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ADMS 4540 Chapter Notes - Chapter 14: Capital Structure, Net Present Value, Capital Asset Pricing Model

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raspberrymouse643

4 Nov 2018

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York University

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Administrative Studies

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Professor

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Document Summary

Adms 4540 ch 14 cost of capital (coc) cost of capital: some preliminaries: required return vs coc. If rr 10% require positive npv of return that exceeds 10% (or return that exceeds initial investment by 10% to compensate for creditors) Implementing the approach: require p0, d0, g1, g1 usually estimated (other 2 factors observable if public) Implement values into equation p. 517: estimating g, use historical growth rate, use analysis forecast for future growth rates available from research departments, different sources different estimates average different estimates, ex. Ignore short term liabilities assume incorporated into cf estimates / or not part of permanent capital structure (ex. If not reliably measure or fluctuates often use bv. Interest paid by corporation tax deductible: distinguish pretax debt & after tax debt, calculate after tax interest rate, wacc equation with tax considered p. 525, solving warehouse problem & similar capital budgeting problems, 1.

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Related Questions

1. Which of the following is true?

The corporation model can be used to value divisions and firms that do not pay dividends.
The discounted dividend model can be used to value divisions and firms that do not pay dividends.
For the discounted dividend model, a firm's weighted average cost of capital is used as the discount rate.
For the corporate valuation model, a firm's cost of equity is used as the discount rate.

Question 2.2. Which of the following is false?

For the constant growth model to hold, a firm's cost of equity needs to be smaller than its constant dividend growth rate (i.e., rs < g).
For the constant growth model to hold, a firm's cost of equity needs to be greater than its constant dividend growth rate (i.e., rs > g).
From the constant growth model, if the constant dividend growth rate is equal to zero, a firm's share price is equal to the constant dividend divided by the cost of equity (i.e., g=0).
If a company's constant dividend growth rate is negative, the formula for the constant growth model cannot be applied.

Question 3.3. From the discussion of a firm's capital budgeting problem in chapter 11, which of the following is false? (Points : 3.5)

The net present value method (NPV) assumes that cash flows are reinvested at the weighted average cost of capital (WACC).
The internal rate of return method (IRR) assumes that cash flows are reinvested at the internal rate of return.
The modified internal rate of return method (MIRR) assumes that cash flows are reinvested at the weighted average cost of cpaital.
For mutually exclusive projects, if there is a conflict between NPV and IRR, the project with the highest IRR is chosen.
The IRR is independent of a firm's weighted average cost of capital.

Question 4.4. Which of the following is true? (

As a firm's dividend payout ratio increases, the firm's WACC decreases.
The WACC only represents the "hurdle rate" for a typical project with average risk. Therefore, the project's WACC should be adjusted to reflect the project's risk.
Firms with riskier projects generally have a lower WACC.
Holding all else constant, an increase in the target debt ratio tends to lower the WACC.

Question 5.5. Which of the following is false?

If interest rates rise, the price of the bond will rise and its YTM (yield to maturity) will fall.
Short-term bond prices are less sensitive than long-term bond prices to interest rate changes.
Companies are not likely to call bonds unless interest rates have declined significantly. Thus, the call provision is valuable to firms but detrimental to long term investors.
On balance, bonds that have a sinking fund are regarded as being safer than those without such a provision.

Question 6.6. Which of the following is not true? (Points : 3.5)

According to SML (security market line), the risk premium on a high-beta stock would increase more than that on a low-beta stock.
If beta < 1.0, the security is less risky than average.
According to the Security Market Line (SML), in general, a companyâs expected return will double when its beta doubles.
According to the Security Market Line (SML), if a portfolio of real world stocks has a beta of zero, the required rate of return for the portfolio is equal to the risk-free rate.

Question 7.7. P&G Industries bonds have a maturity of 15 years with a $1,000 face value, have an 8% semiannual coupon, are callable in 10 years at $1,125, and currently sell at a price of $1,105. What is their nominal annual yield to call?

