Estimating the Cost of Capital

Question 1

What is the equity cost of capital?

Answer 1

-Best expected return available in the market on investments with similar risk
-ri= rf+ betai(E[Rmkt]-rf)

Question 2

What two things must be done to estimate the cost of capital?

Answer 2

-Construct the market portfolio and determine its excess return
-Estimate the stock’s beta

Question 3

What is a value weighted portfolio?

Answer 3

-A portfolio in which each security is held in proportion to its market cap
-xi= [Number of shares outstanding* Price of i per share]/ Total Market Value of all securities in portfolio

Question 4

What is a price weighted portfolio?

Answer 4

A portfolio which holds an equal number of all shares independent of market cap

Question 5

What is the market risk premium?

Answer 5

-E[Rmkt]- rf
-Excess return

Question 6

What is the equation for Rmkt?

Answer 6

rmkt = Div1/P0 +g = Dividend Yield + Expected Dividend growth

Question 7

What is the equation for the debt cost of capital?

Answer 7

rd= y-PL= YTM - P[Default]*Expected Loss Rate

Question 8

What is an all equity comparable?

Answer 8

-An equity financed firm in a single line of business is used as a comparison to the project
-Holding a firm’s stock is equivalent to owning the portfolio of underlying assets

Question 9

How can levered firms be used as comparables?

Answer 9

-Claim on the firm’s assets is recreated by holding both debt and equity simultaneously
-Therefore, the portfolio encompasses all cash flows from the firm

Question 10

What is the equation for the unlevered cost of capital?

Answer 10

-(% firm financed by equity)(Equity cost of capital)+ (%firm financed by debt)(Debt cost of capital)
-ru= (E/E+D)rE + (D/E+D)rD

Question 11

What is the equation for unlevered beta?

Answer 11

Beta (U)= (E/E+D)* Equity Beta + (D/E+D)* Debt Beta

Question 12

What is the equation for net debt?

Answer 12

Net Debt= Debt - Excess Cash and Short Term Investment

Question 13

What happens if a firm has more cash than debt?

Answer 13

-Unlevered beta cost of capital > equity cost of capital
-The risk of the firm’s equity is mitigated by its cash holdings

Question 14

What is operating leverage?

Answer 14

-The relative proportion of fixed versus variable costs for a project
-higher operating leverage represents a higher risk

Question 15

What is the equation for the weighted average cost of capital?

Answer 15

rWACC = (E/E+D)rE + (D/E+D)rD*(1-tax rate)

Question 16

What is the pretax WACC?

Answer 16

-The unlevered cost of capital