Capital Structure and Discount Rates

Question 1

Why do we want a separate discount rate for different divisions in a company?

Answer 1

Discount rates are “project-specific”

Question 2

We can calculate what return a well diversified investor will demand in compensation for any level of systematic risk using what?

Answer 2

The CAPM

Question 3

How do we measure risk?

Answer 3

Beta

Question 4

Do investors care about firm-specific risks?

Answer 4

No; they only care about “project-specific” risks

Question 5

When making capital budgeting decisions, we must determine whether the project we are evaluating delivers sufficient return to compensate our investors for the amount of systematic risk it adds to their well-diversified portfolio. How do we determine whether the project we’re evaluating delivers sufficient returns?

Answer 5

Calculate the present value of the project using the appropriate risk adjusted rate of return

Question 6

Define systematic risk.

Answer 6

Undiversifiable risk; risk of collapse of an entire financial system or entire market,

Question 7

What are two important considerations we need to take into account when using the CAPM for capital budgeting of risky projects?

Answer 7

(1) A firm may have different ‘types’ of projects (different types of projects will have different levels of systematic risk)
(2) A firm may raise finance through both debt and equity (looking only at the return which is required on the firm’s equity will not account for the true cost of funds)

Question 8

Define capital structure.

Answer 8

How firm finances its overall operations and growth by using different sources of funds (debt and equity)

Question 9

Define cost of capital.

Answer 9

Rate of return required to persuade investor to make a given investment (opportunity cost of making a specific investment; it is the rate of return that could’ve been earned by putting the same money into a different investment with equal risk)

Question 10

When evaluating a risky project, we need to assess how much risk we are adding to our investors’ well diversified portfolio. What matters?

Answer 10

The systematic risk of the new project (that is, how the CFs from that project vary with the market. This is the Project Beta)

Question 11

Define project beta

Answer 11

How the CFs from the project vary with the market

Question 12

To do capital budgeting, what do we use the project beta for?

Answer 12

To determine the appropriate discount rate to apply to the project cash flows

Question 13

What kind of projects do we always accept?

Answer 13

Accept all positive NPV projects

Question 14

What doesn’t matter in evaluating a risky project? Why?

Answer 14

The beta of your firm’s other projects. These are not related to the amount of risk that your new project is introducing into your shareholder’s well diversified portfolio.

Question 15

In evaluating a risky project, why can’t we use the beta of our firm’s equity?

Answer 15

It reflects the riskiness of ALL our firm’s cash flows

Question 16

Define asset beta

Answer 16

The firm’s asset beta is a weighted average of each of its project betas; asset beta measures the systematic risk of all the firms cash flows; asset beta reflects how the TOTAL cash flows of the firm vary with the return of the market

Question 17

When we estimate the beta of the firm’s equity, we will have a measure of the asset beta, but we won’t know the beta of the individual projects, and hence don’t know what the right cost of capital to use is for evaluating investments in either type of business. To solve this, what will we typically use?

Answer 17

• We’ll typically use comparable firms (or better- several comparable firms)

Question 18

Define leverage. Why does it come with greater risk?

Answer 18

Amount of debt a firm uses to finance its assets; comes with greater risk because it magnifies gains and losses so not reasonable for firm to have 100% debt financing

Question 19

As leverage increases, what is the effect on the asset beta and the stock beta?

Answer 19

• Asset beta not affected.

* Stock beta increases as leverage increases.

Question 20

When can we use the firm’s WACC to discount a project’s cash flow?

Answer 20

When the project has:

• the same business risk as the rest of the company (same asset beta)
• the same capital structure as the rest of the company

Question 21

What do we do when we cannot use the firm’s WACC to discount a project’s cash flow?

Answer 21

(1) Find comparables (firms with same market risks as our project)
(2) Estimate each comparable’s equity beta (using CAPM)
(3) Unlever each comparable’s equity beta to get its asset beta
(4) Take the average of all the comparable’s asset betas
(5) Relever the average asset beta to the right capital structure to get equity beta
(6) Plug that equity beta into CAPM to get the cost of equity capital
(7) Compute WACC using that cost of equity capital and the appropriate cost of debt capital

Question 22

Define WACC

Answer 22

Rate that a company is expected to pay on average to all its security holders to finance its assets.

Question 23

Who has senior claim? Who has residual claim?

Answer 23

Debt holders have senior claim (get paid first).

Equity holders have residual claim (get whatever is left over)

Question 24

Who bears less of the firm’s systematic risk (per dollar invested)?

Answer 24

Debt holders

Question 25

How do we compensate equity holders for the increase in the amount of systematic risk by increasing our leverage?

Answer 25

Need higher expected returns

Question 26

How do we calculate the cost of capital for the firm’s assets (WACC)?

Answer 26

Sum the weighted average of the expected return on equity and the expected return on debt

Question 27

What are the three main steps in the capital budgeting process?

Answer 27

(1) Using the “project beta” and the “CAPM,” calculate the discount rate for the project (“r”)
(2) Discount the expected cash flows, both inflows and outflows, from the project at the “project discount rate” to get the NPV of the project
(3) Accept all positive NPV projects, reject all negative NPV projects

Question 28

What is a pure-play?

Answer 28

Firms whose only line of business are similar to the project we’re considering