Cost Of Capital

Question 1

Equity and debt as costs of capital are labeled as

Answer 1

Components cost of capital

Question 2

Increasing tax rate will encourage or discourage investment in relation with the NPV method

Answer 2

Encourage

Question 3

Which department is responsible for the financing costs of capital and should capital be raised in small or large sums

Answer 3

Financing , large sums

Question 4

What are the weights used in calculating the WACC

Answer 4

The firms long term target capital Weights, determined by the market prices of capital and not the book value

Question 5

Do we adjust the WACC for different risk carrying projects

Answer 5

Yes upwards with riskier projects and downwards for less riskier projects compared to the average risk of a firms current projects

Question 6

How to solve Dividend discount model and CAPM without calculation errors

Answer 6

Practice more questions

Question 7

What can an analyst use to calculate a companys capital weights

Answer 7

It’s target capital weights if available (often not publicly announced), take the current weights and adjust it to trends as the target weights or take an industry average capital structure weights

Question 8

When does the WACC become the appropriate discount rate for projects

Answer 8

When evaluating projects with risks close to the risk of the average firms projects

Question 9

Alternative method of calculating the after tax cost of debt

Answer 9

Interest rate - tax savings

Question 10

When to consider and when to ignore the tax shield in our after tax cost of debt

Answer 10

When the tax rate is higher than the interest rate we consider it and when the tax rate is lower than the interest rate we ignore it

Question 11

What adjustments should be made when calculating cost of debt using the debt rating approach

Answer 11

We should make adjustments according to the convents and other factors, since the debt rating approach provides the YTM of another companies debt with different characteristics

Question 12

Explain the optimal capital budget

Answer 12

Y-axis has the IRR and the cost of capital
X-axis has the new capital invested/ more projects

The marginal cost of capital line is upward sloping
The opportunity schedule line is downward sloping
(Represents all profitable projects)

The intersection between both is the optimal capital budget

Question 13

The payout rate formula

Answer 13

Dividends divided by earnings per share

Question 14

What is the most used model in calculating the cost of equity/return on equity

Answer 14

CAPM model

Question 15

When is the pureplay method used

Answer 15

When calculating the equity beta for a project for a company that is privately trading, we use a similar company with similar field and use its beta, through unlevering it and then levering it with the projects D/E ratio

Question 16

To calculate the weight of debt give the D/E ratio

Answer 16

We use D/D+E

Question 17

Problems when using the pureplay method

Answer 17

Beta is estimated using historical data
The estimate is affected by which index is chosen to represent the market return
Betas are believed to revert towards 1 over time
Estimated of beta for small cap firms need and upward adjustment

Question 18

Country risk premium formula

Answer 18

Sovereign yield spread* (annualized S.D of equity index of developing countries/ annualized S.D of sovereign bond market in terms of the developed market currency)

Sovereign yield spread= difference between the yield s of the government bonds in the developing country and treasury bonds of Similar maturities

Question 19

Factors that could raise the marginal cost of capital

Answer 19

Raising more capital and deviating from the firms target capital structure

Both are done to undertake short term project opportunities

Question 20

Incorrect calculation of flotation costs

Answer 20

We add (1-flotation cost) in the denominator while calculating the dividend discount model

Question 21

What tax rate is used in calculating the cost of capital

Answer 21

Marginal and not the effective

Question 22

What is levered beta

Answer 22

Levered beta or equity beta can be levered using the comparable companies D/E ratio or the projects D/E ratio

Question 23

Will different equity cost model produce different results

Answer 23

Yes

Question 24

When does a break point occur

Answer 24

When one of the component costs of capital increase

Question 25

What is the marginal cost of capital

Answer 25

Is the last dollar cost raised by the firm

Question 26

Perpetual preferred stock formula

Answer 26

D/R

Question 27

The cost of proffered stock is also called

Answer 27

The dividend yield on the firms newly issued preferred stock