FINC 318 Ch 12: The Cost of Capital SmartBook 2.0

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

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 ___.

>cost of capital >required return >discount rate

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 capital depends on the source of the funds.

False

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

Rp = D/P0

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

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

coupon interest paid on bonds

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: RP=D/P0

true

The growth rate of dividends can be found using:

- security analysts' forecasts - historical dividend growth rates

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

D1/P0 + g

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 - T c)

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

equity

Components of the WACC include funds that come from ______ .

investors

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

its cost of equity

The following are disadvantages of the SML approach

>Requires estimation of beta >Requires estimation of the market risk premium

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

>cost of common stock >cost of debt >cost of preferred stock

What can we say about the dividends paid to common and preferred stockholders?

>dividends to common stockholders are not fixed >dividends to preferred stockholders are fixed

Which of the following are true?

>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

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 >it will reject projects that it should have accepted >the firm overall will become riskier

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

false

The formula of the SML is:

RE = Rf + Beta x (RM- Rf)

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

yield to maturity

Preferred stock ___.

>pays dividends in perpetuity >pays a constant dividend

The dividend growth model is 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

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

false

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

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 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 primary disadvantage of the dividend growth model approach is its simplicity.

false

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

it cannot be observed directly

In the WACC calculation, D represents the _________ value of the firm's debt.

market

The most appropriate weights to use in the WACC are the ______ weights.

market value

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

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

risk

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

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

the risk-free rate

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

use; source

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

value

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

value or price

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

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

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

If a firm has multiple projects, each project should be discounted using ___.

a discount rate commensurate with the project's risk

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

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

cannot

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

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

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