Capital Budgeting, Cost of Capital

Question 1

What sources of capital are there?

Answer 1

Internal (i.e. retained earnings) or External (equity or debt)

Question 2

What is the difference between equity and debt?

Answer 2

Equity is money raised by selling shares in the company, debt is money raised by borrowing money

Question 3

What are the advantages of Equity?

Answer 3

Once shares are sold, interest doesn’t have to be repaid

Equity holders can’t force the firm into bankruptcy because it is not a contractual obligation

Question 4

What are the disadvantages of equity?

Answer 4

You cannot claim all the profits anymore, a percentage belongs to the new shareholders

Question 5

What are the disadvantages of Debt?

Answer 5

Lenders must be repaid, or else can force the firm into bankruptcy

Question 6

What are the advantages of Debt?

Answer 6

You only pay a fixed amount of interest based on what you borrowed, no matter how much your business makes

Question 7

What is the expected return of an all equity firm?

Answer 7

It is known as the discount rate, and is given by the CAPM formula

Question 8

What are two assumptions we make when evaluating a new project?

Answer 8

• This is an all equity firm (doesn’t use any debt)
• The risk of the company is similar to the risk of the projects (so that we can use the company’s beta as a proxy for the new projects because their risks are similar)

Question 9

What is the formula for beta?

Answer 9

Cov(R(i),R(M))/Var(R(M))

Question 10

What is the present value of a cash flow in perpetuity?

Answer 10

PV = C/r