new chapter
ULC 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 (assume all interest can be deducted).
$77; $14 greater
The rate used to discount project cash flows is known as the ___.
-required return -discount rate -cost of capital
The average beta across all stocks is equal to
1
If a firm has $10 million of debt with a debt beta of .4 and $30 million of equity with equity beta of 2, then the firm's asset beta is ____.
1.6
If a firm has $15 million of debt with a debt beta of 0.2 and $40 million of equity with equity beta of 2.2, then the firm's asset beta is ____.
1.65
An all-equity firm has a beta of 1.25. If it changes its capital structure to a debt-equity ratio of 0.35, its new equity beta will be ____. Assume the beta of debt is zero.
1.7
According to the Wall Street Journal, the average dividend yield for the stocks that comprise the S&P 500 Index was approximately:
1.8%
A firm's capital structure consists of 40 percent debt and 60 percent equity. The aftertax yield on debt is 2.5 percent and the cost of equity is 15 percent. The project is about as risky as the overall firm. What discount rate should be used to estimate the project's net present value?
10%
If a preferred stock pays a dividend of $2 per year and is selling for $20, its yield is:
10%
MNO preferred stock pays a dividend of $2 per year and has a price of $20. If MNO's tax rate is 40 percent, the required rate of return on its preferred stock is ___ percent.
10%
According to Ibbotson Associates, the average return on one-year Treasury-bills was:
3.5%
If a company has a cost of debt of 6% and a corporate tax rate equal to 22%, what is the after tax cost of debt?
4.68%
WACC was used to compute the following project NPVs: Project A = $75, Project B = -$250, Project C = $110, Project D = -$70. Which projects should the firm accept?
A and C
WACC was used to compute the following project NPVs: Project A = $100, Project B = -$50, Project C = -$10, Project D = $40. Which projects should the firm accept?
A and D
Which of the following is true? A company cannot deduct interest paid on debt when computing taxable income. A company can deduct interest paid on debt up to 30% of EBIT when computing taxable income A company can deduct dividends paid to shareholders when computing taxable income.
A company can deduct interest paid on debt up to 30% of EBIT when computing taxable income
Which of these statements are correct concerning beta?
A firm's beta may change if the firm increases its debt-equity ratio. The sample size used to compute a firm's beta may be inadequate. Betas may vary over time.
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.
Which of the following is tax-deductible to the firm?
Coupon interest paid on bonds
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 factors that affect beta?
Financial leverage Operating leverage The cyclical nature of revenues
Which of the following are true? Fixed costs do not change as quantity changes. Variable costs change with changes in quantity. Fixed costs never change Variable costs never change.
Fixed costs do not change as quantity changes. Variable costs change with changes in quantity.
Which of the following is true about the average beta across all stocks?
It is equal to 1
Which two of these are the best examples of cyclical firms??
Luxury retailers Automakers
The formula for calculating the cost of equity capital that is based on the dividend discount model is ___.
R = (Div/P) + g
The formula for the dividend discount model when the growth rate is zero is ___.
R = div/ P
What is the CAPM formula?
RS = RF + β× (RM- RF)
Which risk-free rate is preferred over the life of the project?
The anticipated average one-year rate
Which of the following securities is generally used most frequently for the risk-free rate?
The one-year T-bill rate
Which of the following variables is NOT required when using the CAPM to compute the cost of equity capital?
The rate of inflation
Which one of the following is true?
Under U.S. tax law, a corporation's interest payments up to 30% of EBIT are tax deductible.
The ______ is the overall expected return the firm must earn on its existing assets to maintain its value if the firm is levered.
WACC
The most appropriate weights to use in the ________ calculation are target market value weights.
