Deck 11: Risk-Adjusted Expected Rates of Return and the Dividends Valuation Approach

Question 1

One rationale for using expected dividends in valuation is

A) Dividends are a necessary payment in order for a firm to have value.
B) Dividends are paid in cash, and cash serves as a measurable common denominator for comparing the future benefits of alternative investment opportunities.
C) Dividends are the most reliable measure of value because most companies payout dividends to shareholders.
D) Dividend payout ratios are set based on profitability.

Answer 1

B

Question 2

If a firm has a market beta of 0.9,is subject to an income tax rate of 35 percent,has a risk-free rate of 6 percent,a market risk premium of 7 percent,and has a market value of debt to market value of equity ratio of 60 percent,what does the market expect the firm to generate in terms of equity returns using CAPM?

A) 6%
B) 7%
C) 12.3%
D) 13%

Answer 2

C

Question 3

Which of the following is not a problem with using a dividend-based valuation formula

A) dividends are arbitrarily established
B) dividends represent a transfer of wealth to shareholders
C) some firms do not pay a regular periodic dividend
D) it is a challenge to forecast the final liquidating dividend

Answer 3

B

Question 4

Zonk Corp. The following data pertains to Zonk Corp.,a manufacturer of ball bearings (dollar amounts in millions):
Determine the weight on equity capital that should be used to calculate Zonk's weighted-average cost of capital:

A) 21.7%
B) 78.3%
C) 41.8%
D) 50%

Question 5

Equity valuation models based on dividends,cash flows,and earnings have been the topic of many theoretical and empirical research studies in recent years.All of the following are true regarding these studies except:

A) share prices in the capital markets generally correlate closely with share value
B) share prices do not always equal share values
C) temporary deviations of price from value occur
D) unexpected changes in earnings, dividends, and cash flows do not correlate closely with changes in stock prices

Question 6

Zonk Corp. The following data pertains to Zonk Corp.,a manufacturer of ball bearings (dollar amounts in millions):
Assume that Zonk is a potential leveraged buyout candidate.Assume that the buyer intends to put in place a capital structure that has 70 percent debt with a pretax borrowing cost of 14 percent and 30 percent common equity.Compute the revised equity beta for Zonk based on the new capital structure.

A) 1.24
B) 4.77
C) 4.34
D) 3.91

Question 7

When deriving the equity value of a firm,an analyst forecasts the real dividends expected to be paid in the future.In this case,which discount rate should be used?

A) The nominal rate of return
B) The real rate of return
C) The risk free rate of return
D) The risk adjusted rate of return

Question 8

Zonk Corp. The following data pertains to Zonk Corp.,a manufacturer of ball bearings (dollar amounts in millions):
Assume that Zonk is a potential leveraged buyout candidate.Assume that the buyer intends to put in place a capital structure that has 70 percent debt with a pre tax borrowing cost of 14 percent and 30 percent common equity.Compute the weighted average cost of capital for Zonk based on the new capital structure.

A) 20.63%
B) 12.56%
C) 13.01%
D) 9.94%

Question 9

Investors typically accept a lower risk-adjusted rate of return on debt capital than on equity capital because

A) debt is typically less risky because fixed claims bear less residual risk than equity claims.
B) equity bears less residual risk than debt.
C) equity capital costs are tax deductible.
D) the yield to maturity on equity is inversely related to its market value

Question 10

In theory,the value of a share of common equity is the present value of ____________________________________________________________.
the expected future dividends

Question 11

Zonk Corp. The following data pertains to Zonk Corp.,a manufacturer of ball bearings (dollar amounts in millions):
Assuming that riskless rate is 4.2% and the market premium is 6.2% calculate Zonk's cost of equity capital:

A) 10.4%
B) 7.69%
C) 11.89%
D) 2.0%

Question 12

Equity-based valuation models are based on all metrics except

A) dividends
B) cash flow
C) working capital
D) earnings

Question 13

With respect to dividends and priority in liquidation,what has priority over common stock?

A) treasury stock
B) debt capital
C) preferred stock
D) nonconvertible common equity

Question 14

Zonk Corp. The following data pertains to Zonk Corp.,a manufacturer of ball bearings (dollar amounts in millions):
Determine the weight on debt capital that should be used to calculate Zonk's weighted-average cost of capital:

A) 21.7%
B) 78.3%
C) 50%
D) 58.2%

Question 15

Returns on systematic risk-free securities (like U.S.Treasury securities)should exhibit what type of correlation with returns on a diversified marketwide portfolio of stocks?

