17 - Cost of Capital : Advanced Topics

Question 1

weighted average cost of capital

Answer 1

Question 2

Top-down (i.e., external or macro) factors include:

Answer 2

Capital availability.
Market conditions.
Legal and regulatory considerations, country risk.
Tax jurisdiction.

Question 3

Bottom-up (i.e., company-specific) factors that affect the cost of capital include:

Answer 3

Business or operating risk.
Asset nature and liquidity.
Financial strength and profitability.
Security features.

Question 4

Publicly Traded Debt - Estimating Cost of Debt

Answer 4

If the company’s debt is publicly traded, the yield to maturity for the longest maturity straight debt outstanding is generally the best estimate of the cost of debt.

Question 5

Non-Traded/Thinly Traded - Estimating Cost of Debt

Answer 5

If the company’s debt is not traded or is thinly traded, we can use matrix pricing to consider the yields on traded securities with the same maturity and credit ratings.

If the debt is not credit rated, then financial ratios of the company such as interest coverage (IC) ratio or financial leverage (D/E) ratio may be used to infer a credit rating for that debt.

Leases—and specifically, finance (i.e., capital) leases—can be used to estimate the cost of borrowing

Question 6

rate implicit in the lease (RIIL)

Answer 6

implied cost of capital in a lease

Question 7

rate implicit in the lease (RIIL) can be estimated as the IRR of

Answer 7

PV of lease payments + PV of residual value = Fair value of leased asset + Lessor’s initial direct cost

Question 8

incremental borrowing rate (IBR)

Answer 8

the rate on a new secured loan over the same term

Question 9

country risk rating (CRR)

Answer 9

reflects risks related to economic conditions, political stability, exchange rate risk, and the level of capital market development

Question 10

Country Risk Premium

Answer 10

The excess of the median interest rate for that country relative to the benchmark country rate determines the country risk premium

Question 11

The required return on equity security i can be calculated as:

Answer 11

Question 12

two types of estimates of the equity risk premium

Answer 12

historical estimates and forward-looking estimates.

Question 13

Historical Estimates of the Equity Risk Premium

Answer 13

consists of the difference between the historical mean return for a broad-based equity market index, and a risk-free rate over the same period.

Question 14

A weakness of the historical approach Historical Estimates of the Equity Risk Premium

Answer 14

assumption that the mean and variance of the returns are constant over time - equity risk premium actually appears to be countercyclical—it is low during good times and high during bad times
may suffer from survivorship bias

Question 15

Forward Looking Estimates of the Equity Risk Premium

Answer 15

use current information and expectations concerning economic and financial variables

Question 16

There are three main categories of forward-looking estimates

Answer 16

survey-based estimates,
dividend discount model estimates, and
estimates from macroeconomic modeling.

Question 17

Survey Estimates for ERP weakness

Answer 17

tend to be biased toward recent market returns.

Question 18

dividend discount model for ERP

Answer 18

ERP = E(dividend yield) + g − rf

re = (D1/V0) + g

Question 19

Macroeconomic Models for ERP

Answer 19

use the Grinold-Kroner (2001) model to illustrate a macroeconomic model.

Question 20

Grinold-Kroner Model (2001)

Answer 20

Question 21

‘g’ (the capital gains yield, CGY) formula - For the Grinold-Kroner Model (2001)

Answer 21

Question 22

estimating expected inflation formula

Answer 22

Question 23

Several approaches to estimating the required rate of return on equity

Answer 23

DDM
Bond-Yield-Plus–Risk-Premium Method
build-up approaches
Risk Based Model - CAPM
MultiFactor model - (Fama and French)
and risk premium models.

Question 24

DDM for measuring cost of equity

Answer 24

For an individual company, cost of equity is dividend yield plus capital gains yield.

Question 25

Bond-Yield-Plus–Risk-Premium Method for measuring cost of equity

Answer 25

adds a risk premium to the yield to maturity (YTM) of the company’s long-term debt.

Question 26

capital asset pricing model (CAPM)

Answer 26

required return on stock = risk-free rate + (equity risk premium × beta of stock)

Question 27

Multifactor Models for measuring cost of equity

Answer 27

The general form of an n-factor multifactor model is:

required return = rf + (risk premium)1 + (risk premium)2 + … + (risk premium)n

where:

(risk premium)i = (factor sensitivity)i × (factor risk premium)i

Question 28

Multifactor vs CAPM

Answer 28

Multifactor models can have greater explanatory power than the CAPM (which is a single-factor model).

Question 29

Fama–French Models for measuring cost of equity

Answer 29

Question 30

A five-factor Fama–French model for measuring cost of equity

Answer 30

Question 31

Appropriate risk premiums for a private company include

Answer 31

size premium (SP),
industry risk premium (IP), and
specific company risk premium (SCRP).

Question 32

Factors Affecting specific company risk premium (SCRP)

Answer 32

Qualitative factors:
Quantitative factors

Question 33

There are two approaches to estimate the cost of equity for private companies

Answer 33

expanded CAPM and build-up approach.

Question 34

Expanded CAPM Approach for measuring cost of equity for Private Companies

Answer 34

Question 35

Build-Up for measuring cost of equity for Private Companies

Answer 35

Question 36

The estimated equity risk premium for international companies

Answer 36

Question 37

sovereign yield spread

Answer 37

the difference in yields of emerging market government securities relative to developed market benchmark security

Question 38

Damodaran recommended adjusting the sovereign yield spread by the ratio of standard deviation of the country’s equity and bond markets:

Answer 38

Question 39

international CAPM (ICAPM)

Answer 39