Chp 11 - Cost of Capital

Question 1

define cost of capital

Answer 1

The cost, expressed as a percentage rate, that a firm must pay investors for the use of debt and equity financing

Question 2

how to calculate growth in dividends

Answer 2

(current / past)^(1/n) - 1

Question 3

put in order from smallest to largest, cost of debt, cost of equity, cost of preferred

Answer 3

cost of debt < cost of preferred < cost of equity

Question 4

how to get market value weight of debt

Answer 4

add up market values of all different bond issues and divide by value of capital to get weight of debt

Question 5

2 things that makes cost of capital higher

Answer 5

1) high risk

2) low liquidity

Question 6

explain why low liquidity makes cost of capital higher

Answer 6

illiquidity increases cost of equity and therefore increases WACC

Question 7

explain what liquidity means

Answer 7

cost of buying/selling stock

Question 8

define weighted average cost of capital

Answer 8

the average cost of debt and equity financing where the average is computed as a weighted average using the long term target weights of debt and equity

Question 9

what is WACC also called?

Answer 9

average cost of funds

Question 10

true or false? If you can borrow money to finance the expansion of your online custom nail polish distribution company at​ 8%, and you expect to earn​ 12% as a​ result, you should borrow the funds

Answer 10

false. base the decision on the average cost of​ money, not on the cost associated with a particular piece of capital. If the next time you borrow it will cost​ 20%, your current decision may change

Question 11

how is WACC used in capital budgeting decisions - 4 points

Answer 11

1) it is the hurdle rate
2) Return on project must exceed return required by providers of capital
3) It is the opportunity cost or return that investors could earn in another investment of similar risk
4) Firm must earn at least WACC on its investments or the value of the firm will fall

Question 12

how to calculate simple average

Answer 12

sum of grades / number of items

Question 13

how to calculate weighted average

Answer 13

sum of grade*weight

Question 14

define cost of debt

Answer 14

return firm’s lenders demand on new borrowing/interest rate on new borrowing (yield to maturity of existing bonds)

Question 15

how can cost of debt be calculated

Answer 15

interest rate * (1-t)

Question 16

why don’t we use coupon rate for cost of debt?

Answer 16

because that reflects the cost of debt when the bonds were issued

Question 17

explain why we use after-tax cost of debt

Answer 17

1) We need to use the after-tax cost of debt because interest on debt is tax deductible (interest tax shield)
2) Tax shield lowers the cost of debt financing because the government is paying a portion of the expense by reducing the taxes due from the company

Question 18

how much approximately is firm’s avg capital raised from issuing preferred stock?

Answer 18

5%

Question 19

why are dividends not tax deductible?

Answer 19

Dividends are not tax deductible because they are paid from after-tax income (net income)

Question 20

2 things that results from dividends being not tax deductible

Answer 20

1) This makes cost of equity and cost of preferred shares higher than cost of debt
2) Because cost of debt is lower, firms are reluctant to issue stock than bonds

Question 21

price of preferred

Answer 21

dividend/cost of preferred

Question 22

define cost of equity

Answer 22

return on investment required by investors in the stock of a company

Question 23

why is computing cost of equity more uncertain?

Answer 23

there is no promised dividend/cash flow

Question 24

define capital asset pricing model (CAPM)

Answer 24

describes the relationship between the required return, or cost of common stock equity capital, and the non diversifiable/systematic risk of the firm as measured by the beta coefficient

Question 25

what does CAPM compute?

Answer 25

CAPM computes the return investors require to feel compensated for the risk they incur for holding equity

Question 26

3 methods of calculating cost of equity

Answer 26

1) CAPM
2) constant growth model
3) bond yield plus premium

Question 27

define constant growth valuation model

Answer 27

a model for computing the value of stock that assumes dividends grow at a constant rate forever and the price is the PV of these dividends

Question 28

price of equity formula

Answer 28

Dividend1 / (cost of equity - growth) OR price = Dividend0 (1+g) / cost of equity - growth

Question 29

define risk premium

Answer 29

additional return investors require due to the increased risk one investment has over another

Question 30

what is risk premium generally?

Answer 30

between 3-5%

Question 31

what is an additional reason why equity is riskier than debt?

Answer 31

has a residual claim on firm’s assets

Question 32

bond yield plus premium: cost of equity formula

Answer 32

pre-tax cost of debt + risk premium

Question 33

bond yield plus premium: when calculating cost of equity why do we use pre-tax cost of debt?

Answer 33

because cost of equity is not tax deductible

Question 34

interpreting WACC: define target mix

Answer 34

proportions of debt, equity and preferred stock a firm wants in its capital structure

Question 35

interpreting WACC: why do we use target weights?

Answer 35

because WACC is a rate to use in evaluating long term projects

Question 36

interpreting WACC: do we use market value or book values?

Answer 36

market values for all debt, equity, preferred

Question 37

divisional WACC: define divisional cost of capital

Answer 37

cost of capital for specific unit or division within a company that reflects that area’s weighted average cost of funds

Question 38

divisional WACC: how does IRR, WACC affect NPV

Answer 38

If IRR < WACC then NPV < 0

Question 39

divisional WACC: true or false?If the WACC for the health care division is​ 8% and the WACC for the paper products division is​ 4%, assuming each division is the same​ size, would you use​ 6% (computed as average of​ 8% and​ 4%) to evaluate the purchase of a new line of paper​ towels?

Answer 39

This is false, you should use divisional cost of capital

Question 40

divisional WACC: When evaluating an investment for a firm with multiple divisions that each have different​ risk…

Answer 40

use the rate associated with the division most closely related to the new investment.

Question 41

what to do if cost of equity < cost of debt

Answer 41

say none of the above for WACC

Question 42

how to find price of bonds when not given the amount outstanding?

Answer 42

face value * 0.(price)