Question 1

Zonk Corp.
The following data pertains to Zonk Corp., a manufacturer of ball bearings (dollar amounts in millions):
 $$\begin{array} { l r } 
\text { Tetal a55ets } & \$ 7460 \
\text { Interest-bearing debt } & \$ 3652 \
\text { Average pre-tax borrowing cost } & 10.5 \% \
\text { Common equity: } & \
\quad \text { Boak value } & \$ 2950 \
\text { Market value } & \$ 13685 \
\text { Incame tax rate } & 35 \% \
\text { Market equity beta } & 1.13
\end{array}$$
-Determine the weight on equity capital that should be used to calculate Zonk's weighted-average cost of capital:
A) 79.00%
B) 78.3%
C) 41.8%
D) 50%

Accepted Answer

$$\begin{array} { l l l l } 
\text { Debt } & \$3652 & 21.00 \% \
\text { Market Value of Equity } & \underline{13.685} & \underline{79.00 \% }\
\text { Total } & \$ 1737 & 100 \%
\end{array}$$

Question 2

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.

Accepted Answer

Returns on risk-free securities such as U.S. Treasury securities are not affected by marketwide changes and therefore show no correlation with returns on a diversified marketwide portfolio of stocks.

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

Accepted Answer

Dividends representing a transfer of wealth to shareholders is not a problem; it is a fundamental aspect of dividends. The other options highlight challenges in using dividend-based valuation, such as unpredictability and irregularity of dividends.

Question 4

Zonk Corp.
The following data pertains to Zonk Corp., a manufacturer of ball bearings (dollar amounts in millions):
 $$\begin{array} { l r } 
\text { Tetal a55ets } & \$ 7460 \
\text { Interest-bearing debt } & \$ 3652 \
\text { Average pre-tax borrowing cost } & 10.5 \% \
\text { Common equity: } & \
\quad \text { Boak value } & \$ 2950 \
\text { Market value } & \$ 13685 \
\text { Incame tax rate } & 35 \% \
\text { Market equity beta } & 1.13
\end{array}$$
-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) 8.85%
B) 12.56%
C) 13.01%
D) 9.94%

Accepted Answer

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

Question 5

Zonk Corp.
The following data pertains to Zonk Corp., a manufacturer of ball bearings (dollar amounts in millions):
 $$\begin{array} { l r } 
\text { Tetal a55ets } & \$ 7460 \
\text { Interest-bearing debt } & \$ 3652 \
\text { Average pre-tax borrowing cost } & 10.5 \% \
\text { Common equity: } & \
\quad \text { Boak value } & \$ 2950 \
\text { Market value } & \$ 13685 \
\text { Incame tax rate } & 35 \% \
\text { Market equity beta } & 1.13
\end{array}$$
-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) 4.35
B) 4.77
C) 4.34
D) 3.91

Accepted Answer

Levered market equity beta = unlevered market equity beta (1 + (1-t)[MV debt\MV equity])
   ==1.13*(1+(1-.35)[.70/.30]=4.35

Question 6

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%

Accepted Answer

12.3% = [6.0 + (0.9 x .07)]

Question 7

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.

Accepted Answer

Obtaining the national ranking of the firm's external auditors is not a step in the analysis and valuation framework. The other three choices - 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 important steps in understanding the fundamentals of a business and determining its value.

Question 8

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

Accepted Answer

Unexpected changes in earnings, dividends, and cash flows typically do correlate closely with changes in stock prices, as these factors are fundamental drivers of a company's valuation.

Question 9

Zonk Corp.
The following data pertains to Zonk Corp., a manufacturer of ball bearings (dollar amounts in millions):
 $$\begin{array} { l r } 
\text { Tetal a55ets } & \$ 7460 \
\text { Interest-bearing debt } & \$ 3652 \
\text { Average pre-tax borrowing cost } & 10.5 \% \
\text { Common equity: } & \
\quad \text { Boak value } & \$ 2950 \
\text { Market value } & \$ 13685 \
\text { Incame tax rate } & 35 \% \
\text { Market equity beta } & 1.13
\end{array}$$
-Using the above information,calculate Zonk's weighted-average cost of capital:
A) 11.5%
B) 7.97%
C) 7.48%
D) 10.90%

Accepted Answer

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

Question 10

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

Accepted Answer

Exposure to management competence is a firm-specific factor that does increase diversifiable risk. This is because the management of a company can have an impact on the company's performance and financial health, and therefore, their actions could cause the stock price to go up or down. In contrast, exposure to interest rate changes, inflation, and cyclicality are all systematic risks that affect the stock price of all companies to some extent, and therefore, they cannot be diversified away.

