ch.9

Question 1

cost of capital used in capital budgeting is a

Answer 1

weighted average of the types of capital the firm uses - typically debt, preferred stock, and common equity.

Question 2

component cost of debt

Answer 2

is the after-tax cost of new debt. To find: multply the interest rate paid on new debt by (1-T) where T=firm’s marginal tax rate

Question 3

debt flotation cost adjustment

Answer 3

incurred when using investment bankers. Reduce the bond’s issue price by the flotation expenses, reduce the bond’s cash flows to reflect taxes, and then solve for the after-tax yield to maturity.

Question 4

component cost of preferred stock

Answer 4

calculated as (Pref. Div)/(Net Price after flotation costs).

Question 5

flotation costs on preferred stock

Answer 5

are usually fairly high, its necessary to include with compoenent cost of pref. stock. IF the preferred stock is convertible into common stock, then the true cost of the preferred stock will EXCEED the flotation-adjusted yield of the preferred dividend

Question 6

cost of common equity

Answer 6

aka cost of common stock. Is the rate of return required by the firm’s stockholders, can be estimated in 3 ways

1. CAPM
2. dividend-yield-plus-judgemental-risk-premium approach
3. over-own-bond-yield-plus-judgemental-risk-premium approach

Question 7

to use CAPM approach

Answer 7

1. estimate firm’s beta
2. multiply the beta by the market risk premium, to obtain the firm’s risk premium
3. add the firm’s risk premium o the risk-free rate to obtain its cost of common stock.

R(s)= R(rf)+RP(m)b(i)

Question 8

best proxy for the risk free rate

Answer 8

is the yield on long-term T-bonds, with 10 years to maturity used most frequently. aka rf rate = % yield for t-bond 10 years

Question 9

to use the dividend-yield-plus-growth-rate approach

Answer 9

aka discounted cash flow (DCF) approach.

add the firms expected dividend growth rate to its expected dividend yield r(s)=D(1)/P(0) + g

Question 10

growth rate for use in DCF model

Answer 10

can be based on analysts published forecasts, historical growth rates (on earnings & dividends), or on the retention growth model g=(1-Payout)(Return on Equity)

Question 11

the over-own-bond-yield-plus-judgmental-risk-premium approach

Answer 11

calles for adding a subjective risk premium of 3-5% points to the interest rate on the firm’s own long-term debt: r(s)= bond yield + judgemental risk premium

Question 12

When calculating the cost of new common stock, the DCF approach

Answer 12

can be used to estimate the flotation cost. For a constant growth stock, it is r(e)=D(1)/[P(0)*[1-F]]+ g . Note that flotation costs cause r(e) to be greater than r(s).

We can find the diff btwn r(e) and r(s) and then add this differential to the CAPM estimate of r(s) to find the CAPM estimate of r(e)

Question 13

each firm has target capital structure

Answer 13

defined as the mix of debt, preferred stock, and common equity which minimizes its weighted avg cost of capital (WACC)

WACC=w(d)r(d)[1-T]+w(ps)r(ps)+w(s)*r(s)

if you don’t now the target weights, it is better to calculated WACC using market value than book value weights

Question 14

various factors affect a firm’s cost of capital

Answer 14

some deteremined thru financial environment, but the firm can influence others thru

1. financing
2. investment
3. dividend policies

Question 15

many firms estimate

Answer 15

divisional costs of capital that reflect each divisions risk and capital structure

Question 16

the pure play and accounting beta methods

Answer 16

can be used to estimate betas for large projects or for divisions

Question 17

a projects stand-alone risk

Answer 17

is the risk the project would have if it were the firm’s only asset, which is measured by the variability of the assets expected returns

Question 18

corporate or within-firm risk

Answer 18

reflects the effect of a project on the firm’s risk, measured by the project’s effect on the firm’s earnings variability.

Question 19

3 risk measures

Answer 19

1. stand-alone risk
2. corporate risk
3. market risk aka beta

Question 20

decision makers and risk

Answer 20

usually consider all 3 subjectively, and classify projects into risk categories. Using firms WACC as starting point, risk-adjusted costs of capital are developed for each category.

Question 21

risk-adjusted cost of capital

Answer 21

cost of capital appropriate for a given project, given its risk. The greater the project risk, the higher its cost of capital