Cost of Capital

Question 1

What is the cost of capital of a project?

Answer 1

• Rate of return investors expect to obtain on other investments of the same risk
• Opportunity cost for investors today

Question 2

What is the risk of the project if the project is the expansion of the firm’s existing operations?

Answer 2

Same as the risk of the firm’s existing assets

Question 3

IF the project is an expansion project, what is the cost of capital of the project?

Answer 3

Equals to the firm’s cost of capital

Question 4

What is used to calculate firm’s cost of capital? Market values / Book values?

Answer 4

Market values

Question 5

What is the cost of capital of a company?

Answer 5

minimum rate of return on the company’s assets to:

• meet the cost of debt AND
• provide rate of return required by shareholders

Question 6

What methods are used to calculate cost of common stock?

Answer 6

• Dividend growth model

- Security Market Line approach (CAPM) **

Question 7

What are the shortcomings of dividend growth model?

Answer 7

• only applicable for companies that pay dividends
• Constant growth rate assumption is needed, which is more suitable for mature firms, not young firms
• Estimated cost of equity is very sensitive to estimated growth rate
• does not consider risks

Question 8

What are the benefits of SML approach?

Answer 8

• allows for risks
• applies to all listed firms
• more complex approaches which allows beta to be time-varying when forecasting data

Question 9

What are the other requirements of SML?

Answer 9

• requires estimation of market risks premium and beta coefficient
• cost of capital is estimated for future periods, so beta and market risk premium are estimated for future periods

Question 10

Preferred stock is a type of?

Answer 10

Perpetuity

Question 11

What is the cost of debt?

Answer 11

yield to maturity of that bond

Question 12

What is yield of maturity then?

Answer 12

the rate of return that makes the PV of cash payments equals to the bond price in the market, i.e. Bond value = bond price

Question 13

How is the coupon of bonds normally paid? annually or semiannually? how to calculate the interest then?

Answer 13

paid semiannually, if the question gives eg 6% per annum, take 6/2 = 3% is the interest rate for semiannual

Question 14

What is the formula that gives exact effective annual interest rates?

Answer 14

(1+i)^2 - 1, where i = semiannual interest rate

Question 15

How to price a bond between coupon dates?

Answer 15

1. calculate the value of coupon on the next coupon date

2. discount back to current time

Question 16

When calculating WACC using cost of debt and cost of equity, what must be taken into consideration so that WACC is per annum?

Answer 16

Cost of debt and Cost of equity must be per annum

Question 17

Can coupon rate be used as firms’ cost of debt?

Answer 17

NOOOO!

it is the firms’ cost of debt when issued, not now

Question 18

What is floatation cost?

Answer 18

Cost arises when issuing new bonds or stocks to undertake new projects

Question 19

Is floatation cost a relevant cash flow to the project?

Answer 19

YES, as it will incur because of the project

Question 20

Will floatation cost change WACC and investment cost of project? and how?

Answer 20

does NOT change WACC, but will INCREASE investment cost of project

Question 21

What is pure play?

Answer 21

company that focuses on a single line of business

Question 22

For company with more than one line of business, what does WACC reflects?

Answer 22

average risk

Question 23

Shortcomings of WACC for company with more than one line of business

Answer 23

• bias towards risky line, against safe line ( too low for risky lines and too high for safe line)

Question 24

When can a company use cost of capital of pure play?

Answer 24

• considering projects in a new area

- multi-business firm can use for its divisions

Question 25

What are the four steps in business evaluation?

Answer 25

1. Determine a horizon H to which cash flow is forecasted
2. Forecast cash flow for each year to H
3. Predict the business value PV at time H
4. Calculate the PV of business at time 0