True or False: Since 70 percent of preferred dividends received by a corporation is excluded from taxableincome, the component cost of equity for a company which pays half of its earnings out ascommon dividends and half as preferred dividends should, theoretically, beCost of equity = rs(0.30)(0.50) + rps(1 - T)(0.70)(0.50)FalseTrue or False: The cost of debt, rd, is always less than rs, so rd(1 - T) will certainly be less than rs. Therefore,as long as the firm is not completely debt financed, the weighted average cost of capital willalways be greater than rd(1 - T). [Note: Assuming no preferred stock for this firm.]TrueTrue or False: Which of the following is not considered a capital component for the purpose of calculatingthe weighted average cost of capital as it applies to capital budgeting? a. Long-term debt. b. Common stock. c. Accounts payable. d. Preferred stock. e. All of the above are considered cap ital components for WACC and capital budgetingpurposesAccounts PayableWhich of the following statements is most correct? a. Beta measures market risk, but if a firm's stockholders are not well diversified, beta maynot accurately measure stand-alone risk. b. If the calculated beta underestimates the fi rm's true investment risk, then the CAPMmethod will overestimate rs. c. The discounted cash flow method of estimating the cost of equity can't be used unless thegrowth component, g, is constant during the analysis period. d. An advantage shared by both the DCF and CAPM methods of estimating the cost of equitycapital, is that they yield precise estimates and require little or no judgement. e. All of the statements above are false.A. Beta measures market risk, but if a firm's stockholders are not well diversified, beta maynot accurately measure stand-alone risk.Which of the following statements is most correct? a. The CAPM approach to estimating a firm's cost of common stock never gives a betterestimate than the DCF approach. b. The CAPM approach is typically used to estimate a firm's cost of preferred stock. c. The risk premium used in the bond-yield-plus-risk-premium method is the same as the oneused in the CAPM method. d. The DCF method and the CAPM method produce exactly the same estimate for rs. e. The statements above are all falseE. All of the statements are falseWhich of the following statements is most correct? a. The before-tax cost of preferred stock may be lower than the before-tax cost of debt, eventhough preferred stock is riskier than debt. b. If a company's stock price increases, this increases its cost of common stock. c. If the cost of equity capital increases, it must be due to an increase in the firm's beta. d. Statements a and b are correct. e. Answers a, b, and c are correctA. The before-tax cost of preferred stock may be lower than the before-tax cost of debt, eventhough preferred stock is riskier than debt.Which of the following statements is most correct? a. The weighted average cost of capital for a given capital budget level is a weighted averageof the marginal cost of each relevant capital component which makes up the firm's targetcapital structure. b. The weighted average cost of capital is calculated on a before-tax basis. c. An increase in the risk-free rate is likely to increase the marginal costs of both debt and equity financing. d. Answers a and c are correct. e. All of the answers above are correctd. Answers a and c are correct.True or False: The free cash flow valuation model cannot be used unless a company doesn't pay dividendFalseTrue or False: Value-based management focuses on sales growth, profitability, capital requirements, theweighted average cost of capital, and the dividend growth rateFalseTrue or False: If a company's return on invested capital is less than its cost of equity, then the company intrinsic value of operations must be lower than its operating capitalFalseDefinition: Value drivers- subset of inputs that managers are able to influence through strategic choices and execution of the resulting business plans. -Because managers can't change the past, the most recent level of sales and operating capital are not value drivers. This means that growth rates, operating profitability, capital requirements, and the cost of capital are the value driversDefinition: Value-based managementsystematic use of the free cash flow valuation model to identify value drivers and to guide managerial and strategic decisions.Dividend defintionsDt = Dividend the stockholder expects to receive at the end of Year t. D0 is the most recent dividend, which has already been paid; D1 is the first dividend expected, which will be paid at the end of this yearP0 DefintionP0 : Actual market price of the stock todayWhich of the following does NOT always increase