33.1: Cost of Capital

Question 1

Component cost of capital is?

Answer 1

The rate of return required by suppliers of capital for an individual source of a company’s funding, such as debt or equity.

Question 2

What is the Weighted average cost of capital WAAC?

Answer 2

A weighted average of the after-tax required rates of return on a company’s common stock, preferred stock, and long-term debt, where the weights are the fraction of each source of financing in the company’s target capital structure.

Question 3

WAAC Formula is?

Answer 3

WACC = WdRd(1 – t) + WpRp + WeRe,

Where:
· Wd = the target proportion of debt in the capital structure when the company raises new funds;
· Rd = the before-tax marginal cost of debt
· t = the company’s marginal tax rate
· Wp = the target proportion of preferred stock in the capital structure when the company raises new funds
· Rp = the marginal cost of preferred stock we = the target proportion of common stock in the capital structure when the company raises new funds
· Re = the marginal cost of common stock

Question 4

What is important to remember when calculating WAAC?

Answer 4

To know whether the interest rate is tax deductible.

And what is the frequency of coupon payments?

Question 5

What is YTM?

Answer 5

An annual return that an investor earns on a bond if the investor purchases the bond today and holds it until maturity. It is the discount rate that equates the present value of the bond’s expected cash flows until maturity with the bond’s price.

Question 6

How do you calculate YTM?

Answer 6

= [Σ^n t=1 PMTt / ( 1 + Rd/2)^t] + FV / (1 + Rd/2)^n

Question 7

What is the Matrix Pricing (debt-rating) approach?

Answer 7

Process of estimating the market discount rate and price of a bond based on the quoted or flat prices of more frequently traded comparable bonds.

Question 8

Cost of debt formula is?

Answer 8

Rd(1 - t) = %

Question 9

Formula for the Cost of preferred stock is?

Answer 9

Cost of preferred stock = preferred dividend / preferred stock share price

Question 10

What is CAPM?

Answer 10

The use of the basic relationship from the capital asset pricing model theory that the expected return on a stock, E(Ri), is the sum of the risk-free rate of interest, RF, and a premium for bearing the stock’s market risk, βi(RM − RF).

Question 11

What is the Bond yield plus risk premium approach (BYPRP)?

Answer 11

An estimate of the cost of common equity that is produced by summing the before-tax cost of debt and a risk premium that captures the additional yield on a company’s stock relative to its bonds.

Question 12

CAPM (Beta or market risk) formula is?

Answer 12

Cost of Equity = Rf + β(Rm - Rf)

Where:
→ Rf = risk-free rate
→ β = beta;
→ Rm = market return
→ Rm - Rf = equity risk premium ERP

Question 13

The Bond yield plus risk premium approach (BYPRP) formula is?

Answer 13

Re = Rd + Risk premium

Question 14

What is beta?

Answer 14

Beta is an estimate of the company’s systematic or market-related risk.

Question 14

The most commonly used adjustment is?

Answer 14

Adjusted beta = (2/3)(Unadjusted beta) + (1/3)(1.0)

Question 15

What is the asset beta?

Answer 15

It is the unlevered beta, which reflects the business risk of the assets; the asset’s systematic risk.

Question 16

Formula for the unlevered beta is?

Answer 16

βU = βE [ 1 / 1+(1-t) * D/E ]

Where:
- βE be the equity beta of the peer company before removing the effects of leverage
- βD is the debt’s beta
- t is the marginal tax rate of the peer company
D and E are the market values of debt and equity, respectively, of the peer company.

Question 17

Formula for the levered beta is?

Answer 17

βE = βU [ 1+(1-t) * D/E ]

Where:
- βE is now the equity beta of the thinly traded or nonpublic company,
- t is the marginal tax rate of the thinly traded or nonpublic company,
- D and E are the debt-to-equity values, respectively, of the thinly traded or nonpublic company.

Question 18

What are the flotation costs? Investment banker fees..

Answer 18

For raising new capital (incl. other costs).

Question 19

Flotation costs formula is? (The cost of external equity)

Answer 19

Re = (D1 / P0 − F) + g

Where:
- re is the cost of equity
- D1 is the dividend expected at the end of Period 1
- D0 - current dividend
- P0 is the current stock price
- F is the monetary per share flotation cost
- g is the growth rate

Question 20

Flotation costs formula as a percentage applied against the price per share, the cost of external equity is?

Answer 20

Re = [D1 / P0(1 −f )] + g

Question 21

Important points to keep in mind when calculating flotation costs:

Answer 21

· Pay attention whether it is D0 or D1, if D0, then D0 * (1 + g) = D1

· Also, consider whether the stock is issued or not and if it’s internal or external capital raising.