6.87%.
7.37%.
11.05%.
8.32%.

Question 8.8. Which of the following is not the flaw (weakness) of the discounted payback method? (Points : 3.5)

It does not tells us by how much the project should increase shareholder wealth, or by how much a project yields over the cost of capital; it merely tells us when we recover our investment.
It ignores cash flows occurring after the payback period.
It ignores the time value of money, that is, dollars received in different years are all given the same weight.

Question 9.9. Jermey Lin has $52,500 invested a stock with a beta of 0.80 and another $47,500 invested in a stock with a beta of 3.2. If these are the only two investments in his portfolio, what is his portfolio's beta?

1.56.
1.82.
2.00.
1.94

Question 10.10. According to CAPM, if the required rate of the return of Stock A obtained from the security market line (SML) is less than the expected rate of the return of stock A from the capital market transaction, then stock A is

fairly priced.
undervalued.
overvalued.

Question 11.11. Determine the yield-to-call (to nearest 0.1 of a percent) of an LTV bond with a 12 percent coupon, that pays interest annually. The bond can be called in 5 years, has a call premium of $114, and is currently selling for $912.50. The bond has a face value of $1,000.

14.58%.
13.92%.
16.34%.
12.17%.

Question 12.12. Project M costs $1,000, its expected cash inflows are $500 per year for 3 years, and its WACC is 11%. What is the project's NPV? (Points : 3.5)

$259.57.
$221.86.
$195.23.
$257.35.

Question 13.13. Project J costs $1,025, its expected cash inflows are $425 per year for 3 years, and its WACC is 10%. What is the project's IRR?

12.58%.
10.82%.
11.76%.
9.64%.

Question 14.14. Project X costs $6,750, its expected cash inflows are $1250 per year for 10 years, and its WACC is 10%. What is the project's payback?(Note, the regular payback is asked in this question, not the discounted payback.) (Points : 3.5)

5.40 years.
10 years.
4.58 years.
6.12 years.

Question 15.15. Project S costs $800, its expected cash inflows are $350 per year for 3 years, and its WACC is 7%. What is the project's MIRR?

13.97%.
12.04%.
14.93%.
9.15%.

Question 16.16. Project Y costs $650, its expected cash inflows are $500 per year for 5 years, and its WACC is 10%. What is the project's discounted payback?

1.47 years.
1.24 years.
1.62 years.
1.15 years.

1. Which of the following is true?

The corporation model can be used to value divisions and firms that do not pay dividends.
The discounted dividend model can be used to value divisions and firms that do not pay dividends.
For the discounted dividend model, a firm's weighted average cost of capital is used as the discount rate.
For the corporate valuation model, a firm's cost of equity is used as the discount rate.

Question 2.2. Which of the following is false?

For the constant growth model to hold, a firm's cost of equity needs to be smaller than its constant dividend growth rate (i.e., rs < g).
For the constant growth model to hold, a firm's cost of equity needs to be greater than its constant dividend growth rate (i.e., rs > g).
From the constant growth model, if the constant dividend growth rate is equal to zero, a firm's share price is equal to the constant dividend divided by the cost of equity (i.e., g=0).
If a company's constant dividend growth rate is negative, the formula for the constant growth model cannot be applied.

Question 3.3. From the discussion of a firm's capital budgeting problem in chapter 11, which of the following is false?

The net present value method (NPV) assumes that cash flows are reinvested at the weighted average cost of capital (WACC).
The internal rate of return method (IRR) assumes that cash flows are reinvested at the internal rate of return.
The modified internal rate of return method (MIRR) assumes that cash flows are reinvested at the weighted average cost of cpaital.
For mutually exclusive projects, if there is a conflict between NPV and IRR, the project with the highest IRR is chosen.
The IRR is independent of a firm's weighted average cost of capital.

