Question 1

One rationale for using expected dividends in valuation is:

Accepted Answer

Expected dividends serve as a measurable common denominator for comparing the future benefits of alternative investment opportunities since they are paid in cash. They also provide a clearer picture of the cash flow expectations of investors. However, dividends are not a necessary payment for a firm to have value, nor are they the most reliable measure of value. Dividend payout ratios may be set based on profitability, but this is not directly relevant to using expected dividends in valuation.

Question 2

Zonk Corp.
The following data pertains to Zonk Corp., a manufacturer of ball bearings (dollar amounts in millions):
 Assuming that riskless rate is 4.6% and the market premium is 7.3%, calculate Zonk 's cost of equity capital:

Accepted Answer

D

Question 3

Using the above information, calculate Zonk 's weighted-average cost of capital:

Accepted Answer

WACC (Zonk)= [.217 * .115 * (1 - .35)] + (.783 * .1189)=[.210*.105*(1-.35)+(.7900*.0828)=

Question 4

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?

Accepted Answer

When forecasting real dividends, the appropriate discount rate to use is the real rate of return. This is because the real rate of return takes into account the effects of inflation, which can impact the purchasing power of the dividends received. Using the nominal rate of return would not properly adjust for inflation, and using the risk-free rate or risk-adjusted rate would not necessarily provide an accurate reflection of the expected returns from the specific equity investment being analyzed.

Question 5

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 :

Accepted Answer

Obtaining the national ranking of the firm's external auditors is not a step in the analysis and valuation framework used to understand the fundamentals of a business and determine estimates of its value. The other steps listed (analyzing the firm's strategy in terms of the competition, assessing the quality of the firm's accounting and financial reporting, and deriving forecasts of future earnings from the firm's projected financial statements) are all standard steps in this framework.

Question 6

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

Accepted Answer

Returns on systematic risk-free securities like U.S. Treasury securities should have no correlation with returns on a diversified market wide portfolio of stocks, as they are not affected by market-wide events and fluctuations.

Question 7

Equity-based valuation models are based on all metrics except:

Accepted Answer

Equity-based valuation models are typically based on metrics such as assets, debt, pre-tax borrowing, common equity (including both book value and market value), income tax rate, and market equity beta. Working capital, on the other hand, is more relevant to the assessment of a company's short-term liquidity and operational efficiency. Therefore, choice C is the best answer.

Question 8

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

Accepted Answer

Preferred stock has priority over common stock in terms of dividends and liquidation. Treasury stock is stock that has been repurchased by the company and is not relevant to this question. Debt capital is a liability and is not a type of equity. Nonconvertible common equity is still common stock and does not have priority over other types of equity.

Question 9

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

Accepted Answer

The answer of Which of the following is not a...

Question 10

Determine the weight on debt capital that should be used to calculate Zonk 's weighted-average cost of capital:

Accepted Answer

$\begin{array}{lccc}
  \text {Debt} &\$ 3652 & 21.00 \% \
  \text { Market Value of Equity } &\underline {13.685 }&\underline {79.00\%}\
  \text { Total } &\$ 17.337&100 \%\
\end{array}$

Question 11

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 weighted average cost of capital for Zonk based on the new capital structure.

Accepted Answer

New WACC = [.70*.14*(1-.35)]+(.30*.0828)= 8.85%

Question 12

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 :

Accepted Answer

The answer of The historical discount rate of the firm...

Question 13

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

Accepted Answer

Exposure to management competence is a firm-specific factor that may increase the firm's diversifiable risk (specific risk) but not the nondiversifiable risk (market risk) as it is related to the internal operations of the firm and is not affected by the overall market movements. Exposure to interest rate changes, inflation, and cyclicality are firm-specific factors that are correlated with the overall market movements and increase the nondiversifiable risk of the firm.

Question 14

Determine the weight on equity capital that should be used to calculate Zonk 's weighted-average cost of capital:

Accepted Answer

$\begin{array}{lccc}
  \text {Debt} &\$ 3652 & 21.00 \% \
  \text { Market Value of Equity } &\underline {13.685 }&\underline {79.00\%}\
  \text { Total } &\$ 17.337&100 \%\
\end{array}$

Question 15

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 :

Accepted Answer

Unexpected changes in earnings, dividends, and cash flows do correlate closely with changes in stock prices, so statement D is not true. Statements A, B, and C are generally accepted as true in the realm of equity valuation studies.

Question 16

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

Accepted Answer

Debt is typically less risky because fixed claims bear less residual risk than equity claims. This means that in the event of bankruptcy or liquidation, debt holders have priority over equity holders in receiving payment. Therefore, investors are willing to accept a lower rate of return on debt capital in exchange for lower risk.

Question 17

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

Accepted Answer

The answer of In theory, the value of a share...

Question 18

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?

Accepted Answer

First, we need to calculate the cost of equity using CAPM formula, which is:
Cost of Equity = Risk-Free Rate + Beta * Market Risk Premium
Cost of Equity = 6% + 0.9 * 7%
Cost of Equity = 12.3%
Next, we need to calculate the weighted average cost of capital (WACC) using the given debt to equity ratio and tax rate:
WACC = (1 - Tax Rate) * Cost of Equity * Equity Weight + Cost of Debt * Debt Weight
WACC = (1 - 0.35) * 12.3% * 0.4 + Cost of Debt * 0.6
Assuming the cost of debt is 5%, the WACC would be:
WACC = 8.17%
Finally, the market is expecting the firm to generate returns equal to or greater than the WACC, which is 8.17%. Therefore, the answer is C) 12.3%.

Question 19

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:

Accepted Answer

The reason why free cash flows can be used instead of dividends in the cash-flow-based valuation approach is that 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. Free cash flows represent the cash generated by the firm that is available to shareholders after all capital expenditures have been made, and as such, they are a good measure of the expected future payoffs to the investor. Dividends, on the other hand, represent only a portion of the cash paid out to shareholders and do not take into account the cash the firm retains for reinvestment. Therefore, free cash flows provide a more comprehensive measure of the value created by the firm over time.

Question 20

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.

Accepted Answer

The formula to calculate the leveraged beta is:

Leveraged beta = Unleveraged beta * [1 + (1 - tax rate) * (debt/equity)]

Assuming that Zonk's unleveraged beta is 2.5 and the tax rate is 35%, we can calculate the leveraged beta as follows:

Leveraged beta = 2.5 * [1 + (1 - 0.35) * (0.7/0.3)] = 4.77

Therefore, the revised equity beta for Zonk based on the new capital structure is 4.77. The correct answer is B.

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