Cost of capital

Question 1

WACC

Answer 1

• aka marginal cost of capital
• is based on the market value of debt and market value of equity
  
  • not book value

WACC = (we * re) + (wd * rd)*(1-t) + (wp * rp)

the weights should represent the company’s target capital structure, not the current capital structure

Question 2

Calculate cost of debt

Answer 2

YTM approach or debt-rating approach

• YTM; cpt annual I/Y (before-tax cost of debt)
  then I/Y * (t - t)

Question 3

Cost of preferred stock

Answer 3

Pp = Dp / rp

Current pref stock price/share = (pref stock divid/share / cost of pref stock)

cost of pref stock = pref dividend / CURRENT price

*ignore taxes

Question 4

Cost of Equity

Answer 4

capital asset pricing model

bond yield plus risk premium method

Question 5

CAPM

Answer 5

cost of equity (expected return) =
risk free rate + Beta * (expected market return - risk free rate)

re = RFF + B*(Market risk prem)

Question 6

Bond yield plus risk premium method

Answer 6

re = bond yield + risk premium

Question 7

Estimating B for public firms

Answer 7

• beta is a regression of the return on the stock with the return on the market
• the return on market is plotted on the x-axis as an independent variable
• the return on stock is plotted on the y-axis as a dependent variable
• regression B is called the unadjusted or raw beta

adjusted beta: in long-run, B is mean-reverting to 1
= (2/3 * unadjusted B) + (1/3 * 1)

Question 8

Estimating B for nonpublic firms

Answer 8

• select the benchmark public firm
• estimate benchmark’s B
• unlever the benchmak’s B: estimate the B without the impact of debt
• lever the B to reflect the subjuect company’s financial leverage

Question 9

Unlevered B equation

Answer 9

Bu = benchmar firm B (Be) * [ 1 / ( 1 + [ (1 - t) * DE) ] )

Benchmark firm:
B = 1.2, t=.4, DE = .5

Bu = 1.2 * [ 1 / ( 1 + [ ( 1 - .4) * .5) ] ) = .923

Question 10

Levered B formula

Answer 10

• used to cal the B of the subject firm

Be = Bu * [ 1 + [ (1 - t) * DE] )

subject firm 
DE = .7
Benchmark firm 
t=.4
Bu = .923

Be = .923 * [ 1 + [ (1 - .4) * .7] )
= 1.31