Chap12- Risk, Cost of Capital, and Valuation Flashcards
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
What is true about U.S. Treasury instruments?
- They are not expected to default at this time.
- They have never defaulted.
The WACC is the minimum return a company needs to earn to satisfy___.
- its stockholders
- its bondholders
The sales of cyclical firms are ___ sensitive to the business cycle than are the sales of non-cyclical firms.
more
The market risk premium is defined as ____.
=Rm-Rf
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
Examples of cyclical firms?
- Luxury retailers
- automakers
Examples of non-cyclical firms?
- Gas stations
- Grocery chains
U.S. Treasury securities considered to be risk-free because they have minimal, if any, ____ risk.
default
Projects should always be discounted at the firm’s overall cost of capital. True/False
FALSE
What can we say about the dividends paid to common and preferred stockholders?
-Dividends to preferred stockholders are fixed.
Dividends to common stockholders are not fixed.
Suppose a firm has a target debt-equity ratio of 2.5. What is the firm’s target capital structure weight for common stock?
S/(S+B) = 1/3.5 = 28.57%
On what type of returns does the CAPM focus?
Expected returns
To estimate a firm’s equity cost of capital using the CAPM, we need to know the ___.
- stock’s beta
- market risk premium
- risk-free rate
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 return
A company can deduct interest paid on debt when computing taxable income. True/False
TRUE
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?
=4%+2x6% = 16%
What do we know about the stability of a firm’s beta?
- Betas are more likely to be stable if the firm remains in the same industry.
- Betas can change over time.
- The sample size used to compute a firm’s beta may be inadequate
- A firm’s beta may change if the firm increases its debt-equity ratio.
Preferred stock ___.
- pays dividends in perpetuity
- pays a constant dividend
The weighted average cost of capital (Rwacc) is the overall expected return the firm must earn on its existing assets to maintain its ____.
value
Flotation costs are costs incurred to ___.
bring new security issues to the market.
ULC and LEV have earnings before interest and taxes of $110. LEV also has $20 of interest expense. Both companies are taxed at 30 percent, ULC’s aftertax earnings are ____, which is ___ than LEV’s aftertax earnings.
$77;$14 greater
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
The formula for the dividend discount model when the growth rate is zero is ___.
R= Div/P
Which of these statements are correct concerning beta?
- the sample size used to compute a firm’s beta may be inadequate
- a firm’s beta may change if the firm increases its debt-equity ratio
- Betas may vary over time
What are components used in the construction of the WACC?
- cost of debt
- cost of common stock
- cost of preferred stock
What is the CAPM formula?
Rs=Rf+Bx(Rm-Rf)
If a firm stays in the same industry, its beta will never change. True/False
FALSE
If a firm issues no debt, its average cost of capital will equal ___.
its cost of equity
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
To apply the dividend discount model to a particular stock, you need to estimate the ___.
- growth rate
- dividend yield
What is NOT required when using the CAPM to compute the cost of equity capital?
the rate of inflation
For both academics and practitioners, the pendulum has swung over to the ___ for estimating the cost of equity capital.
CAPM
To estimate the dividend yield of a particular stock, we can ___.
- use security analysts’ forecasts
- multiply last year’s dividend by (1+g)
The slope of the characteristic line of a firm’s returns versus those of the market is the ___.
beta
A firm’s cost of debt can be ___.
- obtained by checking yields on publicly traded bonds
- estimated more easily than its cost of equity
- obtained by talking to investment bankers
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.
What does WACC stand for?
Weighted average cost of capital
If the firm issued so much debt that its equity was valueless, its average cost of capital would equal ___.
its cost of debt.
What securities is generally used most frequently for the risk-free rate?
The one-year T-bill rate
Which of the following are factors that affect beta?
- operating leverage
- the cyclical nature of revenues
- financial leverage
The growth rate of dividends can be estimated using ____.
- security analysts’ forecasts
- historical dividend growth rates
- the retention ratio x ROE
What are likely sources for a firm’s forecasts of the market risk premium?
