L2 Cost of Capital

Question 1

What is meant by “appropriate discount rate”

Answer 1

• DR should reflect (1) the risk of cash flow, (2) be consistent with the type of CF discounted, (3) the return required by capital providers (TVM and bearing risk).

Question 2

Which Investment decision rule does not need COC?

Answer 2

Only Payback Period

Question 3

Difference between Risk Free Rate and Risk Premium

Answer 3

RFR Compensates for the TVM and RP compensates for investors bearing risks.

Question 4

Difference between systematic and non-systematic risk?

Answer 4

S is very common to the mkt. Risk premium only applies to SR as it is determined by it. SR is determined by Beta

B –> SR –> RP

Question 5

What is CAPM’s use?

Answer 5

To determine the expected return of any asset.

Question 6

CAPM Equation**

Answer 6

E[Rt] = rf + Bt (E[Rmkt] -rf)

Note that COC of any investment opportunity equals the E[R] of any asset with same Beta

Question 7

Dangers of using Historical Market Price Premium Costs data. The equation we can use to combat #2?

Answer 7

1. Standard errors of estimates are large/
2. Backward looking, does not necessarily represent the future.

Market Risk Premium = Dividend Yield + Expected Growth Rate

MRP = (Div1/P0) + g - rf

Question 8

What is Beta? EQN?

Answer 8

Measure systematic risk.

The expected % change in excess return of the asset for a 1% change in the excess return of the portfolio.

B = covar(ri,rm)/var(rm)

Note: inc. covar –> inc. B –> inc. sys risk –> inc. risk premium –> inc E[R]

Question 9

More intense Beta EQN?

Answer 9

ri-rf = ai +Bi(rm-rf) + ei

if a is (+) = stock has performed better than predicted by the CAPM

if a is (-) = stocks historical return is below SML

Note: a is the intercept

Question 10

What are the 3 types of COC and consequently Beta?

Answer 10

1. Equity COC/B
2. Debt COC/B
3. Asset COC/B

Make sure you use the right one in questions.

Question 11

Finding COC as an Equity Beta?

Answer 11

1. Use when its an all equity financed firm then use equity B and COC as estimated
2. levered firms as comparables

Note: if firms are all equity financed its asset B = equity B

Question 12

Levered Firms as Comparables to find Equity Beta?

Answer 12

Levered firms are financed both by debt and equity so we have to fix em…

(1) find the equity B but we need to (2) convert them to asset B as the total risk to equity holders is no longer = to assets.

Question 13

Asset Unlevered Beta (Bu) EQN

Answer 13

Bu = Be x E/(E+D) + Bd x D/(E+D)

Note E and D are easy to find, E is market value of equity and D is market value of debt .

Question 14

What is YTM?

Answer 14

Return an investor will earn from holding the bond to maturity and receiving its promised payments.

Note: If little risk the firm will default, YTM estimate is reasonable. If high risk, YTM will overstate E[R]