a company's intrinsic value? a. Increasing the expected growth rate of sales. b. Increasing the expected operating profitability (NOPAT/Sales). c. Decreasing the capital requirements (Capital/Sales). d. Decreasing the weighted average cost of capital. e. Increasing the rate of return on invested capitalA. Increasing the expected growth rate of salesTrue or False: The tighter the probability distribution of expect ed future returns, the smaller the risk of agiven investment as measured by the standard deviationTrueTrue or False: According to the Capital Asset Pricing M odel, investors are primarily concerned withportfolio risk, not the isolated risks of indivi dual stocks. Thus, the relevant risk is anindividual stock's contribution to the overall riskiness of the portfolioTrueTrue or False: When adding new securities to an existing portfolio, the higher or more positive the degree ofcorrelation between the new securities and those already in the portfolio, the greater thebenefits of the additional portfolio diversificationFalseTrue or False: Diversifiable risk, which is measured by beta, can be lowered by adding more stocks to a portfolioFalsetrue or false: If the expected rate of return for a particular investment, as seen by the marginal investor,exceeds its required rate of return, we should soon observe an increase in demand for theinvestment, and the price will likely increase until a price is established that equates theexpected return with the required returnTrueTrue or fAlse: When a firm makes bad managerial judgments or has unforeseen negative events happen to itthat affect its returns, these random events are unpredictable and therefore cannot bediversified away by the investorFalseTrue or False: If an investor buys enough stocks, he or she can, through diversification, eliminate all of thenon-market risk inherent in owning stocks, but as a general rule it will not be possible toeliminate all market risk.TrueTrue or False: The Y-axis intercept of the SML indicates the return on the individual asset when the realizedreturn on an average stock (beta = 1.0) is zeroFalseWhich of the following statements is most correct? a. Risk refers to the chance that some unfavorable event will occur, and a probabilitydistribution is completely described by a listing of the likelihood of unfavorable events. b. Portfolio diversification reduces the variability of returns on an individual stock. c. When company-specific risk has been diversified, the inherent risk that remains is marketrisk which is constant for all securities in the market. d. A stock with a beta of -1.0 has zero market risk. e. The SML relates required returns to firms' market risk. The slope and intercept of thisline cannot be controlled by the financial managerE. The SML relates required returns to firms' market risk. The slope and intercept of thisline cannot be controlled by the financial managerStock A has a beta of 1.5 and Stock B has a be ta of 0.5. Which of the following statementsmust be true about these securities? (Assume the market is in equilibrium.) a. When held in isolation, Stock A has greater risk than Stock B. b. Stock B would be a more desirable addition to a portfolio than Stock A. c. Stock A would be a more desirable addition to a portfolio than Stock B. d. The expected return on Stock A will be greater than that on Stock B. e. The expected return on Stock B will be greater than that on Stock Ad. The expected return on Stock A will be greater than that on Stock B.Which of the following statements is most correct? a. The slope of the security market line is beta. b. A stock with a negative beta must have a negative required rate of return. c. If a stock's beta doubles its required rate of return must double. d. If a stock has a beta equal to 1.0, its required rate of return will be unaffected by changesin the market risk premium. e. None of the above statements is correcte. None of the above statements is correctWhich of the following statements is most correct? a. Portfolio diversification reduces the variability of the returns on the individual stocksheld in the portfolio. b. If an investor buys enough stocks, he or she can, through diversification, eliminatevirtually all of the nonmarket (or company-specific) risk inherent in owning stocks.Indeed, if the portfolio contained all publicly traded stocks, it would be riskless. c. The required return on a firm's common stock is determined by its systematic (or market)risk. If the systematic risk is known, and if that risk is expected to remain constant, thenno other information is required to specify the firm's required return. d. A security's beta measures its nondiversifiable (systematic, or market) risk relative to thatof an average stock. e. A