Chapter 12 - Estimating th Cost of Capital

Question 1

According to the CAPM, we can determine the cost of capital of an investment by comparing it to what portfolio?

Answer 1

The Market portfolio

Question 2

What inputs do we need to estimate a firm’s equity cost of capital using the CAPM?

Answer 2

Market portfolio and estimate the beta.

Question 3

Value Weighted Portfolio

Answer 3

also called an equal-ownership portfolio. It consists of the same fraction of the outstanding shares of each security.

Question 4

Passive Portfolio

Answer 4

A portfolio that is not rebalanced in response to price changes

Question 5

Market Index

Answer 5

It is the market value of a broad-based portfolio of securities

Question 6

Price-Weighted Portfolio

Answer 6

holds an equal number of shares of each stock; size of stock doesn’t matter

Question 7

Index Funds

Answer 7

Mutual funds that invest in stocks in proportion to their representation in a published index (e.g. S&P 500)

Question 8

Exchange-traded fund (ETF)

Answer 8

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

Question 9

The yield to maturity of a bond

Answer 9

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.

Question 10

What is a market proxy?

Answer 10

A portfolio whose return they believe closely tracks the true market value.

Question 11

How do you determine the weight of the stock in the market portfolio?

Answer 11

By using the market index

Question 12

How do we define a stock’s alpha, and what is its interpretation?

Answer 12

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.

Question 13

How can you estimate a stock’s beta from historical returns?

Answer 13

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.

Question 14

All equity financed firm

Answer 14

a firm with no debt

Question 15

2 drawbacks for looking at the historical risk premium

Answer 15

1. Despite having at least 50 years of data, the standard errors of the estimates are large
2. Because you’re looking back through history, you can’t be sure that the estimates correctly estimate the current expectations

Question 16

Examples of Market Indexes

Answer 16

1. S and P 500 (value-weighted)

2. Dow Jones Industrial Average (price-weighted)

Question 17

How can you estimate market risk premium?

Answer 17

Historical Data (i.le. stock market index)
Survey
Implied Rates

Question 18

How do we define a stock’s alpha, and what is its interpretation?

Answer 18

It is the distance the stock’s average return is above or below the SML

Question 19

Debt Cost of Capital

Answer 19

cost of capital that a firm must pay on its debt

Question 20

Asset cost of capital (or unlevered cost of capital)

Answer 20

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

Question 21

Levered Firms as Comparables

Answer 21

This is for when the firm has a debt.

Question 22

All equity comparables

Answer 22

This is for when the firm has no debt.

Question 23

Enterprise value

Answer 23

combined market value of the firm’s equity and debt, less any excess cash.

Question 24

True or False

Asset (unlevered) cost of capital does not have any leverage

Answer 24

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

Question 25

How to determine the debt cost of capital (rD)

Answer 25

either by:
Use CAPM for debt (using beta of debt)
use yield to maturity and probability of default

Question 26

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

Answer 26

True

Question 27

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

Answer 27

True

Question 28

Operating Leverage

Answer 28

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.

Question 29

How do you determine the weight of a stock in the market portfolio?

Answer 29

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.

Question 30

Why does the equity beta of a levered firm differ from the beta of its assets?

Answer 30

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.

Question 31

Under what conditions can we evaluate a project using the firm’s weighted average cost of
capital?

Answer 31

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.