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Business Finance Chapter 14 Notes 1. WACC is used to discount cash flows. 2. The return an investor in a security receives is equal to the cost of the security to the company that issued it. 3. The cost of capital depends on the use of funds, not the source of funds. 4. Which of the following are components used in the construction of the WACC? a. Cost of preferred stock b. Cost of debt c. Cost of common stock 5. Finding a firm's overall cost of equity is difficult because there is no way of directly observing the return that the firm's equity investors require on their investment. 6. The WACC is the minimum return a company needs to earn to satisfy _____. a. its stockholders b. its bondholders 7. True: The return an investor in a security receives is equal to the cost of the security to the company that issued it. 8. 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 9. A firm's overall cost of capital will include both its cost of debt, capital and equity capital. 10. To estimate the expected return on a risky asset, we need to know the ___. a. market risk premium b. risk-free rate c. stock's beta 11. Using the SML approach, what is the expected return on a stock if its beta is equal to zero? The risk-free rate - plugging zero in as beta: E(RE) = RF + 0 * (E(RM) − Rf) = Rf 12. The formula for calculating the cost of equity capital that is based on the dividend discount model is: RE = D1/P0 + g 13. Which of the following variables is not required to calculate the expected return on a risky asset? The rate of inflation 14. A firm's cost of debt can be ___. a. obtained by checking yields on publicly traded bonds b. obtained by talking to investment bankers c. estimated easier than its cost of equity 15. The formula for the required return from the SML is: RE = Rf + B(RM − Rf) 16. Preferred stock ___. a. pays dividends in perpetuity b. pays a constant dividend 17. What does WACC stand for? Weighted average cost of capital 18. The most appropriate weights to use in the WACC are the market value weights. 19. Which of the following is true? A company can deduct interest paid on debt when computing taxable income. 20. Which of the following is false? a. A company cannot deduct interest paid on debt when computing taxable income. b. A company can deduct dividends paid to shareholders when computing taxable income. 21. Which of the following are tax-deductible to the firm? Coupon interest paid on bonds 22. The cost of debt can be observed because it is the interest rate the firm must pay on new loans. 23. 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 24. What can we say about the dividends paid to common and preferred stockholders? a. Dividends to common stockholders are not fixed. b. Dividends to preferred stockholders are fixed. 25. The market value cost of debt is often similar to the book value cost of debt. 26. Capital structure weights can be interpreted just like portfolio weights. 27. 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 in the same risk class as the given project. 28. Which one of the following is true? Under U.S. tax law, a corporation's interest payments are deductible for tax purposes. 29. True: Economic value added (EVA) is a means of evaluating corporate performance. 30. Dividends paid to common stockholders cannot be deducted from the payer's taxable income for tax purposes. 31. If a firm has multiple projects, each project should be discounted using: a discount rate that commensurate with the project's risk. 32. The projects should only be evaluated using the firm's overall WACC if the risk of the project is the same as the risk of the overall firm. 33. Including preferred stock in the WACC adds the term: (P/V) × RP 34. If a firm uses its overall cost of capital to discount cash flows from higher risk projects, it will accept too many high-risk projects. 35. 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. Division A is riskier, so its cash flows should be discounted at a higher rate. Because they're not, the projects in Division A will look better than those in Division B. Division B's cash flows will be discounted using a higher rate than should be used, so they will appear less appealing and will be more often rejected. 36. 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, because Projects B and C have negative NPVs so they should be rejected. 37. Other companies that specialize only in projects similar to the project your firm is considering are called pure plays. 38. The most well-known approach to company performance evaluation is the economic value added (EVA) method. 39. 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. 40. False: Projects should always be discounted at the firm's overall cost of capital. 41. Projects' discount rates should reflect their particular level of risk. 42. The issuance costs of bonds and stocks are referred to as flotation costs. 43. 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. 44. If the project's beta is less than the firm's overall beta, its cost of capital will be less than the overall cost of capital, and if the overall cost of capital is used, the project's cash flows will be discounted too severely, leading to the possible rejection of a value creating project. 45. The best way to include flotation costs is to add them to the initial investment. 46. 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. 47. An important advantage to a firm raising equity internally is not having to pay flotation costs. 48. The pure play approach is the use of a WACC that is unique to a particular project, based on companies in similar lines of business. 49. With the use of the subjective approach to estimating WACC, the firm's WACC may change through time as economic conditions change. 50. Flotation costs are costs incurred to bring new security issues to the market. 51. 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? 52. 