stock's beta is less relevant as a measure of risk to an investor with a well-diversifiedportfolio than to an investor who holds only that one stockd. A security's beta measures its nondiversifiable (systematic, or market) risk relative to thatof an average stock.Which of the following statements is most correct? a. Market participants are able to eliminate vi rtually all market risk if they hold a largediversified portfolio of stocks. b. Market participants are able to eliminate virtually all company- specific risk if they hold alarge diversified portfolio of stocks. c. It is possible to have a situation where the ma rket risk of a single stock is less than that ofa well diversified portfolio. d. Answers a and c are correct. e. Answers b and c are correcte. Answers b and c are correctYou have developed the following data on three stocks: Stock Standard Deviation Beta A 0.15 0.79 B 0.25 0.61 C 0.20 1.29 If you are a risk minimizer, you should choose Stock _____ if it is to be held in isolation andStock _____ if it is to be held as part of a well-diversified portfolio. a. A; A b. A; B c. B; A d. C; A e. C; Bb. A; BInflation, recession, and high interest rates are economic events which are characterized as a. Company-specific risk that can be diversified away. b. Market risk. c. Systematic risk that can be diversified away. d. Diversifiable risk. e. Unsystematic risk that can be diversified away.b. market riskAssume that the risk-free rate is 5 percent, and that the market risk premium is 7 percent. If astock has a required rate of return of 13.75 percent, what is its beta? a. 1.25 b. 1.35 c. 1.37 d. 1.60 e. 1.96a. 1.25True or false: There is an inverse relationship between bond ratings and the required return on a bond. Therequired return is lowest for AAA-rated bonds, and required returns increase as the ratings getlower.TrueTrue or False: Floating rate debt is advantageous to investors because the interest rate moves up if marketrates rise. Floating rate debt shifts interest ra te risk to companies and thus has no advantagesfor issuersFalseTrue or False: You have just noticed in the financial pages of the local newspaper that you can buy a $1,000par value bond for $800. If the coupon rate is 10 percent, with annual interest payments, andthere are 10 years to maturity, you should make the purchase if your required return oninvestments of this type is 12 percentTrueTrue or False: A bond with a $100 annual interest payment, $1000 face value, and five years to maturity(not expected to default) would sell for a premium if interest rates were below 9 percent andwould sell for a discount if interest rates were greater than 11 percentrueTrue or False: A firm with a low bond rating faces a more severe penalty when the Security Market Line(SML) is relatively steep than when it is not so steepTrueWhich of the following statements is most correct?(Note: For the definition of "current yield", check your textbook) a. All else equal, if a bond's yield to maturity increases, its price will fall. b. All else equal, if a bond's yield to maturity increases, its current yield will fall. c. If a bond's yield to maturity exceeds the coupon rate, the bond will sell at a premiumover par. d. All of the answers above are correct. e. None of the answers above is correctA. All else equal, if a bond's yield to maturity increases, its price will fallWhich of the following statements is most correct? a. The market value of a bond will always approach its par value as its maturity dateapproaches, provided the issuer of the bond does not go bankrupt. b. If the Federal Reserve unexpectedly announces that it expects inflation to increase, thenwe would probably observe an immediate increase in bond prices. c. The total yield on a bond is derived from inte rest payments and cha nges in the price ofthe bond. d. Statements a and c are correct. e. All of the statements above are correctd. Statements a and c are correct.What is not included in cost of capitalaccounts payable, accruals, deferred taxesflotation costcommissions, legal expenses, fees and any other costs that.a company incurs when it issues new securitiesCompany can raise common equity directly throughissuing new sharesA company can raise common equity indirectly throughretain earningsDoes new equity capital raised by reinvesting earnings have a cost?YesCost of common stockcost a company incurs providing shareholders with their required returnsCAPMcompany's required stock return is cost of common stock by reinvesting earningsDividend Growth approachmethod of estimating cost of common stockCost of capital factors firm can't control (3)Interest rate Market Risk Premium Tax rateCost of capital factors that the firm can controlCapital structure policy