cost of capital

Question 1

Weighted Average Capital Costs (WACC)

Answer 1

always use market values for the calculation, not book values

Question 2

WACC beta

Answer 2

CC can be calculated with an asset beta

r_a = r_f + ß_a *(r_m - r_f)

ß_a is the weighted average of the debt and equity beta

Question 3

equity and debt beta

Answer 3

equity beta:

calculate the ß with the CAPM =>

ß_e = COV(r_E ; r_M) / VAR (r_m)

debt beta:

harder to guess, because it’s traded on markets rarely

often assumed to be zero

Question 4

indicators for the asset betas

Answer 4

• cyclicality => companies whose revenues and sales are strongly correlated with the market (airlines, construction) => typical higher betas
• operating leverage => ratio of fixed cost / variable cost the more fixed cost a project has, the higher the beta ceteris paribus
• time horizon => the longer the

Question 5

cost of debt

Answer 5

one fundamentally difference:

• shareholders are entitled to the residual of revenue and cost => higher risk and upside potential
• bondholders are only entitled to receive the promised payment every year => interest + repayment => lower risk but not upside potential
  
  • the major risk is the repayment risk (default risk)
  • the higher the risk => the higher the interest payment
• Bond rating agencies evaluated companies to analyse their risk and therefore determine the interest rate. this is done by different ratios
  
  • coverage ratios (ebit / interest payments)
  • leverage ratios (debt / equity)
  • liquidity ratios
  • profitability ratios
  • cashflow to debt ratios
• these ratios can be used to determine the credit risk of non traded
• in practice: r_d = r_f + default spread

=> assumption: default risk of investment grade debt =0

Question 6

WACC plus Taxes

Answer 6

interest payments are tax-deductible in comparison to dividend payments, which are not. Therefore there is a tax benefit of holding taxes, we have to adjust the formula accordingly

Question 7

Limitations of the WACC

Answer 7

• only works for the project, which has similar characteristics as the firm undertaking it, so only for the average project
• incorrect for the project, which changes the debt/equity ratio
• uses present characteristics of the firm, but managers use it to calculate future cash flows as well. This is only possible, if the debt ratios don’t change

Question 8

DCF and WACC

Answer 8

• instead of using r in the DCF we will use WACC instead
• warning: the WACC has certain limitations, therefore it a good idea to not only use the capital cost of the the own firm but also use the mean capital cost of a peer group of firm
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Question 9

adjusted present value (APV)

Answer 9

idea: calculate the cost of capital, if the company would be equity financed only, adjust later for the PV of all financing side effect like tax shield, loan subsidies, insurance costs)

1. Step: calculate the base case NPV
2. Calculate the Tax shield
3. calculate other PV of financing expenditures/ benefits

when is it useful:

• different side cost
• projects with commonly high leverage
• decreasing debt ratio over time
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