Business Finance Ch 12 Reading - Connect
preferred stock
- pays a constant dividend - pays dividends in perpetuity A special type of stock whose owners, though not generally having a say in running the company, have a claim to profits before other stockholders do.
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.
True or false: The SML approach is advantageous because all it requires is estimation of beta.
False
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 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.
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 of the SML is:
RE = Rf + Beta x (RM- Rf) security market line (SML)= risk-free rate of return + beta (market return - risk-free rate of return)
The following are disadvantages of the SML approach
Requires estimation of beta Requires estimation of the market risk premium
What is the equation for finding the cost of preferred stock?
Rp = D (dividend)/ P0 (price)
True or false: RP=D/P0
True
What is the appropriate discount rate to use only if the proposed investment is a replica of the firm's existing operating activities?
WACC
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
WACC is used to discount ______ _________.
cash flows
Components of the WACC include funds that come from ______ .
investors
The most appropriate weights to use in the WACC are the ______ weights.
market value
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
The WACC is the minimum required return for _______:
the overall firm
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
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
What will happen over time if a firm uses its overall WACC to evaluate all projects, regardless of each project's risk level?
-It will reject projects that it should have accepted -the firm overall will become riskier -it will accept projects that it should have rejected
To estimate the dividend yield of a particular stock, we need:
-forecasts of the dividend growth rate, g -the current stock price -the last dividend paid, D0
According to the CAPM, what is the expected return on a stock if its beta is equal to zero?
The risk-free rate
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.
The growth rate of dividends can be found using:
- security analysts' forecasts - historical dividend growth rates
The rate used to discount project cash flows is known as the ___.
1. required return 2. cost of capital 3. discount rate
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.
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.
The formula for calculating the cost of equity capital that is based on the dividend discount model is:
RE = D1/P0 + g
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 Reason: The return an investor in a security receives is equal to the cost of the security to the company that issued it.
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)
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
The return an investor in a security receives is ______ _____ the cost of the security to the company that issued it.
equal to
Finding a firm's overall cost of equity is difficult because:
it cannot be observed directly
If a firm issues no debt, its average cost of capital will equal ___.
its cost of equity
Other companies that specialize only in projects similar to the project your firm is considering are called ___.
pure plays
For a firm with outstanding debt, the cost of debt will be the ________ on that debt..
yield to maturity
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
The following are advantages of the SML approach
Adjusts for risk Does not require the company to pay a dividend
Given V = E + D, if we divide both V and D by _________, we can calculate the capital structure weights.
Blank 1: V
The dividend growth model is applicable to companies that pay____________.
Blank 1: dividends
In the WACC calculation, D represents the _________ value of the firm's debt.
Blank 1: market
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
The WACC of a firm reflects the__________ and the target capital structure of the firm's existing assets as a whole.
Blank 1: risk
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.
Blank 1: subjective
The WACC is the overall rate of return the firm must earn on its existing assets to maintain the __________of its stock.
Blank 1: value or price
Which of the following are components used in the construction of the WACC?
Cost of common stock Cost of debt Cost of preferred stock
Which of the following is tax-deductible to the firm?
Coupon interest paid on bonds
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 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.
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: 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.
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 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 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: In the WACC calculation, V = E - D.
False Reason: V = E + D
If the firm is all-equity, the discount rate is equal to the firm's cost of ______ capital.
equity
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 Reason: If the project's beta is less than the firm's overall beta, its cost of capital will be less the the overall cost of capital, and if the overall cost of capital is used, the project's cash flows will be discounted too severely, leading to the possible rejection of a value creating project.
The cost of capital depends primarily on the ______ of funds, not the _____.
use; source Reason: It is the use that determines the risk of the project