A) nearly perfect correlation.
B) perfect correlation.
C) no correlation.
D) Unable to tell without specifics about the portfolio.

Question 16

Zonk Corp. The following data pertains to Zonk Corp.,a manufacturer of ball bearings (dollar amounts in millions):
Using the above information,calculate Zonk's weighted-average cost of capital:

A) 11.5%
B) 11.89%
C) 7.48%
D) 10.90%

Question 17

Under the cash-flow-based valuation approach,free cash flows can be used instead of dividends as the expected future payoffs to the investor in the numerator of the general valuation model because:

A) this approach focuses on earnings as a measure of the capital that a firm creates.
B) over the life of the firm, the free cash flows into the firm and cash flows paid out of the firm in dividends to shareholders will be equivalent.
C) over the life of the firm, the free cash flows out of the firm for investments and cash flows paid into the firm in dividends from these investments will be equivalent.
D) this approach focuses on wealth distribution to shareholders.

Question 18

Firm-specific factors that increase the firm's nondiversifiable risk include all of the following except:

A) exposure to interest rate changes
B) exposure to inflation
C) exposure to management competence
D) exposure to cyclicality

Question 19

The historical discount rate of the firm may be a good indicator of the appropriate discount rate to apply to the firm in the future,when all of the following conditions hold true except:

A) The current risk of the firm is the same as the expected future risk of the firm.
B) Expected future interest rates are likely to equal current interest rates.
C) The existing capital structure of the firm is the same as the expected future capital structure of the firm.
D) The current mix of debt and equity financing is equal.

Question 20

All of the following are steps in the analysis and valuation framework used to understand the fundamentals of a business and determine estimates of its value except:

A) Analyze the firm's strategy in terms of the competition.
B) Assess the quality of the firm's accounting and financial reporting.
C) Derive forecasts of future earnings from the firm's projected financial statements.
D) Obtain the national ranking of the firm's external auditors.

Question 21

In what case will using dividends expected to be paid to shareholders yield the same valuation for the firm as using free cash flows expected to be generated by the firm?

Question 22

Identify the types of firm-specific factors that increase a firm's nondiversifiable risk (systematic risk).Identify the types of firm-specific factors that increase a firm's diversifiable
risk (idiosyncratic risk or nonsystematic risk).Why do models of risk-adjusted expected
returns include no expected return premia for diversifiable risk?

Question 23

In some valuation scenarios,such as a leveraged buyout,it may be necessary to adjust the market equity beta to reflect a ________________________________________.
new capital structure

Question 24

The CAPM computes expected rates of return on common equity capital using the following model:
E[R_Ej] = E[R_F] + b_j x {E[R_M] - E[R_F]}
What are the roles of each of the three components of this model?

Question 25

Implementing a dividend valuation model to determine the value of the common shareholders' equity requires an analyst to measure three elements.What are the three elements that the analyst needs to measure?

Question 26

To determine the appropriate weights to use in the weighted average cost of capital,an analyst will need to determine the ______________________________ of the debt,preferred stock and common equity capital.

Question 27

If dividend projections include the effect of inflation,then the discount rate used should be a ____________________ rate.

Question 28

Bridgetron
An analyst wants to value the sum of the debt and equity capital of the firm and is provided with the following information:
An analyst wants to value the common shareholders' equity of Bridgetron,compute the relevant cost of capital that should be used.

Question 29

Why are dividends value-relevant to common equity shareholders?

Question 30

Under the assumption of clean surplus accounting,how would you compute total dividends paid to common equityholders in order to value the firm?

Question 31

Dividends measure the cash that ____________________ ultimately receive from investing in an equity share.

Question 32

Because the market equity beta reflects the level of operating leverage,financial leverage,variability of sales,and other characteristics of a firm,there are situations where an analyst might have to adjust the beta because of changes in the capital structure.A situation that might require an analyst to estimate a new levered beta is a ___________________________________.

Question 33

Provide the rationale for using expected dividends in a valuation model.

Question 34

Suppose a firm has a market beta of 1.34 and the risk free interest rate is 5.3%.In addition,the excess return over the risk-free rate is 5.9%.Calculate the firm's cost of equity capital using the CAPM model.

Question 35

Explain why analysts and investors use risk-adjusted expected rates of return as discount rates in valuation.Why do risk-adjusted expected rates of return increase with risk?

Question 36

One criticism in using the CAPM to calculate the cost of equity capital is that ______________________________ and the __________________________________________________ are quite sensitive to the time period and methodology used in their computation.

