Financial Policies FINAL Ch 13
A project's NPV w/o flotation costs are $1 million. Its flotation costs are $50k. What is the true NPV?
$950,000
WACC formula for firm with no debt or preferred stock:
1 x cost of equity
Terminal value calculation:
1. EBITDA = EBIT + dep exp 2. EV/EBITDA ratio = terminal value
true or false: A high beta always goes along with a high standard deviation.
False
Formula for calculating cost of equity capital based on dividend discount model __________.
R = (Div/P) + g
Formula for dividend discount model when growth rate is 0
R = Div/P
An important advantage to a firm raising equity internally is not having to pay __________.
flotation costs
A firm needs to sell enough equity to raise $950,000 after cover the Flotation costs of 5%. How much are flotation costs?
$950,000 = amt raised x (1-.05) Amt raised = $1,000,000 Flo. costs = 1m - 950k = $50,000
Which are true?
- BVs are often similar to MVs for debt - MVs are used in WACC as market reflects current values
Which of the following is true about the WACC?
- It is also referred to as the disc rate that is used to discount CFs in cap budgeting problems - It represents the marginal cost of capital
Advantages of the CAPM over the DDM?
- adjusts for risk - applicable to companies with no dividends
Whats true about Betas and industries?
- betas are likely to change when a firm changes industries - can change even when a firm remains in same industry
Firms whose revenues have high standard deviations __________.
- can sometimes have low or high betas
If a point plotted above the SML represents a project being considered by an all-equity firm, the projects IRR must be greater than the cost of ________.
- capital - equity
The rate used to discount project CFs is known as the __________.
- cost of capital - discount rate - required return
A firm's cost of debt can be __________.
- estimated more easily than its cost of equity - obtained by checking yields on publicly traded bonds - obtained by talking to investment bankers
To apply the dividend discount model to a particular stock, you need to estimate the __________.
- growth rate and dividend yield
When a new project constitutes its own industry, comparing the values of its __________ to comparable firms should help determine an appropriate beta.
- operating leverage - financial leverage - cyclicality of revenues
Which of the following is true about security analysts?
- sometimes employees of investment banking houses and money mgt firms
Must know what to calculate firm's cost of capital using CAPM:
- stocks beta - Rf rate - mkt risk premium
Some academics, in defending the dividend discount model, point out that returns in the long run can only come from __________.
- the current dividend yield - future dividend growth
Likely sources of a firm's forecasts of the market risk premium:
- the firm's own subjective forecast - a consensus of forecasts - value line
The growth rate of dividends can be estimated using __________.
- the retention ratio x ROE - historical dividend growth rates - security analysts' forecasts
Which of the following variables do we need to compute the beta for a company's stock?
- the variance of the market index's returns - the covariance between the stock and the market index's returns
True about US treasury instruments:
- they have never defaulted - they are not expected to default at this time
To estimate the dividend yield of a particular stock, we can __________.
- use security analysts' forecasts - multiply last year's dividend by (1 + g)
Which is true?
- variable costs change with changes in quantity - FC do not change as quantity changes
What do we need to compute Beta for a company's stock?
- variance of the markets index returns - covariance between the stock and the market index's returns
What do we know about the stability of a firm's beta?
-Betas can change over time -betas are more likely to be stable if the firm remains in the same industry.
Previously a firm issued bonds at par with 6% coupon. Today, similar bond yields are 8% and Rf rate is 3%. What is the embedded cost of the firm's debt?
6%
About __________ percentage of US companies use the CAPM in capital budgeting.
