CH 9-12 FIN

Wall Inc. forecasts that it will have the free cash flows (in millions) shown below. If the weighted average cost of capital is 14% and the free cash flows are expected to continue growing at the same rate after Year 3 as from Year 2 to Year 3, what is the firm's total corporate value, in millions? Year123Free cash flow-$20.00$48.00$50.50

1. FIND G = FCF3/FCF2-1 2. FIND HORIZON=FCF3/(WACC-G) 3. FINDTOTAL CORP VALUE= (FCF/1+WACC) + (FCF2 + HV2) _________ (1+WACC)^2

The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

A. TRUE (THE COMP..)

If a stock's market price exceeds its intrinsic value as seen by the marginal investor, then the investor will sell the stock until its price has fallen down to the level of the investor's estimate of the intrinsic value. a. True b. False

A. TRUE (if a stock..)

Schnusenberg Corporation just paid a dividend of D0 = $0.75 per share, and that dividend is expected to grow at a constant rate of 6.50% per year in the future. The company's beta is 1.70, the required return on the market is 10.50%, and the risk-free rate is 4.50%. What is the company's current stock price?

Current stock price: d1: DO(1+G) RS: RFR (RMR-RFR)B PO: D1/(R-G)

A stock is expected to pay a dividend of $0.75 at the end of the year. The required rate of return is rs = 10.5%, and the expected constant growth rate is g = 8.2%. What is the stock's current price?

D1: D0(1+G) PO: D1/RS-G

A stock just paid a dividend of D0 = $1.50. The required rate of return is rs = 14.1%, and the constant growth rate is g = 4.0%. What is the current stock price?

D1: D0(1+G) PO: D1/RS-G

If D0 = $1.75, g (which is constant) = 3.6%, and P0 = $40.00, what is the stock's expected total return for the coming year?

D1: D0(1+G) Total return: RS=(D1/PO) + G

Francis Inc.'s stock has a required rate of return of 10.25%, and it sells for $87.50 per share. The dividend is expected to grow at a constant rate of 6.00% per year. What is the expected year-end dividend, D1?

D1: D0(R+G)

A stock is expected to pay a year-end dividend of $2.00, i.e., D1 = $2.00. The dividend is expected to decline at a rate of 5% a year forever (g = -5%). If the company is in equilibrium and its expected and required rate of return is 15%, which of the following statements is CORRECT?

D2: 2(1+5) P2=1.9/15%-5%

Rebello's preferred stock pays a dividend of $1.00 per quarter, and it sells for $55.00 per share. What is its effective annual (not nominal) rate of return?

Effective annual? 1. nominal cost= Annual div/ preff 2. effective annual= (1+Nominal cost/ N)^n. - 1

Misra Inc. forecasts a free cash flow of $55 million in Year 3, i.e., at t = 3, and it expects FCF to grow at a constant rate of 5.5% thereafter. If the weighted average cost of capital (WACC) is 10.0% and the cost of equity is 15.0%, what is the horizon, or continuing, value in millions at t = 3

FCF4=FCF3(1+G)

What happens if g > rs?

If g > rs, the constant growth formula leads to a negative stock price, which does not make sense.• The constant growth model can be used only if:- rs > g.- g is expected to be constant forever.

An increase in a firm's expected growth rate would cause its required rate of return to a. fluctuate more than before. b. increase. c. fluctuate less than before. d. possibly increase, possibly decrease, or possibly remain constant. e. decrease.

LETTER D. (an increase..)

Which of the following statements is CORRECT, assuming stocks are in equilibrium? a. A stock's dividend yield can never exceed its expected growth rate. b. Assume that the required return on a given stock is 13%. If the stock's dividend is growing at a constant rate of 5%, its expected dividend yield is 5% as well. c. Other things held constant, the higher a company's beta coefficient, the lower its required rate of return. d. A required condition for one to use the constant growth model is that the stock's expected growth rate exceeds its required rate of return. e. The dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield.

LETTER E. (which of..)

Preferred Stock

Like bonds, preferred stockholders receive a fixed dividend that must be paid before dividends are paid to common stockholders. However, companies can omit preferred dividend payments without fear of pushing the firm into bankruptcy.

Intrinsic Value and Stock Price

Outside investors, corporate insiders, and analysts use a variety of approaches to estimate a stock's intrinsic value (P0). • In equilibrium we assume that a stock's price equals its intrinsic value. - Outsiders estimate intrinsic value to help determine which stocks are attractive to buy and/or sell. - Stocks with a price below (above) its intrinsic value are undervalued (overvalued).

Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? XYPrice$30$30Expected growth (constant)6%4%Required return12%10%

Who has higher stock price? dividend per share= g * price

Projects C and D are mutually exclusive and have normal cash flows. Project C has a higher NPV if the WACC is less than 12%, whereas Project D has a higher NPV if the WACC exceeds 12%. Which of the following statements is CORRECT?

a. Project D probably has a higher IRR.

If a firm's projects differ in risk, then one way of handling this problem is to evaluate each project with the appropriate risk-adjusted discount rate.

a. True (if a firm proj..)

A proxy is a document giving one party the authority to act for another party, including the power to vote shares of common stock. Proxies can be important tools relating to control of firms. a. True b. False

a. true (a proxy..)

According to the nonconstant growth model discussed in the textbook, the discount rate used to find the present value of the expected cash flows during the initial growth period is the same as the discount rate used to find the PVs of cash flows during the subsequent constant growth period. a. True b. False

a. true (accord)

Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the higher NPV.

a. true (conflicts)

Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets. They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.

a. true (firms raise..)

For a stock to be in equilibrium, two conditions are necessary: (1) The stock's market price must equal its intrinsic value as seen by the marginal investor and (2) the expected return as seen by the marginal investor must equal this investor's required return.

a. true (for a stock..)

One advantage of the payback method for evaluating potential investments is that it provides information about a project's liquidity and risk.

a. true (one adv..)

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, are not deductible by the issuing firm.

a. true (the cost..)

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. Since we cannot be sure that the estimate obtained with any of these methods is correct, it is often appropriate to use all three methods, then consider all three estimates, and end up using a judgmental estimate when calculating the WACC.

a. true (the text..)

When estimating the cost of equity by use of the DCF method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return. This problem leaves us unsure of the true value of rs.

a. true (when estt..)

If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity. However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt.

a.true (if inv)

In theory, capital budgeting decisions should depend solely on forecasted cash flows and the opportunity cost of capital. The decision criterion should not be affected by managers' tastes, choice of accounting method, or the profitability of other independent projects.

a.true (in theory..)

The NPV method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital.

a.true (the npv..)

Since 70% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, beCost of equity = rs(0.30)(0.50) + rps(1 - T)(0.70)(0.50).

b. false (since 70..)

Because "present value" refers to the value of cash flows that occur at different points in time, a series of present values of cash flows should not be summed to determine the value of a capital budgeting project.

b.false (because pv..)

If the IRR of normal Project X is greater than the IRR of mutually exclusive (and also normal) Project Y, we can conclude that the firm should always select X rather than Y if X has NPV > 0.

b.false (if the irr)

Other things held constant, an increase in the cost of capital will result in a decrease in a project's IRR.

b.false (other things..)

Suppose Walker Publishing Company is considering bringing out a new finance text whose projected revenues include some revenues that will be taken away from another of Walker's books. The lost sales on the older book are a sunk cost and as such should not be considered in the analysis for the new book.

b.false (suppose..)

The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

b.false (the firm..)

The two cardinal rules that financial analysts should follow to avoid errors are: (1) in the NPV equation, the numerator should use income calculated in accordance with generally accepted accounting principles, and (2) all incremental cash flows should be considered when making accept/reject decisions for capital budgeting projects.

b.false (the two..)

When considering two mutually exclusive projects, the firm should always select the project whose internal rate of return is the highest, provided the projects have the same initial cost. This statement is true regardless of whether the projects can be repeated or not.

b.false (when..)

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.

c. If a project has normal cash flows and its IRR exceeds its WACC, then the project's NPV must be positive.

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. (if a )

c. If a project's IRR is greater than its WACC, then the MIRR will be less than the IRR.

Which of the following statements is CORRECT? (the cost..)

c. The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity.

Assume that the economy is enjoying a strong boom, and as a result interest rates and money costs generally are relatively high. The WACC for two mutually exclusive projects that are being considered is 12%. Project S has an IRR of 20% while Project L's IRR is 15%. The projects have the same NPV at the 12% current WACC. However, you believe that the economy will soon fall into a mild recession, and money costs and thus your WACC will soon decline. You also think that the projects will not be funded until the WACC has decreased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT?

c. You should recommend Project L, because at the new WACC it will have the higher NPV.

