Question 1

A firm has 4,000,000 shares of stock outstanding with a price per share equal to $22.There are 200,000 bonds outstanding each priced at $995 each.The cost of equity is 14 percent,the cost of debt is 8 percent,and the corporate tax rate is 34 percent.What is the WACC?

Accepted Answer

C

Question 2

Suppose that the median price?to?earnings ratio for the S&P 500 is 20.If the long?run return on equity is 11.5 percent and the long?run growth in gross domestic product (GDP )is expected to be 6 percent (3.5 percent real growth and 2.5 percent inflation),what is the cost of equity implied by the equity-denominated key value driver formula?

Accepted Answer

B

Question 3

Which of the following is NOT an input into the Fama-French three-factor model?

Accepted Answer

The Fama-French three-factor model includes three factors: the market portfolio returns (C), the difference between small-cap returns and large-cap returns (D), and the difference between high book-to-market returns and low book-to-market returns (A). The difference between growth stock returns and value stock returns (B) is not explicitly a factor in the model; instead, the model uses book-to-market ratios as a proxy for value vs. growth.

Question 4

Which of the following is NOT true concerning the index recommended for use in the CAPM?

Accepted Answer

The answer of Which of the following is NOT true...

Question 5

To estimate the risk-free rate in developed economies,the analyst should use:

Accepted Answer

Long-term government zero-coupon bonds best match the horizon of cash flow estimates used in valuing firms.

Question 6

Bloomberg's recommended adjustment to a firm's beta will:

Accepted Answer

Bloomberg's recommended adjustment to a firm's beta is designed to move the beta toward 1, reflecting the belief that a firm's beta will revert to the market average over time. This adjustment is based on the concept of beta regression toward the mean.

Question 7

A firm has 1,200,000 shares of stock outstanding with a price per share equal to $14.There are 10,000 bonds outstanding,priced at $1,125 each.The cost of equity is 14 percent,the cost of debt is 8 percent,and the corporate tax rate is 40 percent.What is the WACC?

Accepted Answer

V = (1,200,000 * $14) + (10,000 * $1,125) = $28,050,000
The weights are:
E/V = 16,800,000/28,050,000 = 0.60
D/V = 11,250,000/28,050,000 = 0.40
WACC = {0.40 * 8% * (1 – 0.40)} + (0.60 * 14%) = 10.31%

Question 8

An analyst should use the pretax cost of equity and the pretax cost of debt to estimate the cost of capital.

Accepted Answer

Since free cash flows are measured without interest tax shields, the after-tax cost of debt is used to incorporate the tax shield into the WACC.

Question 9

Briefly explain the two methods of estimating market returns.

Accepted Answer

The answer of Briefly explain the two methods of estimating...

Question 10

The cost of capital must include the cost of capital for all investors-debt,preferred stock,and common stock.

Accepted Answer

Since free cash flow is available to all investors, it must include the cost of capital for all investors.

Question 11

One should create a synthetic risk-free rate by adding the expected inflation rate to the long-term historical average real risk-free rate for the period following the financial crisis.

Accepted Answer

In the aftermath of the financial crisis of 2008, the U.S. Federal Reserve and several other central banks throughout the world lowered interest rates to historically low levels and simultaneously bought trillions of dollars of government bonds. Together, these actions pushed yields on government bonds to near zero. This poses a challenge in estimating the firm's cost of equity, as these yields are typically used as an estimate of the (nominal) risk-free rate. One can create a synthetic risk-free rate to address this by adding the expected inflation rate to the long-term historical average real risk-free rate.

Question 12

Which of the following is/are FALSE regarding risk-free rates?
I )The 30-year Treasury bonds match the cash flow streams of a company better,and therefore should be used over 10-year bonds in estimating the risk-free rate.
II )One should use government bond yields denominated in the same currency as the company's cash flow to estimate the risk-free rate.
III )One should ensure that the inflation rate embedded in the cash flows is consistent with the inflation rate embedded in the government bond rate being used.

