Valuation methods and cost of capital

Question 1

constant growth dividend discount model (dividend growth model)

Answer 1

a method of arriving at the value of the stock by using expected dividends per share and discounting them back to present value

= last dividend paid x (1 + growth rate) / (discount rate - dividend growth rate)

only use when dividends are growing at a constant rate

Question 2

Steps in the two-stage dividend discount model

Answer 2

1. Calculate and sum the present value of the dividends in the period of high growth
2. Calculate the present value of the stock based on the period of steady growth, discounting the value back to year 1
3. Sum the totals calculated in Step 1 and 2.

Question 3

preferred stock valuation

Answer 3

dividend per share / cost of capital

Question 4

component cost of debt

Answer 4

the after-tax interest rate on the debt

effective rate x (1.0 - marginal tax rate)

Question 5

component cost of preferred stock

Answer 5

cash dividend on preferred stock / market price of preferred stock

Question 6

component cost of common stock

Answer 6

cash dividend on common stock / market price of common stock

Question 7

weighted-average cost of capital

Answer 7

a single composite rate of return on its combined components of capital

weights are based on the components’ respective market values

Question 8

WACC formula

Answer 8

weight x component cost summed for all components

Question 9

What does the optimal capital structure model hold?

Answer 9

shareholder wealth maximization results from minimizing the weighted-average cost of capital

Question 10

cost of new debt

Answer 10

annual interest / net issue proceeds

Question 11

cost of new preferred stock

Answer 11

next dividend / net issue proceeds

Question 12

cost of new common stock

Answer 12

(next dividend / net issue proceeds) + dividend growth rate

Question 13

what is the after-tax cost of preferred stock that sells for $5 per share and offers a $0.75 dividend when the tax rate is 35%

Answer 13

15%

The component cost of preferred stock is the dividend yield, i.e., the cash dividend divided by the market price of the stock ($.75 ÷ $5.00 = 15%). Preferred dividends are not deductible for tax purposes.

Question 14

The weighted-average cost of capital is equal to the

Answer 14

rate of return on assets that covers the costs associated with the funds employed

Question 15

A major homebuilder will use lumber to build a large development of homes next year. If the homebuilder plans to buy the lumber next year, it can hedge its future costs if it

Answer 15

Buys a lumber futures contract today that expires next year.

Question 16

what is a cash flow hedge

Answer 16

an instrument designated as hedging the exposure to variability in expected future cash flows attributed to a particular risk

i.e. buying a wheat futures contract to protect against price fluctuation of wheat