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 (When calculating flotation costs, the target debt-equity ratio should be used.) 53. In reality, most firms cover the equity portion of their capital spending with internally generated cash flow. 54. The percent of investment that the project costs can be referred to as all of the following, except: free cash flow 55. A firm’s target capital structure represents: a fixed debt-equity ratio that the company attempts to maintain. Problems 1. Suppose a corporation issued a 30-year annual, 8 percent bond, 10 years ago. The bond is currently selling for 95 percent of its face value, or $950. What is the corporation’s cost of debt? 8.53% Calculator Key Strokes: N 20 I/Yr PV ? (950) 8.53% PMT 80 FV 1000 Let’s calculate the yield. We can use a financial calculator to calculate the yield. This is an annual bond. N, or the number of years, would be 20, which is 30 years minus the 10 years already passed. The present value or price of the bond is $950. The coupon rate is 8%, so the payment is $80. The future value for most bonds is $1,000, unless otherwise stated. 2. Suppose a corporation issued a 20-year annual, 7 percent bond, 10 years ago. The bond is currently selling for 92 percent of its face value, or $920. What is the corporation’s cost of debt? 8.20% Calculator Key Strokes: N 10 I/Yr PV ? (920) 8.20% PMT 70 FV 1000 Let’s calculate the yield. We can use a financial calculator to calculate the yield. This is an annual bond. N, or the number of years, would be 10, which is 20 years minus the 10 years already passed. The present value or price of the bond is $920. The coupon rate is 7%, so the payment is $70. The future value for most bonds is $1,000, unless otherwise stated. 3. For the Dividend Growth Model, the equation can be written as follows: P0 = =D1/(RE – g). How can this equation be rearranged? RE = (D1/P0) + g 4. If ABC corporation paid a dividend of $6 per share last year. The stock currently sells for $80 per share. You estimate that the dividend will grow steadily at a rate of 6% per year into the indefinite future. What is the cost of equity? 13.95% 5. What is the cost of equity for the TMB Corporation based on the following information? 11.50% Risk premium = 5% Risk free rate = 4% TMB beta: 1.50 RTMB = Rf + ßTMB × (RM - Rf) = 4% + 1.50 × 5% = 11.50% 6. The required return of preferred stock is equal to the dividend yield on the preferred stock. 7. DEF Corporation had two issues of ordinary preferred stock with a $100 par value traded on the NYSE. One issue paid $5.56 annually per share and sold for $95.55 per share. The other paid $5.88 per share annually and sold for $97.50 per share. What is DEF’s Corporation’s cost of preferred stock? 5.93% Using the first issue: Rp = D/P0 = $5.56/95.55 = .0582, or 5.82% Using the second issue: Rp = $5.88/97.50 = .0603 = 6.03% So, DEF’s cost of preferred stock would be about 5.93 percent (the average of the two issues). 8. What is the pure play approach? Using a WACC that is based on companies in similar lines of business. 9. What is the subjective approach? Using a WACC that involves making subjective adjustments based upon the project. 10. Starbucks wants to use the subjective approach to evaluate a new project. They are considering expanding their stores and renting office space to small business owners. They will have a separate reception area and online scheduling for those that want to use the office space. Starbucks has a WACC of 12%. What would be the WACC for this new project? 18% This project would qualify as a new product and would be considered in the High risk category. Thus, the WACC for the project would be 12% + 6% = 18%. Category High risk Moderate risk Examples New products Cost savings, Expansion of existing products Low risk Mandatory Replacement of existing equipment Safety equipment Adjustment Factor 6% 0 (4) n/a 11. If a firm has a cost of equity of 15 percent, and the firm is 100 percent equity financed. The firm is contemplating a $150 million expansion of its existing operations, funded by selling new stock. Flotation costs will run 10 percent of the amount issued. When flotation costs are considered, what is the cost of expansion? $166.67 million $150 million = (1 − .10) × Amount raised Amount raised = $150 million/.90 = $166.67 million The firm’s flotation costs are $16.67 million, and the cost of expansion is $166.67 million. 12. BBQ Corporation has a target capital structure that is 70 percent equity, 30 percent debt. The flotation costs for equity issues are 15 percent of the amount raised; the flotation costs for debt are 8 percent. If BBQ needs $150 million for a new manufacturing facility, what is the cost when flotation costs are considered? $172.22 million Weighted average flotation costs = (E/V) × fE + (D/V) × fD = .70(.15) + .30(.08) = 0.129 = 12.9% Cost of Expansion = $150 million/(1 −.129) = $172.22 million flotation costs = $22.22 million 13. Food Shoppe Galore had the following information: Total market value of a company’s stock: $650 million Total market value of the company’s debt: $150 million The combined market value is $800 million. E/V = 650/800 = 81.25% D/V = 150/800 = 18.75% What is the weighted average of the company’s debt? 18.75% 14. ABC Corporation has 2.8 million shares of stock outstanding. The stock currently sells for $50 per share. The firm’s debt is publically traded and was recently quoted at 95 percent of its face value. It has a total face value of $10 million, and it is currently priced to yield 12 percent. The risk-free rate is 5 percent, and the market risk premium is 7 percent. You’ve estimated that ABC has a beta of 1.25. If the corporate tax rate is 35 percent, what is the WACC of ABC Corporation? 13.38% EQUITY: Cost of equity capital: .05 + 1.25(.07) = .1375 = 13.75% Total value of equity = 2.8 million × $50 = $140 million DEBT: Cost of debt capital: The pretax cost of debt is the current yield to maturity on the outstanding debt, 12%. Total value of debt: .95 × $10 million = $9.5 million Total market value of equity and debt = $140 million + $9.5 million = $149.5 million WACC = (E/V) × RE + (D/V) × RD × (1 − TC) = (140/149.5) × .1375 + (9.5/149.5) × (.12) × (1 − .35) = (.9365) × .1375 + (.0635)(.12)(1 − .35) = .1288+ .0050 = .1338 = 13.38%