WACC
B = the market value of a firm's debt; S = the market value of that same firm's equity; RB = the before-tax yield on the firm's debt; TC = the corporate tax rate; RS = the cost of equity. Given the definitions above, the weighted average cost of capital formula can be written as:
[S/(S+B)]×RS + [B/(S+B)]×RB×(1-Tc)
If a firm has multiple projects, each project should be discounted using ___.
a discount rate commensurate with the project's risk
The weighted-average cost of capital requires the ______-tax cost of debt.
after
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 the current firm
If the operations of a firm are different than its industry, the firm's _______ should be used to estimate the firm's cost of equity capital.
beta
The covariance between the stock and the market index's returns divided by the variance of the market index's returns represents the __________ for a company's stock.
beta
The slope of the characteristic line of a firm's returns versus those of the market is the ___.
beta
Firms whose revenues have high standard deviations ___.
can sometimes have high betas can sometimes have low betas
Dividends paid to common stockholders ______ be deducted from the payer's taxable income for tax purposes.
cannot
Betas are likely to ______ when a firm ______ industries.
change; changes change; does not change
the ______ discount model for a stock can be generalized to the market as a whole.
dividend
One method for estimating the cost of equity is based on the ______ model.
dividend discount
The Wall Street Journal ______ give estimates of the market risk premium.
does not
A cyclical firm is one in which revenues go ______ in the contraction phase of the business cycle.
down
Security analysts typically forecast:
earnings. dividends
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
A firm should only undertake a project if its expected return is ______ that of a financial asset of comparable risk.
equal to or greater than
An increase in a firm' s level of debt is an example of ___.
financial leverage
An increase in ______ will increase beta.
financial leverage operating leverage
The beta of a new project may be ______ the beta of existing pure play firms since it is likely to be more responsive to economy wide movements.
greater than
The equity beta of a levered firm will always be ______ the equity beta of an otherwise identical all-equity firm.
greater than
As a firm replaces variable costs with fixed costs, its cyclicality will:
increase
Cyclicality ______ the same as variability.
is not
There ______ a fixed relationship between standard deviation and beta.
is not
A firm with debt in its capital structure is said to be:
levered
The most appropriate weights to use in the WACC are ______ value weights.
market
Academics have long preferred using the historical market risk premium for its ____.
objectivity
A firm's cost of debt can be ___.
obtained by checking yields on publicly traded bonds obtained by talking to investment bankers estimated more easily than its cost of equity
Changes in _________leverage and _______ leverage will affect beta.
operating financial
Other companies that specialize only in projects similar to the project your firm is considering are called ___.
pure plays
When using the WACC to value an acquisition, one assumes debt-equity ratio will:
remain constant
A project should only be accepted if its return is above what is ___.
required by investors
The CAPM can be used to estimate the ___.
required return on equity
Dividends and capital gains given to the new shareholders represent ______ to the shareholders.
returns
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 correct discount rate on a project ______ the expected return on a financial asset of comparable risk.
should be
For debt, book values and market values are typically:
similar
The cost of capital is an appropriate name since a project must earn enough to pay those who ______ the capital.
supply
The most appropriate weights to use in the WACC are the ______ weights.
target market
When valuing a firm with the weighted average cost of capital, the ________ value of the firm can be estimated by assuming a constant perpetual growth rate for cash flows beyond the horizon.
terminal
The discount rate for the firm's projects equals the cost of capital for the firm as a whole when all projects have ______ risk as the firm.
the same
The firm's cost of equity capital is ______ the required rate of return to the shareholders.
the same as
True or false: Dividend payments on preferred stock are not tax deductible.
true
The beta of the portfolio is a ______ average of the betas of the individual items in the portfolio.
weighted
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
What are the after-tax earnings for HIJ Corporation if it reports $200 in revenue, $90 in operating expenses, has a tax rate of 30%, and pays $20 in interest on its bonds (assume all interest is tax deductible).
$63
A firm's target capital structure weights are evenly split between debt and equity. What is the firm's target debt-equity ratio?
1
The weighted average cost of capital (WACC) formula, for a firm with no debt or preferred stock will have a WACC of:
1 × Cost of equity
If the firm issued so much debt that its equity was valueless, its average cost of capital would equal ___.
