FI 3 Cost of Capital

Question 1

Two reasons why cost of capital is determined

Answer 1

1. Assess a new investment and discount rate required

2. Understand impact on entity’s overall cost of capital due to changes in capital structure.

Question 2

Define hurdle rate

Answer 2

Minimum amount of return required for a project to proceed. Higher the return, riskier the project.

Question 3

Define WACC

Answer 3

Average of after-tax financing costs for both debt and equity, weighted for proportion of each in capital structure

Question 4

How is WACC used in determining project acceptance? If project is same WACC? If higher? If lower?

Answer 4

If same WACC then use WACC, if higher than WACC, use higher discount rate. If lower than WACC, use lower discount rate.

Question 5

How is value of a firm determined using WACC?

Answer 5

Future cash flows discounted at cost of capital

Question 6

What 4 items do you need to calculate WACC?

Answer 6

costs of debt
costs of equity
weighting of each in capital structure
income tax rate

Question 7

WACC formula

Answer 7

Weighting of debt x After-tax cost of debt + Weighting of equity x Cost of equity

Question 8

What is the cost of debt? Is short-term included?

Answer 8

Interest paid. No, only long-term debt.

Question 9

How to determine current cost of debt with fixed rate of interest

Answer 9

Look at yield on debt if publicly traded. If not, then use yield on publicly traded debt that has a similar credit risk and term to maturity. Use FV calculator to determine the interest rate (cost of debt).

Question 10

How to determine cost of debt with variable-rate

Answer 10

Add current base rate plus premium

Question 11

How to determine after-tax cost of debt

Answer 11

Current debt yield (1 - tax rate)

Question 12

Formula to determine cost of preferred shares

Answer 12

Total annual preferred dividends paid on preferred shares / total market value of all preferred shares outstanding

OR

Total annual div paid per preferred share / current market price per pref share

Question 13

CAPM formula

Answer 13

Cost of equity = Risk-free return (Rf) + Risk premium related to risk of investment
OR
Risk-free return (Rf) + Beta x Market Risk Premium

Question 14

Risk-free rate in CAPM model

Answer 14

Government bonds usually - the lowest-yielding bonds in current market

Question 15

Define beta. What does a beta of 1 mean? of 2?

Answer 15

Beta is the systematic risk of an investment. If it is 1, then it is correlated perfectly with the market. When it is 2 it is twice as risky as the market.

Question 16

Define market risk premium

Answer 16

Long-term average of difference between total return on market less return on risk-free investments.

Question 17

Factors that impact cost of equity

Answer 17

Volatility of sales due to product or changes in selling prices
Cash outflows related to cost volatility
Amount of operating leverage - more fixed costs, higher the operating risk
More debt, higher the financial risk

Question 18

WACC calculation

Answer 18

D/V (Rd)(1 – T) + P/V (Rp) + E/V (Re)

where

D is the market value of debt
V is the total of market value of debt, preferred shares, and equity
Rd is the current cost of debt
T is the marginal tax rate
P is the market value of preferred shares outstanding
Rp is the current cost of preferred shares
E is the market value of common shares outstanding
Re is the current cost of equity

Question 19

What is marginal cost of capital

Answer 19

The WAC of the last dollar of capital raised.