Question 4.4. Which of the following is true? (Points : 3.5)

As a firm's dividend payout ratio increases, the firm's WACC decreases.
The WACC only represents the "hurdle rate" for a typical project with average risk. Therefore, the project's WACC should be adjusted to reflect the project's risk.
Firms with riskier projects generally have a lower WACC.
Holding all else constant, an increase in the target debt ratio tends to lower the WACC.

Question 5.5. Which of the following is false? (Points : 3.5)

If interest rates rise, the price of the bond will rise and its YTM (yield to maturity) will fall.
Short-term bond prices are less sensitive than long-term bond prices to interest rate changes.
Companies are not likely to call bonds unless interest rates have declined significantly. Thus, the call provision is valuable to firms but detrimental to long term investors.
On balance, bonds that have a sinking fund are regarded as being safer than those without such a provision.

Question 6.6. Which of the following is not true? (Points : 3.5)

According to SML (security market line), the risk premium on a high-beta stock would increase more than that on a low-beta stock.
If beta < 1.0, the security is less risky than average.
According to the Security Market Line (SML), in general, a companyâs expected return will double when its beta doubles.
According to the Security Market Line (SML), if a portfolio of real world stocks has a beta of zero, the required rate of return for the portfolio is equal to the risk-free rate.

Question 7.7. P&G Industries bonds have a maturity of 15 years with a $1,000 face value, have an 8% semiannual coupon, are callable in 10 years at $1,125, and currently sell at a price of $1,105. What is their nominal annual yield to call? (Points : 3.5)

6.87%.
7.37%.
11.05%.
8.32%.

Question 8.8. Which of the following is not the flaw (weakness) of the discounted payback method? (Points : 3.5)

It does not tells us by how much the project should increase shareholder wealth, or by how much a project yields over the cost of capital; it merely tells us when we recover our investment.
It ignores cash flows occurring after the payback period.
It ignores the time value of money, that is, dollars received in different years are all given the same weight.

Question 9.9. Jermey Lin has $52,500 invested a stock with a beta of 0.80 and another $47,500 invested in a stock with a beta of 3.2. If these are the only two investments in his portfolio, what is his portfolio's beta? (Points : 3.5)

1.56.
1.82.
2.00.
1.94

Question 10.10. According to CAPM, if the required rate of the return of Stock A obtained from the security market line (SML) is less than the expected rate of the return of stock A from the capital market transaction, then stock A is (

fairly priced.
undervalued.
overvalued.

Question 11.11. Determine the yield-to-call (to nearest 0.1 of a percent) of an LTV bond with a 12 percent coupon, that pays interest annually. The bond can be called in 5 years, has a call premium of $114, and is currently selling for $912.50. The bond has a face value of $1,000. (Points : 3.5)

14.58%.
13.92%.
16.34%.
12.17%.

Question 12.12. Project M costs $1,000, its expected cash inflows are $500 per year for 3 years, and its WACC is 11%. What is the project's NPV?

$259.57.
$221.86.
$195.23.
$257.35.

Question 13.13. Project J costs $1,025, its expected cash inflows are $425 per year for 3 years, and its WACC is 10%. What is the project's IRR? (

12.58%.
10.82%.
11.76%.
9.64%.

Question 14.14. Project X costs $6,750, its expected cash inflows are $1250 per year for 10 years, and its WACC is 10%. What is the project's payback?(Note, the regular payback is asked in this question, not the discounted payback.) (Points : 3.5)

5.40 years.
10 years.
4.58 years.
6.12 years.

Question 15.15. Project S costs $800, its expected cash inflows are $350 per year for 3 years, and its WACC is 7%. What is the project's MIRR? (

13.97%.
12.04%.
14.93%.
9.15%.

Question 16.16. Project Y costs $650, its expected cash inflows are $500 per year for 5 years, and its WACC is 10%. What is the project's discounted payback?

1.47 years.
1.24 years.
1.62 years.
1.15 years.