75%
The beta of a new project may be greater than the beta of existing pure play firms since it is likely to be more responsive to __________.
economy wide movements
Firm should only undertake a project if its expected return is _____ that of a fin asset of comparable risk.
equal to or greater than
If the firm is all-equity, the discount rate is equal to the firm's cost of __________ capital.
equity
Regression analysis on stock returns against the risk premium on the market can be used to estimate the __________ beta of a levered firm
equity
Firm has 20% debt, debt flotation costs = 5%, equity flotation costs = 10%, firm wants to raise $9,100, not including flotation costs. What are flotation costs?
f = .2 x 5% + .8 x 10% = 9% 9100/(1-.09) - 9100 = $900
An increase in a firms level of debt is an example of __________.
financial leverage
A firm with a given sales cyclicality will increase its beta if __________ costs replace costs in its production process.
fixed; variable
The equity beta of a levered firm will always be __________ the equity beta of an otherwise identical all-equity firm.
greater than
An increase in a firm's level of debt _______ its beta
increases
If the operations of a firm are similar to its industry, the __________ beta should be used to estimate the firm's cost of equity capital
industry's
Alpha is the __________ of the characteristic line of a stock's returns vs those of the market.
intercept
True about average beta across all stocks?
it is equal to 1
If the firm issued so much debt that its equity was valueless, its average cost of capital would equal __________.
its cost of debt or 1 x the aftertax cost of debt
If a firm issues no debt, its average cost of capital will equal ________.
its cost of equity
If a firm issues no debt, its average cost of capital will equal __________.
its cost of equity
The industry beta may be a better estimate than the firm's own beta due to the __________ standard error of the firm estimate.
larger
Use __________ weights in the WACC.
market
The CAPM appears to contain less __________ than does the DDM.
measurement error
The sales of cyclical firms are ______ sensitive to the business cycle than are the sales of non cyclical firms.
more
The diff between the exp return on the mkt portfolio and the Rf rate is the market risk ....
premium.
Other companies that specialize only in projects similar to the project your firm is considering are called __________.
pure plays
CAPM can be used to estimate the __________.
required return on equity
Dividend yield formula:
stock price/ preferred stock dividend
The most appropriate weights to use in the WACC are the __________ weights.
target market
What security is generally used for the Rf rate?
the one-year T-bill rate
Firm's cost of equity capital is __________ the required rate of return on the shareholders.
the same as
A firm uses its overall cost of capital to discount CFs from higher risk projects, it will accept __________ projects.
too many high-risk
The WACC is the overall expected return the firm must earn on its existing assets to maintain its _________.
value
A firm has a target d-e ratio of .5, but it plans to finance a new project with all debt. What d-e ratio should be used when calculating the project's flotation costs?
.5
MNO preferred stock pays a dividend if $2 per year and has a price of $20. If MNO's tax rate is 40%, the required rate of return on its preferred stock is __________ percent.
10%
Average dividend yield for stocks that compromose the S&P 500 Index was approx:
2.1%
An all-equity firm has a beta of 2. If it changes its capital structure to a debt-equity ratio of .25, its new equity beta will be __________. Assume the beta of debt is zero.
2.5
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 __________.
3% + 7% = 10%
Cost of capital equation?
Rf rate + (all equity firm's beta x market risk premium)
Required rate of return formula using the CAPM?
Rf rate + (beta x (mkt rate of return - Rf rate))
Suppose a firm has a target d-e ratio of 2.5. What is the firm's target capital structure weight for common stock?
S/(S+B) = 1/3.5 = 28.57%
True of False: The divd discount model for a stock can be generalized to the market as a whole.
True
True or False: The correct discount rate on a project should be the expected return on a financial asset of comparable risk.
True
UCL and LEV have earnings before interest and taxes of $110. LEV also has $20 of interest expense. Both companies are taxed at 30%, ULC's aftertax earnings are __________, which is __________ than LEV's aftertax earnings.
ULC = $110 x (1-.3) = $77 LEV = $90 x (1-.3) = $63 $14 greater
Which of the following is true?
Under US tax law, a corporation's interest payments are tax deductible
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
If a firm has multiple projects, each project should be discounted using __________.
a disc rate commensurate with the project's risk
Best way to include flotation costs:
add them to initial investment
Cyclical firms: (non stable sales)
automakers luxury retailers
The __________ of the line of a stocks return versus those of the mkt measures the stocks systematic risk.
beta and slope
Flotation costs are costs incurred to ...
bring new security issues to the market
Dividends to common stockholders __________ be deducted from the payer's taxable income for tax purposes.
cannot
A complication in selecting the right industry beta is __________
classifying the firm's industry
Dividends and cap gains given to the new shareholders represent the __________ to the firm.
costs