Which of the following statements about the capital asset pricing model (CAPM), which is the "father" of the security market line (SML), is(are) most correct?
The CAPM is based on a restrictive set of assumptions.
It has not been empirically verified.
In general, its inputs are difficult to estimate, particularly E(g).
Despite its deficiencies, it provides investors with a rational way of thinking about required rates of return.
All of the above responses are correct.
Which of the following statements about the capital asset pricing model (CAPM), which is the "father" of the security market line (SML), is(are) most correct?
The CAPM is based on a restrictive set of assumptions. | ||
It has not been empirically verified. | ||
In general, its inputs are difficult to estimate, particularly E(g). | ||
Despite its deficiencies, it provides investors with a rational way of thinking about required rates of return. | ||
All of the above responses are correct. |
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True or False: It is free for a company to raise money through retained earnings, because retained earnings represent money that is left over after dividends are paid out to shareholders.
True
False
Points:
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Explanation:
The current risk-free rate of return is 3.80% and the current market risk premium is 6.10%. Blue Hamster Manufacturing Inc. has a beta of 1.56. Using the Capital Asset Pricing Model (CAPM) approach, Blue Hamsterâs cost of equity is selector 1
13.99%
14.65%
13.32%
17.32%
.
Points:
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Explanation:
Fuzzy Button Clothing Company is closely held and, as a result, cannot generate reliable inputs for the CAPM approach. Fuzzy Buttonâs bonds yield 10.20%, and the firmâs analysts estimate that the firmâs risk premium on its stock relative to its bonds is 3.50%. Using the Bond-Yield-plus-Risk-Premium approach, the firmâs cost of equity is selector 1
13.01%
17.13%
13.70%
15.07%
.
Points:
Close Explanation
Explanation:
The stock of Cute Camel Woodcraft Company is currently selling for $25.67, and the firm expects its dividend to be $1.38 in one year. Analysts project the firmâs growth rate to be constant at 7.20%. Using the discounted cash flow (DCF) approach, Cute Camelâs cost of equity is estimated to be...
16.98%
13.21%
12.58%
11.95%
.
Points:
Close Explanation
Explanation:
It is often difficult to estimate the expected future dividend growth rate for use in estimating the cost of existing equity using the DCF approach. In general, there are three available methods to generate such an estimate:
⢠| Carry forward a historical realized growth rate, and apply it to the future. |
⢠| Locate and apply an expected future growth rate prepared and published by security analysts. |
⢠| Use the retention growth model. |
Suppose Cute Camel Woodcraft Company is currently distributing 70.00% of its earnings in the form of cash dividends. It has also historically generated an average return on equity (ROE) of 12.00%. Cute Camel Woodcraft Companyâs estimated growth rate is...
11.70%
3.60%
12.30%
42.00%
.
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. |
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. |
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. |
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. |
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. |
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. |
7.37%. 11.05%. 8.32%. |
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. |
1.82. 2.00. 1.94 |
undervalued. overvalued. |
13.92%. 16.34%. 12.17%. |
$221.86. $195.23. $257.35. |
10.82%. 11.76%. 9.64%. |
10 years. 4.58 years. 6.12 years. |
12.04%. 14.93%. 9.15%. |
1.24 years. 1.62 years. 1.15 years.
|