Chapter 12: Cost of Capital

Question 1

The equilibrium rate of return demanded by investors in the capital markets for securities with the same degree of risk

Answer 1

Cost of Capital

Question 2

Rate in order of highest required rate of return to lowest

a. Short-Term Gov Debt (Treasuy Bills)
b. Low- quality Corporate Bond
c. Common Stock
d. Long term Government Debt
e. High Quality Corporate Debt
f. High Quality Preferred Stock

Answer 2

c. b. f. e. d. a.

Question 3

Three types of capital

Answer 3

Debt
Equity
Preferred Stock

Question 4

Cost of Capital also can be the _____ required by investors in the firm’s securities

Answer 4

required rate of return

Question 5

We want the return to be _____ than the cost of capital to create value for the firm

Answer 5

higher

Question 6

The action of investors moving their capital away from riskier investments to the safest possible investment vehicles

Answer 6

Flight to Quality

Question 7

Used to find the cost of capital for equity

• How much an investor will require in return for the investment
• Used by investors and firms

Answer 7

Capital Asset Pricing Model (CAPM)

Question 8

CAPM Equation

Answer 8

k_e=r_f + B (r_m - f_f)

k – Amount of return equity investors should demand for taking on the amount of present risk
rf – Risk-free rate
rm – Expected market return

Question 9

someone taking a risky investment should get ____ at minimum

Answer 9

the risk free rate

Question 10

(rm - rf) is called

Answer 10

Market Risk Premium

Question 11

Why is WACC important?

Answer 11

Tells you our average cost of capital given your weighted capital structure

Question 12

We want WACC to be as ____ as possible

high or low

Answer 12

low

Question 13

If risk goes up, the required rate of return goes ____

up or down

Answer 13

up

Question 14

How could risk or events impact a firm?

Answer 14

If government begins to deregulate, it increases competition, which creates more risk
If government begins to regulate, cost go up (for new requirements), so many of the small companies can’t afford to keep up. They can drop out or be bought out.

-Government starts raising interest rates (means the economy is doing well). So the assumption is that there’s less risk in the market. So risk discounts go down (risk premium goes down)

Question 15

What does it mean if Government starts raising interest rates?

Answer 15

• economy is doing well (unemployment is low)
• So the assumption is that there’s less risk in the market.
• risk discounts go down (risk premium goes down)

Question 16

WACC can be impacted by

Answer 16

-Regulation

• The distribution of money between the three types
• -Balancing between the three
• -Can’t invest 100% in just debt (given it’s the cheapest) because leverage/risk would be too high
• How old the company is
• -Example – Startups go through a lot of cash, so they don’t want to have a lot of debt. Interest on debt has to be paid, where dividends on equity do not

Question 17

Why do we want to minimize WACC?

Answer 17

it’s easier to add value (the present value of future cash flows will be higher)
It’s the cost of investing in projects; less expensive is better

Question 18

Risk that is specific to an asset or a small group of assets

Answer 18

Idiosyncratic Risk / Firm-Specific Risk

• Risk has little or no correlation with market risk
• Can be substantially mitigated or eliminated from a portfolio by using adequate diversification

Question 19

What is the term for when you have a Diversified portfolio?

Answer 19

“Holding the Market” / “Investing in the Market”

It is less risky, it negate firm-specific risk

Question 20

What happens when there is deregulation

Answer 20

competition starts to increase.
Because more competition, there is more risk. Investors will requite higher rate of return
When regulation happens, a lot of smaller firms will die or get bought out so the competition becomes more consilidated