Cost of Capital

Question 1

What is WACC

Answer 1

Reflects the average return expected by a firm’s capital providers (e.g., shareholders, bondholders):

Question 2

Why do we use WACC as the discount rate when valuing a firm?

Answer 2

Because it reflects the average expected returns of its capital providers (therefore including the risk of the cashflows)

Question 3

What is WACC used for?

Answer 3

1. Discount rate for investment decision making (i.e., required return or hurdle rate)
   a. Since it represents the required return of its capital providers
2. Firm valuation
   Key ingredient in Discounted Cash Flow (DCF) valuation
3. Evaluation of firm performance => Compensation

Question 4

What happens if the firm can lower its cost of capital?

Answer 4

All potential investments appear more attractive, and firm value increases

Question 5

What are the 3 steps to find the WACC?

Answer 5

1. Evaluate firm’s capital structure and determine the relative importance of each component
2. Estimate the opportunity cost of each source of financing and adjust for effects of taxes, if appropriate
   a. Estimate 𝒓𝒅
   b. Estimate 𝒓𝒑𝒔
   c. Estimate 𝒓𝒆
3. Calculate WACC by computing the weighted average of the estimated after-tax costs of capital sources used by the firm

Question 6

Do you use BV or MV when calculating WACC?

Answer 6

Use MV for Equity (difference between MV and BV is huge)
Use BV for Debt if needed (difference between MV and BV is small)

Question 7

How do you estimate cost of debt?

Answer 7

Rfr + Rp = rd
1. Start with Risk Free Premium (typically lowest risk like a treasury)
2. Add Risk Premium based on credit rating of the issuer and risk of the specific bond (look at comparable bonds with similar risk – maturity, industry, etc.)

Question 8

How do you estimate cost of capital?

Answer 8

Since preferred shares a perpetuity, the perpetuity formula is applicable, however, the problem is that we are trying to find the discount rate (rps).
Since the discount rate (rps) is unknown, we can rearrange it to make this formula: rps = div1 / price

Question 9

How are investors rewarded in a CAPM world?

Answer 9

In a CAPM world investors are rewarded with higher expected returns only for bearing systematic risk

Question 10

What is the expected return of a stock determined by?

Answer 10

The stock’s expected return (re) is determined only by its exposure to market risk

Question 11

What is the correlation between re and beta?

Answer 11

Expected return is directly, positively correlated with Beta

Question 12

Match the correct discount rate on the right with the corresponding valuation of each financial security valuation:

If valuing a common equity share you discount cash flows using

If valuing a preferred shared you discount cash flows using

If valuing an entire firm you discount cash flows using

If valuing a bond you discount cash flows using

Answer 12

The cost of equity (𝑟_𝑒)
The cost of preferred shares (𝑟_𝑝𝑠)
The cost of capital (WACC)
The cost of debt (𝑟_𝑑)

Question 13

How can a firm make all potential investments appear more attractive and the value of the firm increase?

Answer 13

Lowering cost of capital

Question 14

Based on the CAPM, equity investors are rewarded with higher expected returns only for bearing…

Answer 14

Systematic risk