1 × the aftertax cost of debt
If a preferred stock pays a dividend of $3 per year and is selling for $25, its yield is:
12%
A firm's capital structure consists of 30 percent debt and 70 percent equity. Its bonds yield 10 percent, pretax, its cost of equity is 16 percent, and the tax rate is 40 percent. What is its WACC?
13%
Suppose the risk-free rate is 5 percent, the market rate of return is 10 percent, and beta is 2. Find the required rate of return using the CAPM.
15%
If the 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%
An all-equity firm has a beta of 2. If it changes its capital structure to a debt-equity ratio of 0.25, its new equity beta will be ____. Assume the beta of debt is zero.
2.5
Assume these market averages: dividend growth rate = 10 percent; average market dividend yield = 3 percent; average 1-year T-bill rate = 2 percent. What is the cost of equity capital for a firm with a beta of 2?
24%
Suppose a firm has a target debt-equity ratio of 2.5. What is the firm's target capital structure weight for common stock?
28.57%
If a company has a cost of debt of 8% and a corporate tax rate equal to 35%, what is the after tax cost of debt?
5.2%
Previously, a firm issued bonds at par with a 6 percent coupon. Today, similar bond yields are 8 percent and the risk-free rate is 3 percent. What is the embedded cost of the firm's debt?
6%
Which of the following is generally true about firm betas and industry membership?
Betas can change even when a firm remains in the same industry. Betas are likely to change when a firm changes industries
Which of the following variables do we need to compute the beta for a company's stock?
The covariance between the stock and the market index's returns. The variance of the market index's returns.
Which of the following are the more likely sources for a firm's forecasts of the market risk premium?
The firm's own subjective forecast A consensus of forecasts Value Line
Suppose Bill's Burgers is considering acquiring Ken's Kampground. Ken's is not publicly traded, so Bill's estimates Ken's future cash flows and calculates the value of Ken's using its own (Bill's) WACC. What assumption of the WACC method is Bill's violating?
The use of Bill's WACC assumes Ken's has the same business risk as Bill's.
Which of the following are true about U.S. Treasury instruments?
They are not expected to default at this time. They have never defaulted.
Which of the following is true about security analysts?
They are sometimes employees of investment banking houses. They are sometimes employees of money management firms.
True or false: Other companies that specialize only in projects similar to the project your firm is considering are called pure plays.
True
Through standard regression technique, the intercept is commonly called ________
alpha
If a firm increases its level of debt, its beta will ___.
also increase
Dividends and capital gains given to the new shareholders represent ______ to the firm.
costs
U.S. Treasury securities considered to be risk-free because they have minimal, if any, ____ risk.
default
Regression analysis on stock returns against the risk premium on the market can be used to estimate the ______ beta of a levered firm.
equity
The asset beta is the beta of common stock had the firm been all _______
equity
When using regression analysis with stock returns as inputs, the _______ beta is estimated.
equity
if the firm is all ______, the discount rate is equal to the firm's_____ of equity capital
equity cost
If the operations of a firm are different than its industry, the ______ beta should be used to estimate the firm's cost of equity capital.
firm's
There is often a trade-off between a firm's ______ costs and its variable costs.
fixed
_______ costs do not change as the quantity sold changes while, ______ costs do change as the quantity sold changes.
fixed variable
A firm with a given sales cyclicality will increase its beta if ________ costs replace _______ costs in its production process.
fixed; variable
Which two of the following are the best examples of non cyclical goods?
milk diapers
The sales of cyclical firms are ______ sensitive to the business cycle than are the sales of non-cyclical firms.
more
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
The ____ of the characteristic line of a stock's returns versus those of the market measures the stock's systematic risk.
slope beta
If a firm uses its overall cost of capital to discount cash flows from higher risk projects, it will accept ______ projects.
too many high-risk
If a firm uses its overall cost of capital to discount cash flows from higher risk projects, it will reject ______ projects.
too many low-risk
True or false: The correct discount rate on a project should be the expected return on a financial asset of comparable risk.
true
True or false: The dividend discount model for a stock can be generalized to the market as a whole.
true
True or false: The rate of return required by shareholders is the same as the firm's cost of equity capital.
true
Which of the following are true? Book values are often similar to market values for debt. Ideally, we should use market values in the WACC. Book values are often similar to market values for equity Ideally, we should use book values in the WACC.