For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure.

c. re > rs > WACC > rd.

Which of the following statements is CORRECT? (a cost..)

d. A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm's stockholders would themselves expect to earn a return on earnings that were paid out rather than retained and reinvested.

Rowell Company spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale or for a new product. Rowell owns the building free and clear--there is no mortgage on it. Which of the following statements is CORRECT?

d. If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it.

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. (one..)

d. One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money.

Which of the following statements is CORRECT? (the npv)

d. The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

Firm M's earnings and stock price tend to move up and down with other firms in the S&P 500, while Firm W's earnings and stock price move counter cyclically with M and other S&P companies. Both M and W estimate their costs of equity using the CAPM, they have identical market values, their standard deviations of returns are identical, and they both finance only with common equity. Which of the following statements is CORRECT?

e. If M and W merge, then the merged firm MW should have a WACC that is a simple average of M's and W's WACCs.

Which of the following statements is CORRECT? (if one)

e. If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net proceeds that could be obtained should be charged as a cost to the project under consideration.

Projects S and L both have an initial cost of $10,000, followed by a series of positive cash inflows. Project S's undiscounted net cash flows total $20,000, while L's total undiscounted flows are $30,000. At a WACC of 10%, the two projects have identical NPVs. Which project's NPV is more sensitive to changes in the WACC?

e. Project L.

Which of the following statements is CORRECT? (sens)

e. Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables.

Which of the following is NOT a relevant cash flow and thus should NOT be reflected in the analysis of a capital budgeting project?

e. Sunk costs that have been expensed for tax purposes.

A company is considering a new project. The CFO plans to calculate the project's NPV by estimating the relevant cash flows for each year of the project's life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flows), then discounting those cash flows at the company's overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows?

e. The additional investment in net operating working capital required to operate the project, even if that investment will be recovered at the end of the project's life.

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. (the high)

e. The higher the WACC used to calculate the NPV, the lower the calculated NPV will be.

Which of the following statements is CORRECT? (using..)

e. Using accelerated depreciation rather than straight line normally has the effect of speeding up cash flows and thus increasing a project's forecasted NPV.

Which of the following statements is CORRECT? (using..)

e. Using accelerated depreciation rather than straight line would normally have no effect on a project's total projected cash flows but it would affect the timing of the cash flows and thus the NPV.

A stock is expected to pay a year-end dividend of $2.00, i.e., D1 = $2.00. The dividend is expected to decline at a rate of 5% a year forever (g = -5%). If the company is in equilibrium and its expected and required rate of return is 15%, which of the following statements is CORRECT? a. The constant growth model cannot be used because the growth rate is negative. b. The company's dividend yield 5 years from now is expected to be 10%. c. The company's expected capital gains yield is 5%. d. The company's current stock price is $20. e. The company's expected stock price at the beginning of next year is $9.50

letter e (a stock..)

Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? X Y Price. $30. $30 Expected growth 6%4% Required return12%10% a. Stock Y has a higher capital gains yield. b. Stock Y has a higher dividend yield than Stock X. c. Stock X has the higher expected year-end dividend. d. Stock X has a higher dividend yield than Stock Y. e. One year from now, Stock X's price is expected to be higher than Stock Y's price

letter e (stock x and y..)

Based on the corporate valuation model, the total corporate value of Chen Lin Inc. is $500 million. Its balance sheet shows $110 million in notes payable, $90 million in long-term debt, $20 million in preferred stock, $140 million in retained earnings, and $280 million in total common equity. If the company has 25 million shares of stock outstanding, what is the best estimate of its stock price per share?

step 1: equity= Corporate value- NP- LONGETERM- PREFERRED Step 2: Stock price= value of equity/ shares outstanding

Corporate Valuation Model

• Also called the free cash flow method. Suggests the value of the entire firm equals the present value of the firm's free cash flows.• Remember, free cash flow is the firm's after-tax operating income less the net capital investment

Issues Regarding the Corporate Valuation Model

• Often preferred to the discounted dividend model, especially when considering number of firms that don't pay dividends or when dividends are hard to forecast. • Similar to discounted dividend model, assumes at some point free cash flow will grow at a constant rate. • Horizon value (HVN) represents value of firm at the point that growth becomes constant.

Facts About Common Stock

• Represents ownership• Ownership implies control• Stockholders elect directors• Directors elect management• Management's goal: Maximize the stock price