Lecture 4 Cost Of Capital

Question 1

Company cost of capital

Answer 1

The expected return on a portfolio of all the company’s debt and equity securities

The opportunity cost of investing in the company’s assets

A blend of:
The cost of debt capital (bank loans or corporate bonds interest rates)
The cost of equity capital (equity’s expected return)

The weighted average cost of capital - WACC

Question 2

What is important in capital budgeting decisions?

Answer 2

It is the discount rate at which a project’s future cash flows are discounted to present.

Question 3

A benchmark for acceptance or rejection of an investment project:

Answer 3

Accept if the project’s return is equal to or greater than the cost of capital.

Reject if the project’s return is less than the cost of capital.

Which is a starting point in determining the discount rates of unusually risky/safe projects.

Question 4

Cost of equity

Answer 4

The rate of return required by common shareholders (Re)

Question 5

Two estimation methods for the cost of equity

Answer 5

The dividend growth model approach

The capital asset pricing model approach

Question 6

The CAPM approach

Answer 6

Estimation of cost of equity
Pros =
Provides an estimate of equity that adjusts for risk (systematic risk)
Can be implemented on all public companies

Cons =
Accuracy is dependent on the estimates of beta and market risk premium - you need to be careful seeing as the quality has to be good
Can’t be applied directly to private companies because workings become more sophisticated

Question 7

Cost of debt capital

Answer 7

It is the interest rate firms must pay on new borrowing:

Estimated for companies on the capital market by:
Interest rates on bank loans
Yields to maturities on corporate notes and bonds
-Observable form the capital market

Question 8

When to use WACC

Answer 8

• useful for projects that are similar to the firm’s existing activities:
• open new stores
• expand existing production
• not useful for projects that are distinct from the firm’s existing business operations:
• reject a profitable project
• accept an unprofitable project

Question 9

When not to use WACC

Answer 9

Not useful for a corporation with more than one business line e.g conglomerates
Each division should apply a unique discount rate commensurate with its risk

Question 10

The remedies for working out cost of capital

Answer 10

Objective approach = estimate the cost of capital of a pure play company operating in the same line of business

Subjective approach: adjust WACC