Book values are often similar to market values for debt. Ideally, we should use market values in the WACC.
the ______ can be used to estimate the required return on equity.
CAPM
True or false: The most appropriate weights to use in the WACC are book value weights.
false
Some academics, in defending the dividend discount model, point out that returns in the long run can only come from ___.
future dividend growth the current dividend yield
When valuing a complete business enterprise, the same process that is used for individual projects can be used. However, the analysis is complicated because a _________ must be used, and a terminal firm value must be determined.
horizon
A firm's beta may change if the debt-equity ratio of a firm:
increases decreases
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
Preferred stock ___.
pays a constant dividend pays dividends in perpetuity
A point above the SML line represents a project with a ______ NPV for an all-equity firm..
positive
The difference between the expected return on the market portfolio and the risk-free rate is the market risk _______
premium
If the expected return of a project is below that of a financial asset of comparable risk, the firm should ______ the project.
reject
Suppose Bill's Burgers has estimated EBIT of $154 million, depreciation expense is estimated to be $25 million, and interest expense is estimated to be $10 million. If the restaurant industry has an average EV/EBITDA multiple of 15, estimate Bill's terminal value.
$2,685 million
A company has a borrowing rate of 15% and a tax rate of 30%. What is its aftertax cost of debt (assume all interest is tax deductible)?
10.5%
If 20-year Treasury-bonds yield 5 percent, and if the term premium is 2 percent what is the average one-year interest rate expected to be over the next 20 years?
3%
Previously, a firm issued bonds at par with a 3% coupon. Today, similar bond yields are 6% and the risk-free rate is 2%. What is the embedded cost of the firm's debt?
3%
Suppose a firm faces a risk-free rate of 2%, a beta of 1, and a market risk premium of 4%. What is its cost of capital if it is an all-equity firm?
6%
A company has a borrowing rate of 8% and a tax rate of 22%. What is its after tax cost of debt (assume all interest is tax deductible)?
6.2%
If the risk-free rate is 3 percent, the market risk premium is 7 percent, the industry beta is 1, and the firm beta is 2, the cost of equity will be ____ percent less if the industry beta is used instead of the firm beta.
7
About _______ percent of U.S. companies use the CAPM in capital budgeting.
75
A firm's capital structure consists of 30% debt and 70% equity. The after tax yield on debt is 3.5% and the cost of equity is 12%. The project is about as risky as the overall firm. What discount rate should be used to estimate the project's net present value?
9.45%
To estimate the terminal value, one can use:
EV/EBITDA
True or false: The CAPM is the only method to compute the cost of equity.
False
A complication in selecting the right industry beta is ___.
classifying the firm's industry
The discount rate of a project is said to be its ______ of capital
cost
Generally, which is easier to determine?
cost of debt
If a point plotted above the security market line (SML) represents a project being considered by an all-equity firm, the project's IRR must be greater than the cost of ______.
equity capital
True or false: A high beta always goes along with a high standard deviation.
false
True or false: If a firm stays in the same industry, its beta will never change.
false
True or false: Projects should always be discounted at the firm's overall cost of capital.
false
Financial leverage _____ risk to the firm's equity.
increases
Alpha is the ______ of the characteristic line of a stock's returns versus those of the market.
intercept
If the firm issued so much debt that its equity was valueless, its average cost of capital would equal ___.
its cost of debt
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
Which of the following are determinants of beta?
operating leverage financial leverage cyclicality of revenues
The weighted average cost of capital (RWACC) is the overall expected return the firm must earn on its existing assets to maintain its ___.
value
There is often a trade-off between a firm's fixed costs and its ______ costs.
variable
