Lecture 3 - Cost of Capital

Question 1

for rf, use…

Answer 1

current yields

match project maturity w/ risk-free asset

Question 2

for E(rm)-rf, use…

Answer 2

for this rf, match maturity of market portfolio (use LT bonds)
historical returns

Question 3

WACC =

Answer 3

(E/V)re + (D/V)rd*(1-T)

E & D are MARKET VALUE!

Question 4

cost of debt is reduced by taxes because…

Answer 4

of interest payments

we need to account for firm debt; when paying interest, we save on taxes and must adjust for AT cost

Question 5

firm’s WACC should reflect

Answer 5

required return on entire firm’s assets
ave risk of firm’s operations & CF’s
also reflects mixture of D/E

Question 6

cost of equity

Answer 6

expected return that equity investors require on their investment in firm

Question 7

cost of debt

Answer 7

use CAPM!

CAREFUL: YTM doesn’t take risk into account; it’s only a promised return

Question 8

difference in loan interest rates should be due to

Answer 8

different loan characteristics that determine the riskiness of the payments

• debt seniority
• debt covenants

Question 9

calculating cost of debt when given prob of default

Answer 9

calculate expected return on debt w/prob & yield (like weighted ave)

Question 10

preferred stocks

Answer 10

have div priority over common stocks
normally w/ fixed div rate
sometimes w/o shareholder rights

Question 11

use firm’s WACC when

Answer 11

project is related to firm’s existing operations & has same ave. risk

firm plans to REBALANCE debt ratio

Question 12

if we use firm’s WACC to evaluate projects across divisions, riskier divisions will receive ____ money

Answer 12

too much!

using firm WACC underestimates discount rate, resulting in higher NPV

Question 13

business risk

Answer 13

equity risk that comes from the nature of the firm’s operating activities

Question 14

financial risk

Answer 14

equity risk that comes from the financial policy/capital structure of the firm

Question 15

βasset

Answer 15

systematic/business risk of entire firm

Question 16

βasset =

Answer 16

(E/V)βe + (D/V)βd

Question 17

β of levered firm depends on….

Answer 17

business risk AND amount of debt

Question 18

βe

Answer 18

levered/equity beta

reflects business AND financial risk of equity

Question 19

βe =

Answer 19

βa + (βa-βd)*(D/E)

Question 20

re =

Answer 20

ra + (ra-rd)*(D/E)

ra = reward for business risk
(ra-rd)*(D/E) = reward for financial risk

Question 21

steps to unlever/relever

Answer 21

1. find βd and original βe
2. find βa
3. find new βe, and βd
4. find new re, and rd (using new β & CAPM)
5. calculate new WACC

Question 22

formulas for unlever/relever

Answer 22

βe = βa + (βa-βd)*(D/E)
re = ra + (ra-rd)*(D/E)

holds in presence of corporate taxes; assuming continuously rebalancing

Question 23

MM formulas

Answer 23

βe = βa + (βa-βd)*(D/E)*(1-T)
re = ra + (ra-rd)*(D/E)*(1-T)

use when assuming constant amount of perpetual debt, D
when debt is issued in fixed amounts

Question 24

use ______ capital structure of the project/firm

Answer 24

target/LR capital structure

this may be different from the firm’s current capital structure!