Chapter 12 - Estimating th Cost of Capital Flashcards
According to the CAPM, we can determine the cost of capital of an investment by comparing it to what portfolio?
The Market portfolio
What inputs do we need to estimate a firm’s equity cost of capital using the CAPM?
Market portfolio and estimate the beta.
Value Weighted Portfolio
also called an equal-ownership portfolio. It consists of the same fraction of the outstanding shares of each security.
Passive Portfolio
A portfolio that is not rebalanced in response to price changes
Market Index
It is the market value of a broad-based portfolio of securities
Price-Weighted Portfolio
holds an equal number of shares of each stock; size of stock doesn’t matter
Index Funds
Mutual funds that invest in stocks in proportion to their representation in a published index (e.g. S&P 500)
Exchange-traded fund (ETF)
Securities that trade on an exchange that are entirely invested in a portfolio of stocks that represent portfolios such as market indices like the S and P 500
The yield to maturity of a bond
is the IRR an investor will earn from holding the bond to maturity and receiving its promised payments.
If there is little risk of the firm defaulting then yield to maturity can estimate the investor’s expected return.
If there is a risk of the firm defaulting, then the yield to maturity of the firm’s debt, it’s promised return will overstate investor’s expected return.
What is a market proxy?
A portfolio whose return they believe closely tracks the true market value.
How do you determine the weight of the stock in the market portfolio?
By using the market index
How do we define a stock’s alpha, and what is its interpretation?
The difference between a security’s expected return, and its CAPM required return, from the security market line. According to the CAPM, all stocks and securities should be on the security market line and have an alpha of zero. If some securities have a nonzero alpha, the market portfolio is not efficient, and its performance can be improved by buying securities
with positive alphas and selling those with negative alphas.
How can you estimate a stock’s beta from historical returns?
Through the best-fitting line.
It is common to estimate a stock’s beta based on the historical correlation and volatilities. Makes sense to do so if the beta is stable over a period of time.
All equity financed firm
a firm with no debt
2 drawbacks for looking at the historical risk premium
- Despite having at least 50 years of data, the standard errors of the estimates are large
- Because you’re looking back through history, you can’t be sure that the estimates correctly estimate the current expectations
Examples of Market Indexes
- S and P 500 (value-weighted)
2. Dow Jones Industrial Average (price-weighted)
How can you estimate market risk premium?
Historical Data (i.le. stock market index)
Survey
Implied Rates
How do we define a stock’s alpha, and what is its interpretation?
It is the distance the stock’s average return is above or below the SML
Debt Cost of Capital
cost of capital that a firm must pay on its debt
Asset cost of capital (or unlevered cost of capital)
expected return required by the firm’s investors to hold the firm’s underlying assets, is the weighted average of the firm’s equity and debt costs of capital
Levered Firms as Comparables
This is for when the firm has a debt.
All equity comparables
This is for when the firm has no debt.
Enterprise value
combined market value of the firm’s equity and debt, less any excess cash.
True or False
Asset (unlevered) cost of capital does not have any leverage
False
It is called this because the return on assets is the same as the return on equity if the firm would have no leverage
How to determine the debt cost of capital (rD)
either by:
Use CAPM for debt (using beta of debt)
use yield to maturity and probability of default
True or False
Debt Cost of Capital: If there is little risk of defaulting, then yield to maturity is a reasonable estimate of investor’s expected debt rate of return
True
True or False
Debt Cost of Capital: If there is a high risk of defaulting, then yield to maturity will overstate estimate of investor’s expected debt rate of return and a correction will be needed
True
Operating Leverage
The relative proportion of fixed versus variable costs. Holding the cyclicality of the project’s revenues fixed, a higher proportion of fixed costs, and thus higher operating leverage, will increase the sensitivity of the project’s cash flows to market risk, and raise the project’s beta.
How do you determine the weight of a stock in the market portfolio?
In a value-weighted portfolio, like the market portfolio, each security is held in proportion to
its market capitalization. The weight of each stock is determined as the fraction of money
invested in that stock corresponding to its share of the total market value of all securities in
the portfolio.
Why does the equity beta of a levered firm differ from the beta of its assets?
If the comparable firm has debt, the returns of the firm’s equity alone are not
representative of the underlying assets; in fact, because of the firm’s leverage, the equity
will often be much riskier. Thus, the beta of levered firm’s equity will not be a good estimate
of the beta of its assets, and of our project.
Under what conditions can we evaluate a project using the firm’s weighted average cost of
capital?
A firm’s beta reflects the market risk of the average project in a firm. So, if the firm
operates in one line of business, or all of the lines of business have the same amount of
market risk, then the firm’s weighted-average cost of capital can be used to evaluate any
project.
