Cost of Capital

Question 1

Which of the below describe the composition of the accounting/ book return?

a) Return on capital employed (return on investment)
b) Expected return on equity
c) ROE and interests
d) Expected return on debt

Answer 1

(a) and (c)

Question 2

Which of the below describe the composition of the required return?

a) Return on capital employed (return on investment)
b) Expected return on equity
c) ROE and interests
d) Expected return on debt

Answer 2

(b) and (d)

Question 3

What is the equation of the weighted average cost of capital (WACC)?

Answer 3

WACC=k_EE/(D+E)+k_D(1-t)*D/(D+E)

Question 4

Which of the following characterize SPESIFIC/ DIVERSIFABLE RISK?

a) Interest rate risk
b) Competitive risk
c) Project risk
d) Inflation risk
e) Default risk
f) Regulatory risk

Answer 4

(b), (c) and (e)

Question 5

Which of the following characterize SYSTEMATIC/ MARKET/ UNDIVERSIFABLE RISK?

a) Interest rate risk
b) Competitive risk
c) Project risk
d) Inflation risk
e) Default risk
f) Regulatory risk

Answer 5

(a), (d) and (f)

Question 6

Which two assumptions is the dividend discount model (DDM) based on?

Answer 6

• The discount rate adjusted to the appropriate level of risk for the business is constant in the long term and the rate’s maturity curve is therefore flat.
• The growth rate for the flow generated by the business is constant in the long term.

Question 7

True or false.

The CAPM (capital asset pricing model) is based on the assumption that investor effectively diversify their portfolios, thereby neutralizing the part of the risk linked to the single stand-alone investments (the so-called diversifiable risk). Consequently, only the part of risk that cannot be eliminated by diversifying should be rewarded and should be featured in the estimating of the levered cost of equity.

Answer 7

True

Question 8

Which of the methods below canNOT be used to estimate the market risk premium (MRP)?

a) Implied risk premium approach: MRP as implied in estimates of CF returns to all shareholders in the index, at consensus growth
b) Set equal to the market risk-free rate
c) MRP directly estimated by Damodaran’s research
d) MRP directly estimated by Fernandez’s research

Answer 8

(b) You cannot extract the MRP directly from the risk-free rate

Question 9

How can you move from beta unlettered to levered beta?

Answer 9

Hamada formula.

β_L=β_U(1+D/E(1-t))

Question 10

Simple explained, what does the cost of debt measure?

Answer 10

The cost of debt measures the current cost that the business must bear to finance new investment projects with debt, or in other words the cost that the firm would bear to bear to refinance existing assets in line with its predetermined target financial structure.

Question 11

Which of the following quantities are included in the cost of debt?

a) A spread
b) Beta
c) Market risk premium
d) A base rate expressing the current return on long-term risk-free investments
e) Short-term risk-free rate

Answer 11

(a) and (d)