Dividend policy Investment policyCost of capitalthe return a company needs to achieve in order to justify the cost of a capital projectTarget Capital StructureThe mix of debt, preferred stock, and common equity the firm plans to raise to fund its future projects.growth optionsopportunities to expand that arise from the firm's current operating knowledge, experience, and other resourcesassets in placetangible: buildings, machines, inventory Intangible: patents, reputation, customer connectionnonoperating assetsmarketable securities on top of cash needed for operation (short-term investment) simply instead of holding cash you buy another companies stocktoe holding-The company plans to acquire a target company -They will hold 3-5%, helps facilitate acquiring company in the futurehorizon valuethe value of operations at the end of the explicit forecast period. Also called terminal value, equal to the present value of all free cash flows beyond the forecast periodfor a company paying no dividend (with no plans for future dividends) which model should you focus on (FCF or Dividend Growth Model)FCF valuation approach (only)For a more mature company with constant growth, which model should you focus on (FCF or Dividend Growth Model)Dividend Growth modelFor a company with non-constant growth, which model should you focus on (FCF or Dividend Growth Model)BothKey Drivers of Firm ValueSales Growth Operating profitability Capital Requirements WACCSales Growth: driving effect on valueeffect depends on capital requirement and cost of capital. Operating capital may become too expensive in order to keep up with sales growthOperating profitability driving effect on valueOp = NOPAT / Sales Positive relationCapital requirement driving effect on valueCR = Operating Capital / Sales Negative relationWeighted Average Cost of Capital driving effect on valueNegative relationThe set of rules, laws, and procedures that influence a company's operations and the decisions made by managers: CARROTScompensationThe set of rules, laws, and procedures that influence a company's operations and the decisions made by managers: STICKSthreat of removalBoard of Directors is effective if:Elections are fair for minority shareholders Allows cumulative voting CEO is not the chairman of the board Consists of the majority of directors from an outside firm Not too large, no interlocking board Appropriate compensationStaggered/ Classified board-small # of positions are up for re-election at different times - allows you to keep current board intact for longer period of time -This is badCumulative voting-a procedure in which a shareholder may cast all votes for one member of the board of directors -This is goodM&AMergers and Acquisition Types: proxy fight, friendly merger, hostile takeoverHostile Takeoverthe acquisition of a company over the opposition of its management Strongest discipline of M&A Problem: anti-takeover measures by target managementGreenmaila practice whereby a hostile bidder buys up a substantial block of a company's shares and threatens a hostile takeover. The target company can resist the takeover attempt by repurchasing its shares at a premium from the hostile bidderPoison pillsallow existing shareholders the right to purchase additional shares at a discount, effectively diluting the ownership interest of a new, hostile party. Makes the cost of a takeover increase.restricted voting rights planautomatically deprived of voting rights if you own a specific amount of stock, board gives you right to voteStock option in compensation plans-Gives owner the right to buy a share at a discount (strike price) even if stock is higher -usually not allowed to exercise this option for the first few years after option grants (vesting period) -Can't exercise option after a given date (expiration or maturity date)value based managementSystematic use of the free cash flow valuation model to identify value drivers and to guide managerial and strategic decisions.ROIC < Cost of Equity, this meansrequired return is not metEquation for Total corporate valueVop + Marketable securitiesEquation for Intrinsic valueTotal Corporate value - debt - PSEquity FormulaMKT value - NP - LT Debt - PSMoral hazardhidden action, managers will take action and hide it from the principle. Shareholders can't measure the manager's effortaverse selectionmeans hidden types, one party knows something bad. Ex: Company knows more insider information that shareholders don't knowNon-pecuniary benefitNon- monetary reward for work e.g. job satisfaction Using too many company resourcesempire buildinginstead of increasing returns, managers try to keep the resources inside of the firm to keep their job more secure

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