of debt.

similar to

Finding a firm's overall cost of equity is _________(straightforward/difficult).

Blank 1: difficult

The _________ ______________ approach is the use of a WACC that is unique to a particular project, based on companies in similar lines of business.

Blank 1: pure Blank 2: play

Capital _________ weights can be interpreted just like portfolio weights.

Blank 1: structure

With the use of the ___________ approach to estimating WACC, the firm's WACC may change through time as economic conditions change.

Blank 1: subjective

The cost of capital depends primarily on the _________(use/source) of funds.

Blank 1: use

Select all that apply Which of the following are components used in the construction of the WACC? Cost of common stock Cost of accounts payable Cost of preferred stock Cost of debt

Cost of common stock Cost of preferred stock Cost of debt

Select all that apply Which of the following are components used in the construction of the WACC? Cost of preferred stock Cost of debt Cost of common stock Cost of accounts payable

Cost of preferred stock Cost of debt Cost of common stock

Which of the following methods for calculating the cost of equity ignores risk?

The dividend growth model

Which of the following variables is not required to calculate the expected return on a risky asset?

The rate of inflation Reason: The CAPM equation is: E(RE) = Rf + Beta * (E(RM) − Rf)

Using the SML approach, what is the expected return on a stock if its beta is equal to zero?

The risk-free rate Reason: Plugging zero in as beta: E(RE) = RF + 0 * (E(RM) − Rf) = Rf

If a firm has two divisions and one division is riskier than the other, what would be the potential result if the firm used its overall WACC to evaluate the projects in both divisions?

The riskier division's projects will typically receive full funding and the less risky division's projects will often be incorrectly rejected.

Which is true of flotation costs in calculating WACC?

They are relevant cash flows.

Economic value added (EVA) is a means of evaluating corporate performance.

True

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

Which one of the following is true?

Under U.S. tax law, a corporation's interest payments are deductible for tax purposes.

What does WACC stand for?

Weighted average cost of capital

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

internally generated cash flow

Select all that apply The WACC is the minimum return a company needs to earn to satisfy _____. the exchange on which its stock is traded its bondholders its stockholders the SEC

its bondholders its stockholders Reason: The WACC is the minimum return a company needs to earn to satisfy the investors who supply its capital.

Select all that apply To estimate the expected return on a risky asset, we need to know the ___. market risk premium risk-free rate stock's beta annual dividend amount

market risk premium risk-free rate stock's beta

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

market value

Select all that apply Preferred stock ___. does not pay dividends pays a constant dividend pays dividends in perpetuity has a fixed maturity

pays a constant dividend pays dividends in perpetuity

Select all that apply The growth rate of dividends can be found using _____. security analysts' forecasts historical dividend growth rates the capital asset pricing model the perpetuity model

security analysts' forecasts historical dividend growth rates

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

supply

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

there is no way of directly observing the return that the firm's equity investors require on their investment

In addition to CAPM, the cost of equity can be determined using the dividend growth model and the _____ approach.

SML

One of the disadvantages of using historical returns to estimate the market risk premium is that the past may not be a good guide to the future _____.

when economic conditions change quickly Reason: When economic conditions are stable, the past is a reasonable guide to the future.

MNO preferred stock pays a dividend of $2 per year and has a price of $20. If MNO's tax rate is 21 percent, the required rate of return on its preferred stock is found by which formula?

$2/$20

A firm has a target debt-equity ratio of .5, but it plans to finance a new project with all debt. What debt-equity ratio should be used when calculating the project's flotation costs?

.5 Reason: When calculating flotation costs, the target debt-equity ratio should be used.

WACC was used to compute the following project NPVs: Project A = $100, Project B = -$50, Project C = -$10, Project D = $40. Which projects should the firm accept?

A and D Reason: A and D both have positive NPV so both should be chosen.

Which of the following is true?

A company can deduct interest paid on debt when computing taxable income. Reason: Interest on debt is tax deductible for corporations. Reason: Dividends are not tax deductible for the issuing corporation

A firm's overall cost of capital will include both its cost of __________ capital and equity capital.

Blank 1: debt

A firm's overall cost of capital will include both its cost of ____________ capital and equity capital.

Blank 1: debt

The cost of ___________ can be observed because it is the interest rate the firm must pay on new loans.

Blank 1: debt

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

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

Sigma Corporation consists of two divisions: A and B. Division A is riskier than Division B. If Sigma Corporation uses the firm's overall WACC to evaluate both Divisions' projects, which Division will probably not receive enough resources to fund all of its potentially profitable projects?

Division B Reason: Division A is riskier, so its cash flows should be discounted at a higher rate. Because they're not, the projects in Division A will look better than those in Division B. Division B's cash flows will be discounted using a higher rate than should be used, so they will appear less appealing and will be more often rejected.

True or false: The cost of debt on the market value basis is typically much higher than the cost of debt on the book value basis.

False Reason: They are typically similar.

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

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

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

RE = D1/P0 + g

The formula for the required return from the SML is:

RE = Rf + B(RM − Rf)

B = the market value of a firm's debt S = the market value of that same firm's equity RB = the before-tax yield on the firm's debt TC = the corporate tax rate RS = the cost of equity Given the definitions above, the weighted average cost of capital formula can be written as:

[S/(S + B)] × RS + [B/(S + B)] × RB × (1 − Tc)

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

a discount rate that commensurates with the project's risk. Reason: The projects should only be evaluated using the firm's overall WACC if the risk of the project is the same as the risk of the overall firm. Reason: The cost of capital used should be appropriate for the project being considered, not the one that was most recently done.

The WACC is the weighted average of the cost of equity and the _____.

aftertax cost of debt

Select all that apply The SML approach requires estimates of the _____. beta coefficient cost of debt capital cost of equity capital market risk premium

beta coefficient market risk premium Reason: The SML approach solves for the cost of equity capital using the market risk premium, the risk-free rate, and the beta coefficient.

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

Flotation costs are costs incurred to ____.

bring new security issues to the market

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

cannot

WACC is used to discount Blank______.

cash flows

Select all that apply The rate used to discount project cash flows is known as the ___. market rate discount rate required return cost of capital

discount rate required return cost of capital

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

The underlying key assumption, and oftentimes a key disadvantage, of the dividend growth model is that it assumes the dividend _____.

grows at a constant rate

Select all that apply The growth rate of dividends can be found using _____. the capital asset pricing model historical dividend growth rates security analysts' forecasts the perpetuity model

historical dividend growth rates security analysts' forecasts

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

too many high-risk

Select all that apply To estimate the growth rate of a particular stock, we can ___. use the average bank's annual CD rate use the average market dividend yield use the historical dividend growth rate. use security analysts' forecasts

use the historical dividend growth rate. use security analysts' forecasts

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

use; source