Chapter 12 Questions
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
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
Which of the following are components used in the construction of the WACC?
- cost of debt - cost of preferred stock - cost of common stock
The rate used to discount project cash flows is known as the ___.
- discount rate - required return - cost of capital
Which of the following are true?
- the market value of debt and equity are not reliable in case of privately owned company - ideally, we should use market values in the WACC
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
T/F: The cost of equity is D1/P0 minus the analysts' estimates of growth.
false
T/F: The discount rate is also known as the expected return.
false
Components of the WACC include funds that come from ______ .
investors
T/F: RP=D/P0
true
The following are advantages of the SML approach
- adjusts for risk - does not require the company to pay a dividend
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
To estimate the dividend yield of a particular stock, we need:
- forecasts of the dividend growth rate, g - the last dividend paid, D0 - the current stock price
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.
- market - book
Preferred stock ___.
- pays a constant dividend - pays dividends in perpetuity
The following are disadvantages of the SML approach
- requires estimation of the market risk premium - requires estimation of beta
To estimate a firm's equity cost of capital using the CAPM, we need to know the ___.
- risk-free rate - stock's beta - market risk premium
The growth rate of dividends can be found using:
- security analysts' forecasts - historical dividend growth rates
The formula of the SML is:
RE = Rf + Beta x (RM- Rf)
What is the equation for finding the cost of preferred stock?
RP=D/P0
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
Which of the following is tax-deductible to the firm?
coupon interest paid on bonds
The dividend growth model is applicable to companies that pay ____.
dividends
T/F: Finding the cost of equity is fairly straightforward.
false
T/F: For publicly traded companies, the component of the dividend yield that must be estimated is the dividend.
false
Finding a firm's overall cost of equity is difficult because:
it cannot be observed directly
The WACC of a firm reflects the ____ and the target capital structure of the firm's existing assets as a whole.
risk
According to the CAPM, what is the expected return on a stock if its beta is equal to zero?
the risk-free rate
T/F: The return an investor in a security receives is equal to the cost of the security to the company that issued it.
true
Given V = E + D, if we divide both V and D by ____, we can calculate the capital structure weights.
v
The WACC is the overall rate of return the firm must earn on its existing assets to maintain the ____ of its stock.
value or price
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
Dividends paid to common stockholders ______ be deducted from the payer's taxable income for tax purposes.
cannot
T/F: 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
In the WACC calculation, D represents the ____ value of the firm's debt.
market
The most appropriate weights to use in the WACC are the ______ weights.
market value
The cost of capital depends primarily on the ______ of funds, not the _____.
use; source
For a firm with outstanding debt, the cost of debt will be the ________ on that debt..
yield to maturity
What is the appropriate discount rate to use only if the proposed investment is a replica of the firm's existing operating activities?
WACC
T/F: The cost of capital depends on the source of the funds.
false
T/F: 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
T/F: The growth rate of dividends can be found using the CAPM.
false
T/F: The primary disadvantage of the dividend growth model approach is its simplicity.
false
True or false: In the WACC calculation, V = E - D.
false
If a firm issues no debt, its average cost of capital will equal ___.
its cost of equity
T/F: The SML approach is advantageous because all it requires is the estimation of beta.
false
T/F: The SML approach is advantageous because all it requires is estimation of beta.
false