Chapter 14
According to the weighted average cost of capital (WACC) formula, a firm with no debt or preferred stock will have a WACC of:
1 * cost of equity
If a preferred stock pays a dividend of $2 per year and is selling for $20, its yield is:
10%
Flotation costs are costs incurred to ________.
Bring new security issues to the market
True or false: Projects should always be discounted at the firm's overall cost of capital
False Projects' discount rates should reflect their particular level of risk
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 market risk premium is defined as:
Rm - Rf
Dividends paid to common stockholders __________ be deducted from the payer's taxable income for tax purposes
cannot dividends paid to common stockholders cannot be deducted from the payer's taxable income for taxable purposes
An important advantage to a firm raising equity internally is not having to pay _________.
flotation costs
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
The most appropriate weights to use in the WACC are the ___________ weights
market value
A firm's cost of debt can be ________.
obtained by checking yields on publicly traded bonds estimated easier than its cost of equity obtained by talking to investment bankers
A project should only be accepted if its return is above what is ______.
required by investors
The SML approach requires estimates of:
the beta coefficient the market risk premium
Which of the following methods for calculating the cost of equity ignores risk? - the dividend growth model - yield to maturity - the CAPM
the dividend growth model
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
A good source for bond quotes is:
www.finra.org/marketdata
A firm has 20 percent debt, debt flotation costs of 5 percent, equity flotation costs of 10 percent, and wants to raise $9,100, not including flotation costs. What are the flotation costs?
$900
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
Which of the following statements is true? - A company cannot deduct interest paid on debt when computing taxable income - A company can deduct dividends paid to shareholders when computing taxable income - A company can deduct interest paid on debt when taxable income
A company can deduct interest paid on debt when computing taxable income
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 _____.
10% (forecast for earnings growth % + dividend yield %)
Preferred stock _____.
pays dividends in perpetuity pays a constant dividend
Economic Value Added (EVA) is a mean of evaluating corporate performance
true
What does WACC stand for?
weighted average cost of capital
If the market value of debt is $45 million and the market value of equity is $105 million, the total firm value is ____ million
$150 ($45+$105)
Which of the following are true? Book values are often similar to market values for debt Ideally, we should book values in the WACC Book values are often similar to market values for equity Ideally, we should use market values in the WACC
Book values are often similar to market values for debt Ideally, we should use market values in the WACC
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 the current firm the discount rate for the firm's projects the cost of capital for the firm as a while when all projects have the same risk as the firm's current projects
To apply the dividend growth model to a particular stock, you need to assume that the firm's ____ will grow at a constant rate.
dividend
The return an investor in a security receives is _________ _________ the cost of the security to the security to the company that issued it.
equal to
WACC was used to compute the following project NPVs: Project A = $100, Project B = -$50, Project C = -$10, Project D = $40. Which project should the firm accept?
A and D A and D both have positive NPV so both should be chosen
To estimate the growth rate of a particular stock, we can _______.
use the historical dividend growth rate use security analysts' forecasts
A firm has a target debt-equity ratio of 0.5, but it plans to finance a new project with all debt. What debt-equity ratio should be used when calculating the project's flotation costs?
0.5
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 $2/$20 = 10% dividend per year / dividend price = required rate of return on preferred stock
Which one of the following is true? Under U.S. tax law, all company interest payments are taxable to the company. Under international tax law, all company interest payments are taxable to the company. Under U.S. tax law, a corporation's interest payments are tax deductible Under international tax law, all company interest payments are tax deductible
Under U.S. tax law, a corporation's interest payments 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)
According to the CAPM, what is the expected return on a stock if its beta is equal to zero?
the risk-free rate
Barry Corporation expects free cash flow of $110 thousand at the end of the year, and steady growth from here on. Its WACC is 12% and its expected growth rate is 5%. What is the value of Barry Corporation today?
$1,571,429 Present value = V0 = $110,000 / (0.12 - 0.05) = $1,571,429 present value = expected cash flow at end of year / (WACC - expected growth 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
To estimate a firm's equity cost of capital using the CAPM, we need to know the _____.
- market risk premium - stock's beta - risk-free rate
The growth rate of dividends can be found using:
- security analysts' forecasts - historical dividend growth rates
A company has a borrowing rate of 15 percent and a tax rate of 30 percent. What is its aftertax cost of debt?