Accepted Answer

I is false because the choice of Treasury bonds (whether 30-year or 10-year) for estimating the risk-free rate does not necessarily depend on matching a company's cash flow streams but rather on the need for a risk-free benchmark. II and III are true statements regarding the estimation of the risk-free rate.

Question 13

Since the factors and their measurement for use in the arbitrage pricing theory (APT )model have become fairly standardized,the APT model is becoming a more popular alternative to the CAPM in estimating the market risk premium.

Accepted Answer

In practice, implementation of the model has been tricky, as there is little agreement about how many factors there are, what the factors represent, or how to measure the factors. For this reason, use of the APT resides primarily in the classroom.

Question 14

What challenges did the financial crisis of 2008 and its aftermath pose for estimating a firm's cost of capital? How should one handle these challenges?

Accepted Answer

The answer of What challenges did the financial crisis of...

Question 15

A firm has a target debt-to-equity ratio of 1.Its cost of equity equals 12 percent,the cost of debt is 8 percent,and the tax rate is 30 percent.What is the weighted average cost of capital (WACC)?

Accepted Answer

D/E = 1.0 => D/(D + E) = E/(D + E) = 0.50
WACC = {0.5 * 8% * (1 – 0.3)} + (0.5 * 12%) = 8.8%

Question 16

A firm has a target debt-to-equity ratio of 3.Its cost of equity equals 12 percent,its cost of debt is 9 percent,and the tax rate is 34 percent.What is the WACC?

Accepted Answer

W_d = 3/(3 + 1) = 0.75, We = 1 – 0.75 = 0.25, and WACC = 0.75 × 0.09 × (1 – 0.34) + 0.25 × 0.12 = 0.0746 or 7.46%

Question 17

Theoretically,one should discount each year's cash flow at a cost of equity that matches the maturity of the cash flow.However,for practical purposes,analysts typically choose a single yield to maturity that best matches the cash flow stream being valued.

Accepted Answer

In choosing the bond’s duration, the most theoretically sound approach is to discount each year’s cash flow at a cost of equity that matches the maturity of the cash flow. In other words, year 1 cash flows would be discounted at a cost of equity based on a one-year risk-free rate, while year 10 cash flows would be discounted at a cost of equity based on a 10-year discount rate. To do this, one should use zero-coupon bonds (known as STRIPS) rather than Treasury bonds that make interim payments. The interim payments cause their effective maturity to be much shorter than their stated maturity.
However, using multiple discount rates is quite cumbersome. Therefore, few practitioners discount each cash flow using its matched bond maturity. Instead, most choose a single yield to maturity that best matches the cash flow stream being valued.

Question 18

In computing the cost of equity for a firm,which of the following are recommended steps in estimating the CAPM beta using regression analysis?
I.Use a sample size equal to or greater than 60.
II.Use daily returns.
III.Use a diversified value-weighted index.
IV.Watch for possible distortions from market bubbles.

Accepted Answer

Using a sample size equal to or greater than 60 is recommended to ensure statistical significance. Using a diversified value-weighted index helps to capture the overall market risk. Also, it is important to watch for possible distortions from market bubbles, as these can skew the results of the regression analysis. However, using daily returns may not always be appropriate, depending on the frequency of the data available and the specific characteristics of the firm's industry. Therefore, option II is not recommended in all situations.

Question 19

Researchers have concluded that an appropriate range of the equity risk premium for use in valuation models should be 10 to 12 percent.

Accepted Answer

Different forms of measurement converge on an appropriate range of market risk premium of 4.5 to 5.5 percent, which has held even during the financial crisis of 2008.

Question 20

Which of the following are true concerning the index recommended for use in the CAPM?
I.It should include both traded and untraded investments.
II.The S&P 500 is the most common proxy for U.S.stocks.
III.The S&P 500 and the

Accepted Answer

The S&P 500 is the most common proxy for U.S. stocks, and it includes both traded and untraded investments.

Quiz 13: Estimating the Cost of Capital