FINA211 WK12 L23 Cost of Capital

Question 1

What is the first approach to calculating the discount rate that should be used when evaluating projects for a company?

Answer 1

CAPM
R = R.f + B(ER.m - R.f)
where
ER = required return
R.f = risk free return
B = beta
ER.m = expected return on market
(ER.m - R.f) = market premium

Question 2

What is the second approach to calculating the discount rate that should be used when evaluating projects for a company?

Answer 2

Gordon Growth Model (GGM)/Dividend Discount Model (DDM)
P.0 = Div/(R-g)
R = (Div/P.0) + g

Question 3

What is the cost of debt/bonds?

Answer 3

The cost of debt is the return expected by bond investors, which is the yield to maturity (YTM).
When interest on a debt is paid before tax is deducted, the amount of tax that needs to be paid is reduced.
So the cost of debt becomes
R = (1-t)*YTM

Question 4

What is the tax benefit of debt?

Answer 4

When interest on a debt is paid before tax is deducted, the amount of tax that needs to be paid is reduced.

Question 5

What is the formula for the value of a firm (V)?

Answer 5

V = S + B + P
where
V = value of a firm
S = value of stock or equity, equal to the number of outstanding shares times the share price
B = value of debt or bonds, if debt is not trade/no bonds use figure on balance sheet, if debt is traded/bonds use market value of debt
P = value of preferred stock, equal to the number of outstanding shares times the share price

Question 6

What is the formula for weight of stock or equity in relation to the value of a firm?

Answer 6

S.weight = S/S+B+P = S/V

Question 7

What is the formula for the weight of debt or bonds in relation to the value of a firm?

Answer 7

B.weight = B/S+B+P = B/V

Question 8

What is the formula for the weight of preferred stock in relation to the value of a firm?

Answer 8

P.weight = P/S+B+P = P/V

Question 9

What is the formula for the weighted average of the cost of capital (WACC)?

Answer 9

R.WACC = (S/S+B+P)R.S + (B/S+B+P)R.B(1-TR) + (P/S+B+P)R.P