Question 37

A company with a market beta of 1 has systemic risk ____________________ to the average amount of systemic risk of all equity securities in the market.

Question 38

Why do investors typically accept a lower risk-adjusted rate of return on debt capital than equity capital? Suppose a stable,financially healthy,profitable,tax-paying firm that has been
financed with all equity and no debt decides to add a reasonable amount of debt to its capital
structure.What effect will that change in capital structure likely have on the firm's
weighted average cost of capital?

Question 39

Normally,valuation methods are designed to produce reliable estimates of the value of a firm's ______________________________.

Question 40

Explain the theory behind the dividends valuation approach.Why are dividends value-relevant to common equity shareholders?

Question 41

The following financial statement data pertains to Outside,Inc.,a manufacturer of men's outerware (dollar amounts in millions):
Required:
a.Calculate the company's cost of equity capital.
b.Calculate the weight on debt capital that should be used to determine Outside's weighted-average cost of capital.
c.Calculate the weight on equity capital that should be used to determine Outside's weighted-average cost of capital.
d.Calculate Outside's weighted-average cost of capital.

Question 42

Conceptually,why should an analyst expect the dividends valuation approach to yield equivalent value estimates to the valuation approach that is based on free cash flows available to be distributed to common equity shareholders?

Question 43

For each of the following companies,determine the total dividends paid to common equity holders in order to value the firm:

Question 44

The following financial statement data pertains to Northridge,Inc.,a manufacturer of women's outerware (dollar amounts in millions):
Required:
a.Calculate the company's cost of equity capital.
b.Calculate the weight on debt capital that should be used to determine Northridge's weighted-average cost of capital.
c.Calculate the weight on equity capital that should be used to determine Northridge's weighted-average cost of capital.
d.Calculate Northridge's weighted-average cost of capital.

Question 45

For each of the following scenarios determine the value as of the beginning of 2012 of the continuing dividend:

Question 46

The dividends valuation approach measures value-relevant dividends to encompass various transactions between the firm and the common shareholders.What transactions should the analyst include in value-relevant dividends for purposes of implementing the dividends valuation model? Why?

Question 47

Carr Industries must raise $100 million on January 1,2012 to finance its expansion into a new market.The company will use the money to finance construction of four retail outlets and a distribution center.The stores are expected to open later this year.The CFO has come up with three alternatives for raising the money:
1)Issue $100 million of 8% nonconvertible debt due in 20 years.
2)Issue $100 million of 6% nonconvertible preferred stock (100,00 shares).
3)Issue $100 million of common stock (1 million shares).
The company's internal forecasts indicate the following 2012 year-end amounts before any option is chosen:
Carr has no preferred stock outstanding but currently has 10 million shares of common stock outstanding.EPS has been declining for the past several years.Earnings in 2011 were $1 per share,which was down from $1.10 during 2010,and management wants to avoid another decline during 2012.One of the company's existing loan agreements requires a debt-to-equity ratio to be less than 2.Carr pays taxes at a 40% rate.
Required:
1.Assess the impact of each financing alternative on 2012 EPS and the year-end debt to equity ratio.
2.Which financing alternative would you recommend and why?

Question 48

Watson manufactures and sells appliances.Intro develops and manufactures computer technology.Trenton operates general merchandise retail stores.Selected data for these companies appear in the following table (dollar amounts in millions).For each firm,assume that the market value of the debt equals its book value.
Required
a.Assume that the intermediate-term yields on U.S.Treasury securities
are roughly 3.5 percent.Assume that the market risk premium is 5.0 percent.
Compute the cost of equity capital for each of the three companies.
b.Compute the weighted average cost of capital for each of the three companies.
c.Compute the unlevered market (asset)beta for each of the three companies.
Calculating the Cost of Capital.(Dollar Amounts in Millions)

Question 49

The following data pertain to Loren Corporation (dollar amounts in thousands):
Using this information,calculate the following:
a.Loren Corporation's cost of equity capital
b.The weight on debt capital that should be used to calculate Loren's weighted-average cost of capital.
c.Loren Corporation's weighted-average cost of capital

Question 50

Why is the dividends valuation approach applicable to firms that do not pay periodic (quarterly or annual)dividends?

Question 51

According to the text,dividends are value-relevant even though the firm's dividend policy is irrelevant.How can that be true? What is the key assumption in the theory of dividend policy irrelevance?

Question 52

Shady Sunglasses operates retail sunglass kiosks in shopping malls.Below is information related to the company:
Using the above information and assuming that steady-state growth in year 2017 and beyond will be 4% calculate Shady Sunglasses value per share.