B2 - M1: Capital Structure Part 1

Question 1

What is CAPM?

Answer 1

Capital Asset Pricing Model

Question 2

What are the components of calculating CAPM?

Answer 2

Beta Coefficiant, Risk Free Rate, Market Rate of Return, Required Rate of Return (Required Rate is the Objective of calculating CAPM)

Question 3

How is CAPM Calculated?

Answer 3

( (Market Return - Risk Free Rate) ) * Beta) + Risk Free Rate = Required Rate of Return for Equity

Question 4

What does the Beta Coefficient Measure within CAPM?

Answer 4

Volatility of a stock relative to the Market

Question 5

What is the major advantage of acquiring capital through Debt?

Answer 5

The tax savings due to tax deductions allowed on interest payments

Question 6

What is WACC?

Answer 6

Weighted Average Cost of Capital

Question 7

What does WACC measure?

Answer 7

WACC is used to measure the combined average cost of all financing used by a company (categories are typically Common Stock Equity, Preferred Stock Equity, and Debt).

Question 8

What is the Internal Rate of Return?

Answer 8

The internal rate of return is the anticipated return on a particular investment that the company is considering

Question 9

What do you do with the Internal Rate of Return?

Answer 9

The IRR of a potential project is compared to WACC. If the IRR is greater or equal to the WACC then it is acceptable to invest in that project.

Question 10

What is removed from the Cost of Debt prior to analyzing it for the purposes of WACC?

Answer 10

Tax Savings are considered a benefit and thus are removed from the cost.

Question 11

What are the characteristics of Commercial Paper?

Answer 11

“1.) Generally does not have an Active Secondary Market,
2.) Generally Maturity dates are less than 270 days (9 months),
3.) Can be sold through brokers dealers and investment brokers,
4.) Can be sold direct between one company and another.”

Question 12

What are the benefits of Commercial Paper?

Answer 12

“1.) Avoids the expense of compensating balances required by a Bank
2.) Provides a Broad Distribution for Borrowing
3.) The borrower’s name becomes more widely known”

Question 13

The components needed to calculate Cost of Equity Capital are?

Answer 13

“1.) Current Dividends Per Share (D),
2.) Expected Growth Rate in Dividends (G),
3.) Current Market Price of common stock (P)”

Question 14

How is Cost of Equity Capital calculated?

Answer 14

“If (R) is the cost of capital (return):
R = (D-dividends in 1 year / P-price today) + G-growth rate; R = (D’1’/P’0’) + G
(NOTE: this formula is for common stock. Preferred Stock Dividends are fixed, so growth rate is irrelevant)”

Question 15

Dividend Growth Model is the foundation of which Capital Structure Calculation?

Answer 15

Cost of Equity Capital

Question 16

What are other terms referring to the cost of Equity Capital?

Answer 16

“1.) Dividend Growth Model,
2.) Cost of Retained Earnings,
3.) Discounted Cash Flow (DCF)”

Question 17

How is the cost of Preferred Stock calculated?

Answer 17

“If (R) is the cost of capital (return):
R = $ amount of Dividends / Net Proceeds (Price today less any Issuance Costs)
(NOTE: Unlike Common Stock, Preferred Stock Dividends are fixed, so growth rate is irrelevant)”

Question 18

What is Market Capitalization?

Answer 18

The number of common shares outstanding MULTPLIED BY the fair market value per share

Question 19

What is Risk/Reward Ratio analyzing?

Answer 19

Risk/Reward Ratio compares the amount of return to the risk of loss assumed. Thus the Standards Deviation is SUBTRACTED from the Mean Return.