FIN 305 Chapter 12 Learnsmart

True or false: Finding the cost of equity is fairly straightforward.

False: It is difficult because there is no way to directly observe the return that the firm's equity investors require on their investment.

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.

Formula for the cost of preferred stock

RP = D/P0

WACC is used to discount ______.

cash flows

The return an investor in a security receives is ______ the cost of the security to the company that issued it.

equal to

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

Components of the WACC include funds that come from ______ .

Investors

Given V = E + D, if we divide both E and D by ________ we can calculate the capital structure weights.

V

For a firm with outstanding debt, the cost of debt will be the ______ on that debt.

Yield to Maturity

he 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 that of the firm overall

WACC

is the minimum return a company needs to earn to satisfy all it's investors.

Finding a firm's overall cost of equity is difficult because ______.

it cannot be observed directly

The most appropriate weights to use in the WACC are the ______ weights. Multiple choice question. book value

market value

The WACC of a firm reflects the ___________and the target capital structure of the firm's existing assets as a whole.

risk

It is difficult to establish discount rate for individual projects, so firms often adopt an approach that involves making _________adjustments to the overall WACC.

subjective

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 that collect and store data

The WACC is the minimum required return for ______.

the overall firm

Which of the following is true about a firm's cost of debt?

-Yields can be calculated from the observable data. -It is easier to estimate than the cost of equity

The formula of the SML is ______.

RE = Rf + Beta x (RM- Rf)

True or false: The discount rate is also known as the expected return.

falseL It is known as the required return, appropriate discount rate, and cost of capital.

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

Some risk adjustment to a firm's WACC for projects of differing risk, even if it is subjective, is probably ______.

tter than no risk adjustment

Which of the following are components used in the construction of the WACC?

-cost of common stock -cost of preferred stock -cost of debt

The rate used to discount project cash flows is known as the ______.

-cost if capital -required return -discount rate

To estimate a firm's equity cost of capital using the SML approach, we need to know the ______

-market risk premium -risk-free rate -stocks beta

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 should have been rejected -it will reject project that is should have accepted

True or false: The return an investor in a security receives is equal to the cost of the security to the company that issued it.

True

What is the appropriate discount rate to use only if the proposed investment is a replica of the firm's existing operating activities?

WACC

Other companies that specialize only in projects similar to the project your firm is considering are called ______.

Pure Plays

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

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 − TC)

Weighted Average Cost of Capital (WACC)

expected rate of return on a portfolio of all the firm's securities, adjusted for tax savings due to interest payments

The formula for calculating the cost of equity capital that is based on the dividend discount model is ______.

RE = D1/P0 + g