11.85%
The best way to include flotation costs is to ________.
add them to the initial investment
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
Other companies that specialize only in projects similar to the project your firm is considering are called _____.
pure plays Other companies that specialize only in projects similar to the projects similar to the project your firm is considering are called pure plays
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
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 high-risk
Dang's Donuts has EBIT of $25,432, depreciation of $1,500, and a tax rate of 21%. The company will not be changing its net working capital, but plans a capital expenditure of $6,324. What is Dang's adjusted cash flow from assets?
$15,267.28 $24,432 + $1,500 - $5,340.72 - $6,324 = $15,267.28 EBIT + depreciation - tax expense - capital expenditure = cash flow from assets
A firm needs to sell enough equity to raise $950,000 after covering the flotation costs of 5 percent. How many will it pay in flotation costs?
$50,000
What are the after-tax earnings for HIJ Corporation if it reports $200 in revenue, $90 in operating expenses, has a tax rate of 21 5, and pays $20 in interest on its bonds
$71.1 ($200 - $90 - $20) * (1 - 0.21) = $71.1 (revenue - operating expenses - interest) * (1 - r) = after-tax earnings
ULC and LEV have earnings before interest and taxes of $110. LEV also has $20 of interest expense. Both companies are taxed at 21 percent, ULC aftertax earnings are _______, which is ______ than LEV's aftertax earnings
$86.9 ; $15.8 greater
A firm's capital structure consists of 40 percent debt and 60 percent equity. The aftertax yield on debt is 2.5 percent and the cost of equity is 15 percent. The project is about as risky as the overall firm. What discount rate should be used to estimate the project's net present value?
10% WACC = .4 * 2.5% + .6 * 15% = 10% ((equity % * cost of equity %) + (debt % * yield % * (1 - tax rate)) = WACC
A firm's capital structure consists of 30 percent debt and 70 percent equity. Its bond yield 10 percent, pretax, its cost of equity is 16 percent, and the tax rate is 21 percent. What is its WACC?
13.57% (0.7 * .16) + (0.3 * 0.1 * (1 - 0.21)) = .1357 = 13.57% ((equity % * cost of equity %) + (debt % * yield % * (1 - tax rate)) = WACC
Suppose the risk-free rate is 5 percent, the market rate of return is 10 percent, and beta is 2. Find the required rate of return using the CAPM
15% 5% + (2 * (10% - 5%)) = 15% risk-free rate + (beta * (market rate of return - risk-free rate)) = CAPM
If the risk-free rate is 4 percent, an all-equity firm's beta is 2, and the market risk premium is 6 percent, what is the firm's cost of capital?
16% 4% + 2 * 6% = 16% risk-free rate + all-equity firm beta * market risk premium = cost of capital
If an all-equity firm's beta is 2, the risk-free rate is 3%, and the historical market risk premium is 7%, what is the firm's cost of capital?
17% Re = 3% + 2 * 7% = 17% Note that 7% is the market risk premium, which is (Rm - Rf) cost of capital = risk-free rate + beta * market risk premium
If a firm faces a risk-free rate is 2%, a beta of 1, and a market risk premium of 4%. What is its cost of capital if it is an all-equity firm?
6% Re = 2% + 1 * 4% = 6% Note that 6% is the market risk premium, which is (Rm - Rf) cost of capital = risk-free rate + beta * market risk premium
Sigma Corporation consists of two divisions: A and B. Division A is riskier than Division B. If Sigma Corporation uses the firm's overall WACC to evaluate both Division's projects, which Division will probably not receive enough resources to fund all of its potentially profitable projects?
Division B
If a firm has multiple projects, each project should be discounted using ___.
a discount rate the commensurates with the project's risk
WACC is used to discount ______ _________.
cash flows
The rate used to discount project cash flows is known as the ______.
cost of capital required return discount rate
Which of the following are components used in the construction of the WACC? cost of common stock cost of preferred stock cost of debt cost of accounts payable
cost of common stock cost of preferred stock cost of debt
Which of the following are tax-deductible to the firm? coupon interest paid on bonds dividends paid on common stock principal amounts paid on debt dividends paid on preferred stock
coupon interest paid on bonds
One method for estimating the cost of equity is based on the _________ model.
dividend growth
Finding a firm's overall cost of equity is difficult because:
there is no way of directly observing the return that the firm's equity investors require on their investment