Question 11

Zonk Corp.
The following data pertains to Zonk Corp., a manufacturer of ball bearings (dollar amounts in millions):
 $$\begin{array} { l r } 
\text { Tetal a55ets } & \$ 7460 \
\text { Interest-bearing debt } & \$ 3652 \
\text { Average pre-tax borrowing cost } & 10.5 \% \
\text { Common equity: } & \
\quad \text { Boak value } & \$ 2950 \
\text { Market value } & \$ 13685 \
\text { Incame tax rate } & 35 \% \
\text { Market equity beta } & 1.13
\end{array}$$
-Assuming that riskless rate is 4.6% and the market premium is 7.3% calculate Zonk's cost of equity capital:
A) 10.4%
B) 7.69%
C) 11.89%
D) 8.28%

Accepted Answer

cost of equity capital = 046+1.13(.073)=8.28

Question 12

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

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 on the value of money over time, which is important in determining the value of future cash flows. The nominal rate of return includes an inflation premium, which would not be appropriate to use in this case as it would overstate the discount rate. The risk free rate of return and the risk adjusted rate of return are not necessarily relevant in this case, as they are typically used in determining the discount rates for assets with varying levels of risk.

Question 13

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.

Accepted Answer

Free cash flows are used instead of dividends in the cash-flow-based valuation approach because 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. This means that free cash flows represent the actual cash flows available to the investors, while dividends represent only a portion of the cash flows paid out to investors. Therefore, using free cash flows provides a more accurate representation of the expected future payoffs to the investor.

Question 14

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

Accepted Answer

Preferred stock generally has priority over common stock in terms of both dividends and liquidation. Preferred stockholders usually receive a fixed dividend payment before any dividends are paid to common stockholders, and they have a higher claim on assets in the event of liquidation. Treasury stock, debt capital, and nonconvertible common equity are all subordinate to preferred and common stock in terms of priority in dividends and liquidation.

Question 15

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.

Accepted Answer

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

Question 16

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 of...

Question 17

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.

Accepted Answer

Expected dividends are used in valuation because they are paid in cash, which serves as a measurable common denominator for comparing the future benefits of alternative investment opportunities. It is not correct to say that dividends are necessary for a firm to have value (as some companies, such as growth companies, may prioritize reinvesting their earnings rather than paying dividends) or that they are the most reliable measure of value (as some companies may choose not to pay dividends even if they are profitable). Additionally, dividend payout ratios are set based on the company's dividend policy, not profitability.

Question 18

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

Accepted Answer

Debt is typically less risky because fixed claims bear less residual risk than equity claims. In other words, lenders have a priority claim to a company's assets and earnings, whereas equity holders are residual claimants and only receive payment after all other obligations have been met. Therefore, investors are willing to accept lower returns on debt capital compared to equity capital.

Question 19

Equity-based valuation models are based on all metrics except
A) dividends
B) cash flow
C) working capital
D) earnings

Accepted Answer

Equity-based valuation models are based on dividends, earnings, and cash flow, but not on working capital.

Question 20

Zonk Corp.
The following data pertains to Zonk Corp., a manufacturer of ball bearings (dollar amounts in millions):
 $$\begin{array} { l r } 
\text { Tetal a55ets } & \$ 7460 \
\text { Interest-bearing debt } & \$ 3652 \
\text { Average pre-tax borrowing cost } & 10.5 \% \
\text { Common equity: } & \
\quad \text { Boak value } & \$ 2950 \
\text { Market value } & \$ 13685 \
\text { Incame tax rate } & 35 \% \
\text { Market equity beta } & 1.13
\end{array}$$
-Determine the weight on debt capital that should be used to calculate Zonk's weighted-average cost of capital:
A) 21.7%
B) 21.00%
C) 50%
D) 58.2%

Accepted Answer

$$\begin{array} { l l l l } 
\text { Debt } &\$ 3652 & 21.00 \% \
\text { Market Value of Equity } & \underline{13.685} & \underline{79.00 \% }\
\text { Total } & \$ 1737 & 100 \%
\end{array}$$

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

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?

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

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:

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:

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

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?

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:

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

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:

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

One rationale for using expected dividends in valuation is

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

Equity-based valuation models are based on all metrics except