Chapter 12
MNO preferred stock pays a dividend of $2 per year and has a price of $20. If MNO's tax rate is 40%, the after-tax rate of return on its preferred stock is:
- 10%
-If a preferred stock pays a dividend of $2 per year and is selling for $20, its yield is:
- 2 / 0.20 = 10%
If an analyst's forecast for a firm's earnings growth is 7%, and its dividend yield is 3%, its cost of equity will be ____.
- 3% + 7% = 10%
What does WACC stand for?
- Weighted average cost of capital
Some risk adjustment to a firm's WACC for projects of differing risk, even if it is subjective, is probably:
- Better than no risk
The rate used to discount project cash flows is known as the ___
- Cost of capital - Discount - Required return
Which of the following are components used in the construction of the WACC?
- Cost of deb - Cost of common stock - Cost of preferred stock
What will happen over the time if a firm uses its overall WACC to evaluate all projects, regardless of each project's rick level?
- The firm overall will become riskier - It will reject projects that it should have accepted - It will accept projects that it should have rejected
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
If a firm is funded with $400 in debt and $1,200 in equity, the weight of equity is ___ and the weight of deb is ____ to be used to compute the WACC.
- V = E + D = 1,200 + 400 = 1600 Weight of equity = E / V = 1200/1600=75% Weight of debt = D / V = 400 / 1200 = 25%
Book values are often similar to market values for debt
Ideally, we should use market values in the WACC
What can we say about the dividends paid to common and preferred stockholders?
- Dividends to common stockholders are not fixed - Dividends to preferred stockholders are fixed
The return an investor in a security receives is ___ ___ the cost of the security to the company that issued it.
- Equal to
If the firm is all-equity, the discount rate is equal to the firm's cost of____ capital
- Equity
Projects should always be discounted at the firm's overall cost of capital.
- False
Components of the WACC include funds that come from:
- Investors
Finding a firm's overall cost of equity is difficult because:
- It cannot be observed directly
To estimate a firm's equity cost of capital using the CAPM, we need to know the
- Market risk - Risk-free rate - Stock's beta
Preferred stock ___.
- Pays dividends in perpetuity - Pays a constant dividend
Other companies that specialize only in projects similar to the project your firm is considering are called ___.
- Pure plays
Suppose the risk-free rate is 5%, the market rate of return is 10%, and beta is 2. Find the required rate of return using the CAMP
- R = Rf + B x (Rm - Rf) - R = 5% + 2 x (10% - 5%) - R = 15%
The formula for calculating the cost of equity capital that is based on the dividend discount model is:
- Re = D1 / Po + g
If the risk-free rate is 4%, an all-equity firm's beta is 2, and the market risk premium is 6%, what is the firm's ost of capital?
- Rf + B x (Rm - Rf) = 4% + 2 x 6% =16%
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 company has a borrowing rate of 15% and a tax rate of 30%. What is its aftertax cost of debt?
- Ro x (1 - Tc) = 0.15 x (1 - 0.30) = 10.5%
The growth rate of dividend can be found using:
- Security analysts' forecasts - Historical dividend growth rates
To estimate the dividend yield of a particular stock, we need:
- The current stock price - Forecasts of the dividend growth rate, g - The last dividend paid Do
A firm's capital structure consists of 30% debt (D/V) and 70% equity (E/V). Its bonds yield 10% pretrax ( Ro), its cost of equity 16% (Re), and the tax rate is 40% (Tc). What is its WACC?
- WACC= (E/V) x Re + (D/V) x Ro x (1-Tc) = 0.70 x 0.16 + 0.30 x 0.40 (1 - 0.40) = 13%
Which of the following is true about a firm's cost of debt?
- Yield can be calculated from observable data - It is easier to estimate than the cost of equity
The weighted average cost of capital is:
- [E/V] x Re + [D/V] x Rd x (1 - Tc)
