sabaruch

Junior analyst Quentin Haggard is struggling with a required return calculation. His main concern is compensating for exchange rate fluctuations between the country where his company is based and the home country of a portfolio of stocks he is analyzing. Haggard should calculate the return in his home country’s currency, then adjust:

A) for expected changes in the foreign country’s currency value.

B) for expected changes in the foreign country’s inflation rate.

C) the beta to account for exchange-rate fluctuations.

---

The proper method of compensating for changes in exchange rates is to calculate the required return in the home currency, then adjust the return using forecasts for changes in the exchange rate.

sabaruch

Candace Elwince is attempting to calculate the required return of Skeun Inc., a machine-tool manufacturer in a small Eastern European company. Elwince has solid data from the German market but is not sure how to account for the exchange-rate risk Skeun investors would face. Her best choice for creating a risk premium is the:

A) Gordon Growth model.

B) difference between the bond yields of both markets.

C) difference between the inflation rates of both markets.

---

The country spread model suggests an analyst can approximate the risk premium between a developed market and an emerging market by subtracting the bond yields in the developed market from yields in the emerging market.

sabaruch

When attempting to build a risk premium into the required returns of stocks in a developing country, an analyst should use the:

A) modified Gordon Growth model.

B) country’s weighted average cost of capital.

C) country spread model.

---

The country spread model uses data from a developed market, then adjusts it using the difference between the bond yields for the emerging and developed markets. Neither a modified Gordon Growth model nor a weighted average cost of capital will do this job.

sabaruch

Marina Syltus, chief financial officer of Worcester Water Treatment, wants to know the cost of the company’s capital so it can make wiser budgeting decisions. Syltus has assembled the following data:

• Worcester’s long-term debt has a market value of $230 million.
• Worcester’s shares have a total market value of $782 million.
• The marginal tax rate is 37%.
• The required return on equity is 14.6%.
• Worcester’s long-term debt has a weighted average interest rate of 9.4%.

To calculate the weighted average cost of capital, Syltus needs:

A) the required return on debt.

B) the target debt/equity ratio.

C) both the required return on debt and the target debt/equity ratio.

---

The equation for the weighted average cost of capital is as follows:
Market value of debt / market value of debt and equity × required return on debt × (1 − tax rate) + market value of equity / market value of debt and equity × required return on equity.
As such, we need the required return on debt to determine the WACC. However, analysts normally assume debt and equity are at their target ratio to calculate the cost of capital. If the current capital allocation does not match the target weighting, we use the target weighting. Thus, we also need the target weights for debt and equity, which we can derive from a target debt/equity ratio.

sabaruch

For an analyst seeking to value an entire company, the best tool is the:

A) capital asset pricing model.

B) weighted average cost of capital.

C) Pastor-Stambaugh model.

---

The capital asset pricing model and Pastor-Stambaugh models are used to calculate the required return on equity. The weighted average cost of capital is used to value an entire company

sabaruch

Jaime Moreno, a new hire at the venture-capital fund Burkhart Partners, has been tasked with assessing the appeal of various potential equity investments. Moreno has been given the weighted average cost of capital (WACC) for each company. To determine the value of each company’s equity, Moreno should:

A) strip the effects of debt out of the WACC, then calculate the value of equity.

B) calculate the equity value using the WACC, then incorporate the value of debt.

C) calculate the firm value using the WACC, then strip out the value of debt.

---

WACC is used to value an entire firm. To value the equity, use the WACC to calculate the firm’s value, then subtract the market value of its long-term debt.

sabaruch

Joe Bates, CFA, has prepared a schedule of real cash flows for his company’s plant expansion. Bates generally uses the weighted average cost of capital to discount such cash flows, but in order to accurately determine the present value of those real cash flows, he should adjust the discount rate to reflect:

A) expected inflation.

B) the company’s cost of both debt and equity.

C) expected changes in the market growth rate.

---

In the context of cash flows, “real” refers to inflation-adjusted cash flows. The weighted average cost of capital already takes the cost of both debt and equity into account, but this is a nominal, not a real, discount rate. The market’s growth rate is rarely relevant to cash flows to the firm and is not part of the WACC calculation.

sabaruch

Cash flows to the firm should be discounted at the:

A) market’s estimated rate of return.

B) firm’s weighted average cost of capital.

C) rate determined by the capital asset pricing model.

---

The weighted average cost of capital is the preferred discount rate for cash flows to the firm, as it reflects the cost of both debt and equity.