Ch7-The cost of capital

Question 1

What is the cost Capital?

Answer 1

The project cost of capital is the required rate of return, or hurdle rate, for the project. The expected returns of the project or investment must exceed the project cost of capital for the project to be deemed a worthwhile investment opportunity.

Question 2

The Cost Of Equity

Answer 2

The cost of equity is more than the cost of debt, in part due to the more favourable tax treatment of debt. (the business will pay less tax on their overall profits since interest payments will lower the profit)

~ the cost of equity represents the opportunity cost of capital - the rate forgone by shareholders investing in the project rather than investing in the alternatives securities.

~ The equity is risky hence they have to be compensated for the risk taken (that is a high return)

~ Cost of equity = Risk-free rate + Equity risk premium

Question 3

How do we analyze equity performance?

Answer 3

1. The length of the period of investigation- data that is taken from as long a period as possible should be used,
2. The data must also be homogeneous(the degree to which the results of studies included in a review are similar)
3. Use the results that are taken more frequently (in order to enhance data)
4. Trends over time
5. Significant once-off event
6. Reliability of data

Question 4

Discuss the equity performances options

Answer 4

~ We look at past data to analyse the trends. Past and present data is used to project for the future.

~ the period has to be long to catch the cycles/trends.
~ homogeneity of results is comparing like with like. Analysing data that is the same.
~ if there is an increase in interest rate, we analyse this because there might be a chance of this occurring again but with once-off events, we don’t go through the investigation
~ trends over time- trough depends on marketing conditions. it is seasonal. it could be that they are offering more goods demanded during that season
~ the data is more accurate with continuous extraction of data
~ the data won’t be comparable if there isn’t any reliability of data. results will be inaccurate
~ to check if the data is reliable, you can do that by checking if it’s from large samples, the source of data, if it has credibility attached to it then you can rely on it.

Question 5

What is the risk-free rate?

What is the equity risk premium?

How do you determine you can invest in stock?

Answer 5

~is the rate of return of a hypothetical investment with scheduled payment over a fixed period of time that is assumed to meet all payment obligations
~return on government bonds

~compensation for the extra risk equity holds

~look at the return related to portfolios
~look at the business cycles- see the trends on the market
~return over a period of time

Question 6

CAPM and specific risk

What is the CAPM?

Answer 6

~a market portfolio of equities suffers a high degree of volatility
~In a stock market, not all shares move in the same direction at the same time and to the same degree
~the CAPM divides the volatility of the stock price into two parts, the specific risk and systematic risk.

~ it measures the performance volatility of an individual share compared to the market average

Question 7

The aspects of specific risk

what does a beta of 1 indicate?

what is beta of a stock?

Answer 7

it refers to the specific business
~ it can be diversified away
~ interest rates (relating to the company level of borrowing)
~ the company rating

• it indicates a stock that has amplified the return of the whole market
• a beta close to zero indicates a stock that provided a more stable return than the market as a whole
• a negative beta shows a stock whose performance was counter-cyclical, offsetting the overall market experience

~ it can be regarded as a measure of the systematic risk associated with a particular stock

Question 8

Systematic RISK

Answer 8

~ it cannot be diversified away
~, not all economies move in the same cycle, this does affect the business cycle because the economy is highly interdependent today(there is an underlying cycle of business activity which affects all businesses)
~ the interest rates are a second economic influence that affects all businesses. It depends on the level of borrowing
~ Inflation rate- rising inflation depresses profits short-term, however in the long run the price rises restore margins and profits kept pace with the inflation.
~ Tax- changes in tax can have an impact on price levels and affect all companies
~ Currency movements- companies that trade in affected countries will suffer to different degrees. International crises, and wars affect the global economy
~ Natural events can have systematic effects. Climate change have major economic impacts

Question 9

Adjusting for gearing

Answer 9

The cost of equity stock = risk-free rate + Equity risk premium x beta for stock
~ the company’s beta will vary with the period over which the estimation is made
~ the cost of equity is affected by the company’s existing gearing
~ Gearing = ungeared beta x (1 + debt:equity ratio x (1 - tax rate))

Question 10

What is the impact of capital structure on the cost of capital?

Answer 10

~ the cost of debt will vary from company to company depending on its credit worthiness, often expressed as a credit rating
~ the marginal cost of debt will increase as the level of debt is pushed up
~ the average cost = average cost of new debt + existing debt
~ further debt increases the average cost of capital because of the secondary effects