equity side cost of capital

Question 1

how is leverage related to equity cost of capital?

Answer 1

the higher the leverage, the higher K_e (and also return to equity)

Question 2

the main difference between asset side cost of capital and k_e?

Answer 2

asset side return is constant and independent of financial leverage

Question 3

3 methods for estimating cost of capital

Answer 3

1. CAPM
2. Historical series of past returns (market returns and accounting returns)
3. Implied returns in current stock market prices (DDM model)

Question 4

rules when using historical past returns for the purpose of estimating k_e

Answer 4

1. use of homogenous business
2. reference period of 10 or more years
3. eliminate outliers

4.** homogenous levels of financial leverage.
If they diverge, compute K_e, de-lever it and compute WACC

Question 5

accounting returns averages, two options

Answer 5

1. average ROI/ROE: considers each company equal to the other
2. weighted ROI/ROE: results are weighted by the invested capital

Question 6

how do you estimate g in the DDM?

Answer 6

g = plowback ratio * ROE

where plowback ratio = (NI - Div)/NI

Question 7

the general approach to the question of optimal debt levels

Answer 7

if benefits of marginal debt exceed costs, more debt increases value of shareholders

the tricky part is that the benefits and costs of debt are not constant, but vary with respect to the level of financial leverage

Question 8

under which conditions is capital structure completely irrelevant according to Modigliani and Miller?

Answer 8

1. perfect financial markets and perfect information
2. absence of taxes
3. absence of bankruptcy costs
4. no transaction costs
5. cost of money is the same for companies and investors

Question 9

the trade off theory

Answer 9

maximize the economic financial convenience of debt by minimizing the cost of capital and the consequent maximization of the value of equity

Question 10

pecking order theory

Answer 10

in the presence of information asymmetry, companies tend to resort to financing in order of least senstitive to most sensitive to information:

1. internal financing
2. debt financing
3. equity financing

Question 11

market timing theory

Answer 11

companies resort to the most convenient form of financing depending on the timing.

for example, issuing equity when a stock is overvalued