FIN 320F Unit 13
Which of the following are true?
- Ideally, we should use market values in the WACC - Book values are often similar to market values for debt.
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%
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
There are two parts to this problem. This is part 1. NB's managers are concerned about their operating leverage. The forecast sales of 3,500 units and would like to know if they will be profitable at this sales level. The initial investment in the manufacturing facilities for the Ab Stretcher is $500,000, depreciated straight-line over the project's five-year economic life to a $0 salvage value. Sales price is $200 per unit and variable cost per unit is $30. Fixed operating costs are $100,000 per year and their tax rate is 20%. What is NB's break-even point?
Break even point: Depreciation=($500,000-$0)/5=$100,000 Total annual cost=(fixed operating costs+depreciation)(1-TC) =($100,000+$100,000)(1-.20) =$160,000 Contribution margin=(sales price-variable cost per unit)(1-TC) =($200-$30)(1-.20) =$136 Break even point=$160,000/$136 =1,176.47 Ab stretchers
True or False: Projects should always be discounted at the firm's overall cost of capital.
False
If a firm issues no debt, its average cost of capital will equal ____.
Its cost of equity
There are three parts to this question. This is part 1. Natural Bodyworks produces the popular Ab Stretcher that they sell for $200 per unit. NB's total fixed costs (fixed operating costs + depreciation) for the Ab Stretcher are $200,000.Their variable costs are $30 per unit. They are financed entirely by equity and face a 20% corporate tax rate. Given their current production level of 4,000 units what is their Net Operating Income?
NOI at 4000 unit: Sales revenue(4000×200) =$800,000 Less: variable cost(4000×30)=$120,000 Fixed cost. =$200,000 NOI. =$480,000
What is the equation for finding the cost of preferred stock?
Rp=D/P0
The cost of capital depends primarily on the ___ of funds, not the ____.
Use, Source
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
The dividend growth model is only applicable to companies that pay
dividends
The return an investor in a security receives is _____ ____ the cost of the security to the company that issued it.
equal to
If a firm is all-equity, the discount rate is equal to the firm's cost of _______ capital.
equity
Finding a firm's overall cost of equity is difficult because:
it cannot be observed directly
Other companies that specialize only in projects similar to the project your firm is considering are called _____.
pure plays
The formula of the SML is?
r(stock) = rf + RP(market) * B(stock)
The WACC is the overall ________________ the firm must earn on its existing assets to maintain the _______________ of its stock.
return; value
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
For a firm with outstanding debt, the cost of debt will be the ___ on that debt.
yield to maturity
The following are disadvantages of the SML approach
-requires estimation of beta -requires estimation of the market risk premium
Suppose the risk-free rate is 5 percent, the market rate is 10 percent, and beta is 2.Find the required rate of return using the CAPM.
15%
The formula for calculating the cost of equity capital that is based on the dividend discount model is:
Re=D1/P0+g
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 growth rate of dividends can be found using:
- security analysts' forecasts - historical dividend growth rates
To estimate the dividend yield of a particular stock, we need:
- the current stock price - forecasts of the dividend growth rate, g - the last dividend paid, D0
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.
The following are advantages of the SML approach
-adjusts for risk -does not require the company to pay a dividend
The rate used to discount project cash flows is known as the:
-discount rate -required return -cost of capital
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% 3%+7%=10%
Suppose a firm's capital structure consists of 30% debt, 10% preferred stock and 60% equity. The firm's bonds yield 10% on average before taxes, the cost of preferred stock is 8% and the cost of equity is 16%. Calculate the firm's WACC assuming a tax rate of 40%
12.20% 0.6 x 16% +.3 x 10% x (1-.4) +.1 x 8% = 12.20
If a 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 x 6
If a firm is funded with $400 in debt and $1200 in equity, the weight of equity is ____ and the weight of debt is __ to be used to compute the WACC
75%; 25%
Components of the WACC include funds that come from:
Investors
Natural Bodyworks produces the popular Ab Stretcher that they sell for $200 per unit. NB's total fixed costs (fixed operating costs + depreciation) for the Ab Stretcher are $200,000.Their variable costs are $30 per unit. They are financed entirely by equity and face a 20% corporate tax rate. If sales surge to 5,000 units, what is NB's new NOI?
NOI at 5000 unit: Sales revenue(5000×200) =$1,000,000 Less: variable cost(5000×30)=$150,000 Fixed cost. =$200,000 NOI. =$650,000
Natural Bodyworks produces the popular Ab Stretcher that they sell for $200 per unit. NB's total fixed costs (fixed operating costs + depreciation) for the Ab Stretcher are $200,000.Their variable costs are $30 per unit. They are financed entirely by equity and face a 20% corporate tax rate. Did NB's NOI go up or down?
NOI will go up by $170,000. NOI per unit at 4000 unit=480,000/4000=$120 NOI per unit at 5000 unit=650,000/5000=$130 This increase in profit occurred because of fixed cost. As they are fixed, if sales go up then fixed cost per unit goes down . Due to which net operating income increase. Here at 4000 units the fixed cost per unit is $50(200000/4000),but at 5000 level it is $40 (200000/5000). This cost reduction nicely increase operating profit.
What is the required rate of return on a stock (Re), according to the constant dividend growth model, if the growth rate (g) is zero?
Re=D1/P0
The WACC is the minimum required return for _____
The overall firm
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:
WACC = (E/V) x Re + (D/V) x Rd x (1-Tc)
There are two parts to this question. This is part 1. The Wilson Bat Company has, at market value, $300,000 in bonds and $700,000 in stock outstanding. The coupon rate on the debt, which is currently selling at par, is 7%. The company's current stock price is $20, with an equity beta of 1.8 and an expected dividend next year of $1.40 which is expected to grow at 6% indefinitely. The company faces a corporate tax rate of 25%. Wilson is considering purchasing Harrison Balls, Inc. As part of its acquisition research, Wilson has determined that the average beta for ball manufacturers is 1.2. The current risk-free rate is 4%, and the current return on the S&P 500 is 8%. Calculate Wilson's WACC. The CFO directs that in calculating this WACC you are to calculate the equity return using the CAPM.
WACC = 0.09415 or 9.42%
Managers project sales of 3,500 units. Given your calculation of the break-even point in question 4, would you advise NB's to go ahead with the Ab Stretcher?
Yes, the Ab stretcher is expected to be profitable.
There are two parts to this problem. This is part 2. If Wilson can expect a return of 9% on its investment in Harrison, should they complete the purchase?
Yes, the should complete the purchase