Chapter 12 - Estimating the cost of capital

Question 1

In essence, what can we say that the cost of capital includes+

Answer 1

Risk premium

Question 2

What is the cost of capital?

Answer 2

Cost of capital is the return we can get elsewhere in a project with similar risk. More specifically, the cost of capital is the BEST alternative return for similar risk.

Question 3

how does the CAPM relate to cost of capital?

Answer 3

Since CAPM relates beta with expected return, similar risk investments gets the asme expected return. Therefore, “similar risk” means “similar beta”. This is useful because it allows us to use the beta of a firm to evaluate its risk AND thus the expected return.

Question 4

To value a share of a stock, we need to calculate the …

Answer 4

Equity cost of capital

Question 5

What do we need in order to calculate the equity cost of capital for a stock?

Answer 5

We need the beta of the stock.

Question 6

What is total risk?

Answer 6

Volatility of the security

Question 7

What is market risk?

Answer 7

beta

Question 8

what determines cost of capital?

Answer 8

Market risk

Question 9

What inputs do we need to estimate the firms equity cost of capital?

Answer 9

We need the market portfolio, and the market excess return.

Then we need to find the beta (sensitivity) of the investment relative to the market.