Corporate Finance Chapter 12
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/(E+D)] × RP (V/P) × RP (P/V) × RP
(P/V) × RP
The growth rate of dividends can be found using: historical dividend growth rates the perpetuity model the capital asset pricing model security analysts' forecasts
- security analysts' forecasts - historical dividend growth rates
The following are advantages of the SML approach Requires estimation of the market risk premium Adjusts for risk Requires estimation of beta Does not require the company to pay a dividend
Adjusts for risk Does not require the company to pay a dividend
Dividends paid to common stockholders ______ be deducted from the payer's taxable income for tax purposes. can should may cannot
Cannot
Which of the following are components used in the construction of the WACC Cost of accounts payable Cost of common stock Cost of debt Cost of preferred stock
Cost of common stock Cost of debt Cost of preferred stock
The dividend growth model is applicable to companies that pay ______
Dividends
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
T/F: Conglomerates are companies that specialize only in projects similar to the project your firm is considering.
False
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
Which of the following are true? -Ideally, we should use book values in the WACC. -Ideally, we should use market values in the WACC. -The market value of debt and equity are not reliable in case of privately owned company. -Book values are often similar to market values for equity.
Ideally, we should use market values in the WACC. The market value of debt and equity are not reliable in case of privately owned company.
In the WACC calculation, D represents the ________ value of the firm's debt
Market
The formula for calculating the cost of equity capital that is based on the dividend discount model is: RE = D1/P0 + g RE = D0/P1 + g RE = D1/P0 - g RE = (D1/P0)/g
RE = D1/P0 + g
What is the equation for finding the cost of preferred stock RP=D(1+g)/P0 RP=P0/D RP=D/P0
RP=D/P0
The WACC of a firm reflects the ________ and the target capital structure of the firm's existing assets as a whole.
Risk
Given V = E + D, if we divide both V and D by ________, we can calculate the capital structure weights.
V
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. Yields can be checked by using the DDE model.
Yields can be calculated from observable data It is easier to estimate than the cost of equity.
If a firm has multiple projects, each project should be discounted using ___ the firm's overall cost of capital the average cost of capital the marginal cost of capital for the latest project a discount rate commensurate with the project's risk
a discount rate commensurate with the project's risk
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: multiplying the components by the inflation rate multiplying these two components. adding these two components. subtracting the first from the second.
adding these two components.
Some risk adjustment to a firm's WACC for projects of differing risk, even if it is subjective, is probably: an irreducible absurdity better than no risk adjustment preferred over the pure play approach uncalled for
better than no risk adjustment
The rate used to discount project cash flows is known as the ___ cost of capital market rate discount rate required return
cost of capita discount rate required return
Components of the WACC include funds that come from ______ investors accruals non-cash expenses
investors
If a firm issues no debt, its average cost of capital will equal ___. its cost of equity its dividend yield its cost of debt half the sum of the cost of debt and equity
its cost of equity
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 ___. does not pay dividends pays a constant dividend pays dividends in perpetuity will never be repaid
pays a constant dividend pays dividends in perpetuity
Other companies that specialize only in projects similar to the project your firm is considering are called __ conglomerates matched pairs pure plays knock-offs
pure plays
To estimate a firm's equity cost of capital using the CAPM, we need to know the __ risk-free rate annual dividend amount stock's beta market risk premium
risk-free rate stock's beta market risk premium
SmartKids, a textbook publisher, is considering investing in a software company that collects and stores data. What beta should SmartKids use to assess the risk of the project? the beta for software companies as a whole the beta for SmartKids the beta for software companies that collect and store data the beta for the textbook industry as a whole
the beta for software companies that collect and store data
What will happen over time if a firm uses its overall WACC to evaluate all projects, regardless of each project's risk level? -the firm overall will become riskier -it will accept projects that it should have rejected -It will reject projects that it should have accepted -the firm's risk will not change over time -using the firm's WACC to evaluate all projects is appropriate
the firm overall will become riskier it will accept projects that it should have rejected It will reject projects that it should have accepted
The WACC is the minimum required return for _______ a firm's stockholders a firm's bondholders the NYSE the SEC the overall firm
the overall firm
What does WACC stand for? Working amount of corporate cost Weighted average cost of capital Weighted average company cost Working amount of corporate cash
weighted average cost of capital
For a firm with outstanding debt, the cost of debt will be the ________ on that debt.. coupon rate yield to maturity current yield average yield
yield to maturity
The following are disadvantages of the SML approach Adjusts for risk Does not require the company to pay a dividend Requires estimation of beta Requires estimation of the market risk premium
Adjusts for risk Does not require the company to pay a dividend
Which of the following is tax-deductible to the firm? Dividends paid on preferred stock Principal amounts paid on debt Dividends paid on common stock Coupon interest paid on bonds
Coupon interest paid on bonds
What can we say about the dividends paid to common and preferred stockholders? -Dividends to preferred stockholders are fixed. -Dividends are guaranteed for both preferred and common stockholders. -Dividends to common stockholders are not fixed. -Preferred stock dividends change every year based on the earnings of the firm
Dividends to preferred stockholders are fixed Dividends to common stockholders are not fixed.
T/F: Projects should always be discounted at the firm's overall cost of capital.
False
T/F: The SML approach is advantageous because all it requires is estimation of beta
False
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
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
Finding a firm's overall cost of equity is difficult because: it cannot be observed directly it requires the use of differential equations the federal government refuses to disclose equity costs it can only be guessed at
it cannot be observed directly
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: accepted, as it should be accepted, when it should be rejected rejected, as it should be rejected, when it should be accepted
rejected, when it should be accepted
To estimate the dividend yield of a particular stock, we need: the current stock price the last dividend paid, D0 forecasts of the dividend growth rate, g the risk-free rate from a bank's CD rates beta from the Wall Street Journal
the current stock price the last dividend paid, D0 forecasts of the dividend growth rate, g
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 the optimal number of too few
too many
The return an investor in a security receives is ______ _____ the cost of the security to the company that issued it less than greater than unrelated to equal to
Equal to
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
The formula of the SML is: RE = Rf + Beta x (RM- Rf) RE = Rf + Beta/(RM+ Rf) RE = Rf - Beta + RM- Rf
RE = Rf + Beta x (RM- Rf)
T/F: RP=D/P0
True
The cost of capital depends primarily on the ______ of funds, not the _____. use; cost use; source source; use source; cost
use; source
