Cost of capital

Question 1

Equity cost of capital

Answer 1

Intuition: cost of capital of any investment opportunity equals the expected return of available investments with the same beta
Methods to estimate:
- Capital Asset Pricing Model (CAPM)
- Dividend discount model
- Bond yield plus risk premium

Question 2

CAPM

Answer 2

ri = rf + βi∗ (E [rMkt] − rf)

• unsystematic risk is diversifiable
• systematic risk is not
  -> quantify the amount of systematic risk & determine the risk premium to compensate for this amount of risk

Question 3

Calculation of equity cost of capital r(i)

Answer 3

Construct market portfolio and determine its expected excess return (E[r mrkt.] - r(f)]
- value-weighted portfolio of all securities traded on the market (S&P f.e.)
- determine risk free rate through f.e. U.S. Treasury securities
(Alternative discount rate -> dividend yield + expected dividend growth rate)

Estimate the stock’s beta ß(i)
(expected percent change in the excess return of the security for a 1% change in the excess return of the market portfolio)
1. method: Regression analysis with best fitting line from securities historic excess returns compared to market
2. method: calculated as the covariance of a stock with the market divided by the variance of the market (beta > 1.0 stock is riskier than the overall market and has higher expected returns)

Question 4

Debt cost of capital

Answer 4

Reflects the (debt) market rate the company is paying

Methods:
- Yield-to-maturity approach
Debt cost of capital = Yield to maturity on a firm’s outstanding debt
- debt-rating approach
Debt cost of capital = Yield based on similarly rated debt (bonds) with similar maturity
- Beta-CAPM approach
Debt cost of capital = expected return for debt based on its beta using the CAPM

Question 5

Projects cost of capital

Answer 5

• to calculate we need to find a comparable company and estimate the cost of capital of assets as a proxy for the project’s cost of capital
  -> All-equity firm comparables
  -> levered firm comparables

Question 6

Project risk characteristics and financing

Answer 6

• Firm asset betas reflect market risk of the average project in a firm
• Individual projects may be more or less sensitive to market risk
• Financial managers in multi-divisional firms should evaluate projects based on asset betas of firms in a similar line of business
• Also affecting market risk of a project is its degree of operating leverage
  -> relative proportion of fixed versus variable costs
  -> higher fixed proportion -> higher project beta -> higher cost of capital