Ch. 8 - Cost of Capital

Question 1

Weighted Average Cost of Capital (WACC)

Answer 1

The dollar-weighted average of debt and equity a firm takes on after tax. It is the discount rate for the firm (R = k = WACC)

Question 1

How do firms raise capital?

Answer 1

Firms raise capital through debt and equity. Debt includes borrowings and bonds. Equity includes preferred shares and ordinary shares

Question 2

Fisher’s Separation Theorem

Answer 2

A firm’s financing decisions are separate from the firm’s investment decisions

Question 3

How are the weights for debt and equity of a firm computed?

Answer 3

The weights for debt and equity are computed using market prices. Thus, they will fluctuate over time

Question 4

Why is the debt component of WACC multiplied by (1-T)?

Answer 4

The firm gets a tax deduction on the interest paid on debt, but not on the dividends paid to equity because they are already after tax

Question 5

Why is it desirable for firms to take on debt?

Answer 5

Firms gain a tax saving from debt due to the interest tax shield