- the firm’s own subjective forecast
- value line
- a consensus of forecasts
What is true about security analysts?
- They are sometimes employees of investment banking houses.
- They are sometimes employees of money management firms
The most appropriate weights to use in the WACC are the ____ weights.
target market value
According to the CAPM, what is the expected return on a stock if its beta is equal to zero?
The risk-free rate
Examples of non cyclical goods.
- milk
- diapers
The issuance costs of bonds and stocks are referred to as ____ costs.
flotation
A project should only be accepted if its return is above what is ___.
required by investors
Firms whose revenues have high standard deviations____.
- can sometimes have high betas
- can sometimes have low betas
What can cause a firm’s beta to change over time?
- changes in leverage
- changes in technology
- changes in product line
If a preferred stock pays a dividend of $2 per year and is selling for $20, its yield is…
2/20=$10
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 ___.
economywide movements
What is true about caluclated WACC.
- Ideally, we should use market values in the WACC
- Book values are often similar to market values for debt.
If the operations of a firm are fundamentally different from its industry, the ___ beta should be used to estimate the firms cost of equity capital.
firm’s
According to the CAPM, what is the expected return on a stock it its beta is equal to zero?
the risk-free rate
The average beta across all stocks…
is equal to 1.
In reality, most firms cover the equity portion of their capital spending with___.
internally generated cash flow.
The equity beta of a levered firm will always be ___ the equity beta of an otherwise identical all-equity firm.
greater than
If a firm’s retention ratio is 80 percent and its ROE is 5 percent, then the dividend growth rate is ___.
80%x5% = 4%
Which of the following are factors that affect beta?
- Financial leverage
- The cyclical nature of revenues
- Operating leverage
If a firm increases its level of debt, its beta will___.
also increases
A firm needs to raise $950,000 but will incur flotation costs of 5 percent. How much will it pay in flotation costs
$950000=amount raised x (1 - .05)
amount raised = $1,000,000
flotation costs = $1,000,000 - 950,000 = $50,000
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
Dividend payments on preferred stock are not tax deductible. True/Falso
TRUE
The rate used to discount project cash flows is known as the …
- cost of capital
- discount rate
- required return
If the retention ratio is 60 percent and ROE is 20 percent, then the growth rate of dividends is…
12%
The cost of capital is an appropriate name since a project must earn enough to pay those who ___ the capital.
supply
When a new project constitutes its own industry, comparing the values of its ___ to comparable firms should help determine an appropriate beta.
- cyclicality of revenues
- operating leverage
- financial leverage
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?
WACC= .4x2.5%+.6x15%=10%
If a firms 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
What is true about fixed and variable costs?
- Variable costs change with changes in quantity
- Fixed costs do not change as quantity changes
If an analyst’s forecast for a firm’s earnings growth is 7 percent, and its divident yield is 3 percent, its cost of equity will be___.
3%+7%=10%
A firm with a given sales cyclicality will increase its beta if ___ costs replace ___ costs in its production process.
fixed;variable
The firm’s cost of equity capital is ___ the required rate of return to the shareholders.
the same as
The industry beta may be a better estimate than the firm’s own beta due to the ____ standard error of the firm estimate.
larger
An important advantage to a firm raising equity internally is not having to pay___.
flotation costs
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%
A complication in selecting the right industry beta is ___.
classifying the firm’s industry
An asset beta is a ___ average of the debt and equity betas of that asset.
weighted
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 aftertax WACC?
(.07x.16)+(0.3x.1x(1-.04)) = .13 or 13%
Other companies that specialize only in projects similar to the project your firm is considering are called ___.
pure plays
Assume these market averages: dividend growth rate=10 percent; average market dividend yield=3 percent; average 1-year T-bill rate=2percent. What is the cost of equity capital for a firm with a beta of 2?
Rm=3%+10=13%
Cost of Capital = 2% + 2(13% - 2%) = 24%
