Finance SB 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/V) × RP

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 growth rate of dividends can be found using:

- security analysts' forecasts - historical dividend growth rates

The following are advantages of the SML approach

Adjusts for risk Does not require the company to pay a dividend

True or false: For publicly traded companies, the component of the dividend yield that must be estimated is the dividend.

False

True or false: In the WACC calculation, V = E - D.

False

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 formula for calculating the cost of equity capital that is based on the dividend discount model is:

RE = D1/P0 + g

The formula of the SML is:

RE = Rf + Beta x (RM- Rf)

What is the equation for finding the cost of preferred stock?

RP=D/P0

The following are disadvantages of the SML approach

Requires estimation of the market risk premium Requires estimation of beta

True or false: RP=D/P0

True

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 - T c)

Dividends paid to common stockholders ______ be deducted from the payer's taxable income for tax purposes.

cannot

Which of the following is tax-deductible to the firm?

coupon interest paid on bonds

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

equal to

True or false: 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

True or false: The SML approach is advantageous because all it requires is estimation of beta.

false

True or false: The cost of capital depends on the source of the funds.

false

True or false: The expected percentage is the overall rate of return the firm must earn on its existing assets to maintain the value of its stock.

false

True or false: The growth rate of dividends can be found using the CAPM.

false

Components of the WACC include funds that come from ______ .

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.

market value

Preferred stock ___.

pays a constant dividend pays dividends in perpetuity

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

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

required return discount rate cost of capital

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

risk

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 firm's often adopt an approach that involves making ___ adjustments to the overall WACC

subjective

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

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

The WACC is the overall rate of return the firm must earn on its existing assets to maintain the ___ of its stock

value

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

yield to maturity

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

Cost of debt Cost of preferred stock Cost of common stock

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.

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:

adding these two components

The dividend growth model is applicable to companies that pay

dividends

In the WACC calculation, D represents the ___ value of the firms debt

market

The cost of capital depends primarily on the ______ of funds, not the _____.

use; source

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

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

True statements

The market value of debt and equity are not reliable in case of privately owned company. Ideally, we should use market values in the WACC.

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

V

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

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 that of the firm overall

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

True or false: Conglomerates are companies that specialize only in projects similar to the project your firm is considering.

false

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

false

True or false: Projects should always be discounted at the firm's overall cost of capital.

false

True or false: The cost of equity is D1/P0 minus the analysts' estimates of growth.

false

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

false

True or false: The primary disadvantage of the dividend growth model approach is its simplicity.

false

To estimate the dividend yield of a particular stock, we need:

forecasts of the dividend growth rate, g; the last dividend paid, D0; the current stock price

What will happen over time if a firm uses its overall WACC to evaluate all projects, regardless of each project's risk level?

it will accept projects that it should have rejected the firm overall will become riskier It will reject projects that it should have accepted

If a firm issues no debt, its average cost of capital will equal ___.

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

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

pure plays

According to the CAPM, what is the expected return on a stock if its beta is equal to zero?

the risk-free rate

If the firm is all-equity, the discount rate is equal to the firm's cost of ______ capital.

equity

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