Lecture 4b: Cost of Capital Flashcards
3.) Cost of Capital 4.) Weighted average Cost of Capital 5.) Relationship between project and company cost of capital
Define “Cost of Capital”
Rate of returns suppliers of capital (lenders/SH) require
What kind of cost of “Cost of Capital”. Explain.
An opportunity cost. Suppliers of capital will require a rate of return at least as great as they can obtain from another project of similar risk.
What kind of evaluation are projects based on
Project’s cost of capital
What is the effective company tax rate formula
te = tc (1- y)
tc = statutory company tax rate y = % of tax collected that is paid to shareholders and recovered through credits
When do we use WACC to evaluate a project
- ) Risk of new project = Risk of existing projects
2. ) New project will not change capital structure
Can we use WACC to evaluate all projects
Typically no because of risk differences
What are the problems with using WACC to evaluate all projects
- ) Rejecting +NPV projects (Below WACC Line and above market line); Accepting -NPV Projects (Above WACC Line and below market line)
- ) Increase risk profile
What is the solution for correctly evaluating projects
Use a divisional cost of capital (industry same risk) and examine each project individually
What do we have to know about CAPM
Adjustments has to be made to include tax credits to obtain after-tax rates of return
Can CAPM be used to evaluate projects
It cannot because we can’t use beta (covariance with the market) on a project.
We cannot measure beta on a project (a project does not covary with the market)
Is CAPM useful?
Though it is difficult to estimate beta and adjust tax, it is useful in estimating some components of the WACC.
If I’m an investor in Australia, what are the 3 ways I get return on Equity
- ) Dividends
- ) Capital Gains
- ) Tax Credits
Why is it difficult to measure project cost of capital
No direct link between returns to suppliers (equity and debtholders) and returns to individual projects.
Suppliers invest in COMPANY, not projects.
The intuition: Returns to suppliers depend on COMPANY risk as a whole, not project risk.
Should changing a company’s capital structure affect the NPV of new projects. Explain.
No. Any advantage presumably by borrowing should be attributed to existing asset rather than proposed new projects.
What is “Market Capitalization of $500mil”
Company’s outstanding shares (EQUITY) cost $500mil
