Chapter 13 Risk, Cost of Capital, Valuation
A firm raises $1,000,000 in equity with flotation costs of 5%. How much will it pay in flotation costs?
$50,000 1,000,000 x .05
A firm needs to sell enough equity to raise $950,000 after covering the flotation costs of 5 percent. How much will it pay in flotation costs?
$50,000 Reason: $950,000 = Amount Raised × (1 - .05) Amount Raised = $1,000,000 Flotation Costs = $1,000,000 - 950,000 = $50,000
A project's NPV without flotation costs is $750,000 and its flotation costs are $25,000. What is the true NPV?
$725,000 $750,000-$25,000
ULC and LEV have earnings before interest and taxes of $110. LEV also has $20 of interest expense. Both companies are taxed at 30%, ULC's aftertax earnings are ___ , which is ___ than LEV's aftertax earnings (assume all interest can be deducted).
$77; $14 greater Reason: UCL = $110 × (1 - .3) = $77 LEV= $90 × (1 - .3) = $63
A firm's target capital structure weights are evenly split between debt and equity. What is the firm's target debt-equity ratio?
1 Reason: Target D/E = .5/.5= 1
The weighted average cost of capital (WACC) formula, for a firm with no debt or preferred stock will have a WACC of:
1 x cost of equity
If a company has a cost of debt of 6% and a corporate tax rate equal to 22%, what is the after tax cost of debt?
4.68%
If a company has a cost of debt of 8% and a corporate tax rate equal to 35%, what is the after tax cost of debt?
5.2% Reason: = 8*(1-0.35)
Which of the following is true?
A company can deduct interest paid on debt up to 30% of EBIT when computing taxable income.
What do we know about the stability of a firm's beta?
Betas can change over time. Betas are more likely to be stable if the firm remains in the same industry.
Which of the following are true?
Book values are often similar to market values for debt Ideally, we should use market values in the WACC
Flotation costs are costs incurred to ____.
Bring new security issues to the market
What is the CAPM formula?
RS = RF + β× (RM- RF)
Which of the following variables do we need to compute the beta for a company's stock?
The covariance between the stock and the market index's returns. The variance of the market index's returns.
Which of the following are true about U.S. Treasury instruments?
They are not expected to default at this time. They have never defaulted.
Which one of the following is true?
Under U.S. tax law, a corporation's interest payments up to 30% of EBIT are tax deductible.
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) Reason: The last component of the formula in this answer (cost of debt) needs to be multiplied by 1 - the tax rate.
If a firm has multiple projects, each project should be discounted using ___.
a discount rate commensurate with the project's risk
The weighted-average cost of capital requires the ______-tax cost of debt.
after
The covariance between the stock and the market index's returns divided by the variance of the market index's returns represents the _______ for a company's stock.
beta
Dividends and capital gains given to the new shareholders represent ______ to the firm.
costs
U.S. Treasury securities considered to be risk-free because they have minimal, if any, ____ risk.
default
The ______ discount model for a stock can be generalized to the market as a whole.
dividend
The issuance costs of bonds and stocks are referred to as ______ costs.
flotation
The industry beta may be a better estimate than the firm's own beta due to the ______ standard error of the firm estimate.
larger
A firm's cost of debt can be ___.
obtained by checking yields on publicly traded bonds obtained by talking to investment bankers estimated more easily than its cost of equity
The CAPM can be used to estimate the ___.
required return on equity
Dividends and capital gains given to the new shareholders represent ______ to the shareholders.
returns
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 correct discount rate on a project ______ the expected return on a financial asset of comparable risk.
should be
For debt, book values and market values are typically:
similar
The ____ of the characteristic line of a stock's returns versus those of the market measures the stock's systematic risk.
slope beta
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
True or false: The dividend discount model for a stock can be generalized to the market as a whole.
true
According to the Wall Street Journal, the average dividend yield for the stocks that comprise the S&P 500 Index was approximately
1.8%
Suppose a firm has a target debt-equity ratio of 2.5. What is the firm's target capital structure weight for common stock?
28.57% Reason: S/(S + B) = 1/3.5 = 28.57%
If a point plotted above the security market line (SML) represents a project being considered by an all-equity firm, the project's IRR must be greater than the cost of ______.
equity capital
An important advantage to a firm raising equity internally is not having to pay ___.
flotation costs
According to the Wall Street Journal, the average dividend yield for the stocks that comprise the S&P 500 Index was approximately:
1.8
The ____ can be used to estimate the required return on equity.
CAPM
When valuing a complete business enterprise, the same process that is used for individual projects can be used. However, the analysis is complicated because a _________ must be used, and a terminal firm value must be determined.
horizon
Preferred stock ___.
pays a constant dividend pays dividends in perpetuity
A point above the SML line represents a project with a ______ NPV for an all-equity firm..
positive
The difference between the expected return on the market portfolio and the risk-free rate is the market risk
premium
If the expected return of a project is below that of a financial asset of comparable risk, the firm should ______ the project.
reject
When valuing a firm with the weighted average cost of capital, the ________ value of the firm can be estimated by assuming a constant perpetual growth rate for cash flows beyond the horizon.
terminal
The firm's cost of equity capital is ______ the required rate of return to the shareholders.
the same as
The risk free measure for the risk-free rate should be ______ the risk-free rate used for the market risk premium.
the same as
If a firm uses its overall cost of capital to discount cash flows from higher risk projects, it will reject ______ projects.
too many low-risk
True or false: The correct discount rate on a project should be the expected return on a financial asset of comparable risk.
true
True or false: The rate of return required by shareholders is the same as the firm's cost of equity capital.
true
One method for estimating the cost of equity is based on the ______ model.
dividend discount
The weighted average cost of capital (RWACC) is the overall expected return the firm must earn on its existing assets to maintain its ___.
value
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
What are the after-tax earnings for HIJ Corporation if it reports $200 in revenue, $90 in operating expenses, has a tax rate of 30%, and pays $20 in interest on its bonds (assume all interest is tax deductible).
$63 Reason: ($200 - $90 - $20) × (1 -0.3) = $63
A project's NPV without flotation costs is $1,000,000 and its flotation costs are $50,000. What is the true NPV?
$950,000 Reason: $1,000,000 - 50,000 = $950,000
If the risk-free rate is 3 percent, the market risk premium is 7 percent, the industry beta is 1, and the firm beta is 2, the cost of equity will be ____ percent less if the industry beta is used instead of the firm beta.
7 Reason: (1 - 2) × 7% = -7%
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.
True or false: If a firm stays in the same industry, its beta will never change.
False
True or false: The CAPM is the only method to compute the cost of equity.
False
Which of the following variables is NOT required when using the CAPM to compute the cost of equity capital?
The rate of inflation
The ______ is the overall expected return the firm must earn on its existing assets to maintain its value if the firm is levered.
WACC
The slope of the characteristic line of a firm's returns versus those of the market is the ___.
beta
Generally, which is easier to determine?
cost of debt
A firm should only undertake a project if its expected return is ______ that of a financial asset of comparable risk.
equal to or greater than
True or false: Projects should always be discounted at the firm's overall cost of capital.
false
In reality, most firms cover the equity portion of their capital spending with ___.
internally generated cash flow
If a firm issues no debt, its average cost of capital will equal ___.
its cost of equity
