Cost of Capital - Foundation

Question 1

Calculate and Explain WACC

Explain the tax implications

Answer 1

Weighted Average Cost of Capital

The cost to the firm of borrowing money

(Wd) [Kd (1-T)] + (Wps)(Kps) + (Wce)(Kce)

We get a tax break on interest payments when debt financing is used.

Question 2

Which values do you use for calculating WACC

Answer 2

Market values
Forward looking values

Question 3

How do you estimate the pre tax cost of debt?

Answer 3

1. When available, use the market rate (YTM) which assumes the cost is the same as the YTM on the irm’s existing traded debt
2. When not available, estimate it using a yield cure for debt of a similar rating.

Question 4

Calculate the Dividend Payment, Price and Yield of preferred stock

Answer 4

Dividend
/
Price x Yield (decimal

Triangle ^

Question 5

Estimate the cost of common equity (method one)

Answer 5

CAPM

Rf + B (ERmkt - Rf)

Rf = Risk free rate
B = Beta / risk
ERmkt = estimated return on the market

Question 6

Estimate the cost of common equity (method two)

Answer 6

Cost of common equity = Bond Market yield + risk premium

This assumed you are trading bonds and can use the yield as a proxy / estimate

Question 7

Estimate the costs of Beta

Answer 7

1. Identify comparable firm to take beta from
2. Un-lever it (remove the impact of debt financing.

This multiplies the beta by 1/ 1+tax x D/E ratio.

If D/E is 1/1, the figure will be 1 (no debt)

3. Re Lever it (multiply it by 1 + tax + D/E of subject company
4. use it to estimate WACC

Question 8

What is the correct method to account for flotation costs

Answer 8

The correct method to account for flotation costs of raising new equity capital is to increase a project’s initial cash outflow by the flotation cost attributable to the project when calculating the project’s NPV.