LearnSmart Ch 12 Conceptual Questions

ULC and LEV have earnings before interest & taxes of $110. LEV has $20 of interest expense. Both companies are taxed at 30%, ULC's after tax earnings are _______, which is ________ than LEV's after tax earnings.

$77; $14 greater

If capital structure is evenly split between debt & equity, what is the ratio?

1

What's true about betas?

1) Betas vary over time. 2) The sample size used to compute a firm's beta may be inadequate. 3) A firm's beta may change if the firm increases its D/E ratio.

What causes a firm's beta to change over time?

1) Change in leverage 2) Change in technology or product line NOT change in betas of other companies (generally aren't related).

Three ways to estimate growth rate of dividends:

1) Historical dividend growth rates 2) Retention ratio * ROE 3) Security analysts' forecasts

Firm's cost of debt can be:

1) obtained by talking to IBers 2) estimated more easily than its cost of equity 3) obtained by checking yields on publicly traded bonds. NOT taking PV of tax shields from fixed A.

If a firm's earnings growth is 7% and the dividend yield is 3%, its cost of equity is:

10% 7% growth + dividend yield 3%

If a 20-year T-bond yields 5% & the term premium is 2%, what is the average 1 year interest rate expected to be over the next 20 years?

3%. 5% bond yield - 2% interest rate

WACC is the minimum return a company needs to earn to satisfy:

Bondholders + stockholders. WACC is the overall expected return the firm must earn on existing assets to maintain its value.

Which are components in the construction of WACC?

Cost of debt, equity (common stock), preferred stock.

Some academics point out that returns in the LR can only come from ________. (Div. Discount Model)

Current dividend yield & future dividend growth. NOT increases in Rf rate or changes in a firm's beta.

Dividend discount model with zero growth:

Div/P

What is the average beta across all stocks?

Equal to 1, NOT unmeasurable or between 0.75 and 1.25.

What type of return does CAPM focus on?

Expected returns, NOT real returns (net of inflation) or actual returns.

When a new project constitutes its own industry, comparing the values of its _____ to comparable firms should help determine an appropriate beta:

Financial leverage, cyclicality of revenues, operating leverage

Important ADVANTAGE of a firm raising equity internally = not having to pay _______

Flotation costs, NOT capital gains/dividends

To apply the Div Discount Model to a particular stock, you need to estimate the:

Growth rate & dividend yield, NOT beta/Rf rate.

To estimate a firm's equity cost of capital using CAPM, we need to know the:

Market risk premium, Rf rate, stock's beta. NOT annual dividend amount.

What is true about betas?

NOT a) Betas don't change over time. NOT b) They are more likely to change if the firm remains in the same industry. Betas change over time & are more likely to be stable if the firm stays in the same industry.

Academics have long preferred using historical market risk premium for its ________.

Objectivity, NOT subjectivity.

What are factors affecting beta?

Operating leverage, financial leverage, cyclical nature of revenues. NOT changes in market risk premium.

Preferred stock: a) pays a constant dividend b) pays dividends in perpetuity c) has a fixed maturity d) does not pay dividends

Pays a constant dividend, has dividends in perpetuity. Generally does not have fixed maturity.

CAPM formula

R(s) = Rf + β[E(RM)-Rf]

If a firm's target DE ratio is 2.5, what is the firm's target capital structure weight for common stock?

S/(S+B) = 1/3.5 = 28.57%

What is true?

T: BV are often similar to MV for debt and ideally, we should use MV in the WACC. F: BV are often similar to MV for equity and we should use BV in WACC.

Which two Rf rates are preferred over the life of a project?

T: Rate that matches the maturity of the project & the average 1 yr rate anticipated over the life of the project. F: Historical average 30 year T-bond rate & current 1 yr T-bill rate.

What is true about security analysts?

T: Sometimes employees of IB houses or money management firms. F: Only study individual securities/bonds.

Project's NPV without flotation costs if $1M and flotation costs are $50k. What is the true NPV?

True NPV = NPV - flotation costs $1M - $50K = $950,000

Firm's capital structure is 40% debt & 60% equity. After tax yield on debt is 2.5% and cost of equity is 15%. Project is about as risky as the overall firm. What discount rate should be used to estimate the project's NPV?

Use WACC = (0.4 * 2.5%) + (0.6 * 15%) = 10%.

Market Risk Premium formula

[E(RM)-Rf]

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

a discount rate commensurate with the project's risk NOT the firm's overall cost of capital/average cost of capital/marginal cost of capital for the latest project.

The ______ of the characteristic line of a stock's returns vs those of the market measures the stock's systematic risk.

beta, slope NOT width/length

Flotation costs are costs incurred to:

bring new security issues to the market, NOT keep a firm in business.

Firms whose revenues have high SDs:

can sometimes have either high/low betas.

U.S. Treasury securities considered Rf because the have minimal (if any) ________ risk.

default

Cyclical firm revenues go ______ in the contraction phase of business cycle.

down

A firm has 20% debt, flotation costs 5%, equity flotation costs of 10%, wants to raise $9,100 (not including flotation costs). What are the flotation costs?

f(0) = (0.2*5%) + (0.8*10%) = 9%. $9100/(1-0.9) - $9100 = $900.

Firms should only accept project is exp. return is ______ that of a financial asset of comparable risk.

greater than/equal to

If a firm issues no debt, its WACC =

its cost of equity, NOT its dividend yield

A point above the SML represents a project with a ______ NPV for an all-equity firm.

positive

When valuing a firm with the WACC, the ______ value of the firm can be estimated by assuming a constant perpetual growth rate for CF beyond the horizon

terminal

Term premium for long periods is positive because the term structure of interest rates typically slopes:

upward, NOT in an S-shape.

Equity Risk Premium formula

β[E(RM)-Rf]

What is true about U.S. Treasury instruments?

T: They have never defaulted and aren't expected to default at this time. F: Are completely free of the risk of default. T-bills are perfectly risk free, T-bonds aren't.

If the operations of a firm are fundamentally different from its industry, the _____ beta should be used to estimate the firm's cost of equity capital.

firm's, NOT industry's or market's.

Equity beta of a levered firm will always be ______ the equity beta of an otherwise identical all-equity firm.

greater than; financial leverage adds risk to the firm's equity (because some CF belongs to debt holders).

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

Dividends to preferred stockholders are fixed; to common stockholders aren't fixed. They are generally guaranteed for preferred stock holders but not common stock holders. Preferred stock dividends DO NOT change every year based on earnings of firm.

Which are cyclical firms? (gas stations, automakers, grocery chains, luxury retailers)

ONLY automakers and luxury retailers are cyclical; the others are fairly stable because they are still needed/used even in economic downturn.

Which of the following variables do we need to compute the beta for a company's stock?

T: The covariance between stock & market index's returns and the variance of the market index's returns. F: Covariance between the stock and industry index's returns and the correlation between stock's returns & CPI index.

Which is true: a) Under US tax law, a corporation's interest payments are tax deductible b) Under US tax law, all company interest payments are taxable to the company.

T: Under US tax law, a corporation's interest payments are tax deductible.