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Question 1

Why is cost of capital important

Answer 1

-Return earned on assets depends on the risk of those assets
-return to an investor = as the cost to coy
-Cost of capital provides us with an indication of how the mkt. views the risk of our assets
-Knowing cost of capital helps determine our req. return for capital budgeting proj.

Question 2

Required return

Answer 2

the same as appropriate discount rate - based on the risk of cash flow
-need req. ret. to compute NPV and take inv.
-need to earn at least the req. ret to compensate our investors for the financing they have provided.

Question 3

Cost of Equity

Answer 3

return req. by equity investors given the risk of CF from the firm.
Methods
-Dividend growth model (DGM)
-SML or CAPM

Question 4

Alternative way to estimate growth

Answer 4

If the coy has a stable ROE, a stable div. policy and is not planning on raising new ext. capital, then the following relationship can be used:
g = Retention ratio * ROE

Question 5

Advantages & Disadv. of DGM

Answer 5

-Easy to understand and use

-Only applicable to companies currently paying dividends.
− Not applicable if dividends aren’t growing at a reasonably constant rate.
− Extremely sensitive to the estimated growth rate - an increase in g of 1% increases the cost of equity by 1%.
− Does not explicitly consider risk.

Question 6

Adv. & Disadv. SML approach

Answer 6

-explicitly adjusts for systematic risk
-applicable to all coy. as long as we can compute beta

Disadvantages
-have to estimate the exp. mkt risk prem. which does vary over time.
-have to estimate beta, which varies over time
-we are relying on the past to predict the future, which is not always reliable.

Question 7

Cost of Debt

Answer 7

-it is the required return on our coy. debt
-focus on the cost of long term debt/bonds
-best estimated by computing the Yield to maturity on the existing debt
-We may also use estimates of current rates based on the bond rating we expect when we issue new debt.

Question 8

Cost of Preferred Stock

Answer 8

• Reminders
  − Preferred generally pays a constant dividend every period
  − Dividends are expected to be paid every period forever
• Preferred stock is an annuity, so we take the annuity formula, rearrange and solve for RP
  RP = D/P0

Question 9

Weighted Average Cost of Capital (WACC)

Answer 9

• We can use the individual costs of capital that we have computed to get our “average” cost of capital for the firm.
• This “average” is the required return on our assets, based on the market’s perception of the risk of those assets.
• The weights are determined by how much of each type of financing that we use

Question 10

Impact of taxes on WACC

Answer 10

Interest expense reduces our tax liability.
This reduction in taxes reduces our cost of debt
=> After-tax cost of debt = RD(1 – TC)
* Dividends are not tax deductible, so there is no tax impact on the cost of equity.

Question 11

Divisional & Project cost of capital

Answer 11

-Pure Play Approach
-Subjective Approach

Question 12

Pure Play Approach

Answer 12

Find one or more companies that specialize in the product or service that we are considering.
* Compute the beta for each company.
* Take an average.
* Use that beta along with the CAPM to find the appr. return for a project of that risk.
* Often difficult to find pure play companies.