WACC Smartbook

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

Ideally, we should use market values in the WACC. (True/False).

TRUE

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 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

WACC is used to discount Blank______.

cash flows

A firm's overall cost of capital will include both its cost of_____________capital and equity capital.

debt

The cost______ of can be observed because it is the interest rate the firm must pay on new loans.

debt

Finding a firm's overall cost of equity is (straightforward/difficult).

difficult

To apply the dividend growth model to a particular stock, you need to assume that the firm's ___ will grow at a constant rate.

dividend

One method for estimating the cost of equity is based on the ______ model.

dividend growth

The most well-known approach to company performance evaluation is the _____ method.

economic value added

MNO preferred stock pays a dividend of $2 per year and has a price of $20. If MNO's tax rate is 21 percent, the required rate of return on its preferred stock is found by which formula?

$2/$20

The SML approach requires estimates of:

- market risk premium - beta coefficient

The cost of capital depends primarily on the __________(use/source) of funds.

Use

the weighted average cost of capital formula can be written as: Multiple choice question.

[S/(S + B)] × RS + [B/(S + B)] × RB × (1 − Tc)

The best way to include flotation costs is to ___.

add them to the initial investment

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

cannot

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

Projects that have the same risk are said to be in the same _____.

risk class

The cost of capital is an appropriate name since a project must earn enough to pay those who ______ the capital.

supply

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

use; Source

Including preferred stock in the WACC adds the term:

(P/V) × RP

A firm's cost of debt can be ___.

*obtained by checking yields on publicly traded bonds *estimated easier than its cost of equity *obtained by talking to investment bankers

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.

preferred stock___

-pays a constant dividend -pays dividends in perpetuity

Preferred stock ___.

-pays dividends in perpetuity -pays a constant dividend

The growth rate of dividends can be found using _____.

-security analysts' forecasts -historical dividend growth rates

To estimate the expected return on a risky asset, we need to know the ___.

-stock's beta -market risk premium -risk-free rate

A firm has a target debt-equity ratio of .5, but it plans to finance a new project with all debt. What debt-equity ratio should be used when calculating the project's flotation costs?

.5

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

Coupon interest paid on bonds

Sigma Corporation consists of two divisions: A and B. Division A is riskier than Division B. If Sigma Corporation uses the firm's overall WACC to evaluate both Divisions' projects, which Division will probably not receive enough resources to fund all of its potentially profitable projects?

Division B

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

False

The formula for the required return from the SML is:

RE = Rf + B(RM − Rf)

In addition to CAPM, the cost of equity can be determined using the dividend growth model and the _____ approach.

SML

Capital______ weights can be interpreted just like portfolio weights.

Structure

A company can deduct interest paid on debt when computing taxable income.(TRUE or FALSE)

TRUE

Which is true of flotation costs in calculating WACC?

They are relevant cash flows.

Economic value added (EVA) is a means of evaluating corporate performance.

True

The WACC is the weighted average of the cost of equity and the _____.

aftertax cost of debt

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

Flotation costs are costs incurred to ____.

bring new security issues to the market

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

market value

The_______ ,_________ approach is the use of a WACC that is unique to a particular project, based on companies in similar lines of business.

pure play

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

Which of the following are true?

Ideally, we should use market values in the WACC. Book values are often similar to market values for debt.

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

RE = D1/P0 + g

The underlying key assumption, and oftentimes a key disadvantage, of the dividend growth model is that it assumes the dividend _____.

grows at a constant rate

When discounting the cash flows of a project at the WACC to estimate NPV, we need to find an alternative in the financial markets that is _____ as the given project.

in the same risk class

In reality, most firms cover the equity portion of their capital spending with ___.

internally generated cash flow

A project should only be accepted if its return is above what is ___.

required by investors

The market value cost of debt is often Blank______ the book value cost of debt.

similar to

With the use of the _____________, Correct Unavailable approach to estimating WACC, the firm's WACC may change through time as economic conditions change.

subjective

What does WACC stand for?

weighted average cost of capital

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

Which of the following methods for calculating the cost of equity ignores risk?

The dividend growth model

Which of the following variables is not required to calculate the expected return on a risky asset?

The rate of inflation

Using the SML approach, what is the expected return on a stock if its beta is equal to zero?

The risk-free rate

If a firm has two divisions and one division is riskier than the other, what would be the potential result if the firm used its overall WACC to evaluate the projects in both divisions?

The riskier division's projects will typically receive full funding and the less risky division's projects will often be incorrectly rejected.

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

equal to

The issuance costs of bonds and stocks are referred to as ______ costs.

flotation

An important advantage to a firm raising equity internally is not having to pay ___.

flotation costs

True or false: Projects should always be discounted at the firm's overall cost of capital. T/F

False

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

a discount rate that commensurates with the project's risk.

Under U.S. tax law, a corporation's interest payments are deductible for tax purposes.(true/false)?

TRUE