Deck 13: Estimating the Cost of Capital

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?

A)10.3 percent.
B)9.8 percent.
C)8.0 percent.
D)8.8 percent.

Answer 1

8.0 percent.

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?

A)7.9 percent.
B)8.4 percent.
C)8.9 percent.
D)9.4 percent.

Answer 2

8.4 percent.

Question 3

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

A)The difference between low book-to-market returns and high book-to-market returns.
B)The difference between growth stock returns and value stock returns.
C)The market portfolio returns.
D)The difference between small-cap returns and large-cap returns.

Answer 3

B

Question 4

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

A)It should include both traded and untraded investments.
B)The S&P 500 is the most common proxy for U.S.stocks.
C)The S&P 500 and the

Question 5

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

A)Short-term commercial paper.
B)Short-term government discount instruments.
C)Long-term coupon-paying government bonds.
D)Long-term government zero-coupon bonds.

Question 6

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

A)Lower beta in all cases.
B)Increase beta in all cases.
C)Move the beta toward 1.
D)Either increase or decrease beta,but it depends on the size of the standard error of the estimated beta.

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?

A)10.3 percent.
B)10.8 percent.
C)9.8 percent.
D)8.8 percent.

Question 8

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

Question 9

Briefly explain the two methods of estimating market returns.

Question 10

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

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.

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.

A)I only.
B)II only.
C)III only.
D)I and III only.

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.

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?

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)?

A)10.0 percent.
B)10.8 percent.
C)9.8 percent.
D)8.8 percent.

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?

A)7.46 percent.
B)8.97 percent.
D )10.00 percent.
D)10.49 percent.

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.

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.

A)I,II,and III only.
B)I,III,and IV only.
C)II and IV only.
D)II,III,and IV only.

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.

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

Question 21

Which of the following practices are appropriate in estimating a firm's cost of debt?
I.Use the coupon rate on outstanding debt that is investment grade.
II.Use the yield to maturity on outstanding debt that is investment grade.
III.Use the yield to maturity on outstanding debt that is below investment grade.
IV.Use the adjusted present value (APV )method to value firms that have debt that is below investment grade.

A)I and IV only.
B)III and IV only.
C)II and III only.
D)II and IV only.

Question 22

If an observable market value is not readily available,book value of debt can be used to calculate capital structure.

Question 23

Which of the following most accurately describes the types of companies where the yield to maturity on outstanding bonds is an appropriate proxy for the cost of debt?

A)All companies with outstanding bonds.
B)Only companies whose bonds are rated investment grade.
C)All companies whose bonds are rated investment grade or below investment grade but not in default.
D)The yield to maturity is not an appropriate proxy for the cost of debt for any company because of the reinvestment rate assumption.

Question 24

An analyst gathers the following information for Firm A and Firm B.Using the information to compute the industry unlevered beta,what is the appropriate beta for each company for use in the WACC? (Assume that the debt beta for each firm equals zero. ) Firm A: CAPM beta = 0.9;debt-to-equity ratio = 0.4
Firm B: CAPM beta = 1.2;debt-to-equity ratio = 2

A)0.73;1.56
B)0.90;1.20
C)0.52;0.52
D)1.12;1.65

Question 25

While estimating the cost of debt for a firm,one should always use market prices for publicly traded debt.

Question 26

The weights to use in the WACC should reflect the:

A)Current book values.
B)Current market values.
C)Target-market-based values.
D)Book values in the case of bonds and market values in the case of equity.

Question 27

If interest rates have changed since the company's last valuation or if the company has entered into financial distress,book value is a reasonable approximation of market value.

Question 28

Yield to maturity should be calculated on liquid,option-free,short-term debt.

Question 29

You are analyzing a distressed bond with one year to maturity.If the probability of default rises for this bond,the yield to maturity will likely increase,while the cost of debt will likely decrease.

Question 30

An analyst gathers the following information for Firm A and Firm B.Use the information to compute the industry unlevered beta and the appropriate beta for Firm B to use in the WACC. Firm A: CAPM beta = 1.6;debt-to-equity ratio = 1.2
Firm B: CAPM beta = 1.0;debt-to-equity ratio = 0.8
The appropriate beta for Firm B is closest to:

A)1.026
B)1.154
C)1.170
D)1.163

Question 31

Which of the following is NOT a property necessary for a consistent estimate of the WACC?

A)It uses book-value-based weights.
B)It includes the opportunity cost of all investors.
C)It includes related costs/benefits such as the interest tax shield.
D)The duration of the securities used in estimating the WACC equals the duration of the free cash flows.

Question 32

To estimate a company's beta,using an industry-derived unlevered beta relevered to the company's target capital structure is preferred to directly estimating a company-specific beta.