Lecture 5 - Cost of Capital

Question 1

Why do we need to work out the cost of capital?

Answer 1

To discount the expected cash flows of a project to their present value

Question 2

What is the cost of capital?

Answer 2

The opportunity that is foregone by investing in a project rather than financial securities, with the same risk

Question 3

What level of cost of capital should be used?

Answer 3

If the project is high risk- higher cost of capital

Low risk- lower cost of capital

Question 4

What can we use to determine COC if the project (asset) beta is know?

Answer 4

The CAPM model

Question 5

Why do companies the use cost of capital rather than the CAPM model?

Answer 5

Project betas are not available in most cases - therefore use the company cost of capital as the benchmark instead

Question 6

What is the CAPM formula?

Answer 6

r(project)= rf+B(Rm-Rf)

Question 7

What is the COC formula?

Answer 7

COC= rassets= rdebt D/V+ requity E/V

Question 8

What is the consequence of using the company cost of capital rather than the project cost of capital?

Answer 8

Good, low risk investments with truly positive NPVs will be rejected
High risk, bad projects with truly negative NPVs will be accepted

Question 9

What does the WACC represent?

Answer 9

The company cost of capital reflective of the tax shield of interest

Question 10

What can we use to determine the cost of equity?

Answer 10

CAPM: r=equity= Rf+ Bequity (Rm-Rf)

Question 11

How do we estimate equity beta?

Answer 11

By observing the historical beta as the future beta is usually not far off from past beta as the estimate of most stocks is quite stable over time

Question 12

How do we calculate the beta?

Answer 12

Run a regression of the monthly rates of returns, against the corresponding market returns, the slope of the regression line is an estimate of beta

Question 13

What does the beta tell us?

Answer 13

On average, how the stock price changed with the market return was 1% higher of lower

Question 14

Where does diversifiable (firm specific) risk show up?

Answer 14

Scatter of points around the line

Question 15

What does r2 represent?

Answer 15

The proportion of the total variance that can be explained by market movements (market risk)

Question 16

Should we use industry betas?

Answer 16

Yes- they are more reliable as they have lower standard errors

Question 17

What are two instances when the beta may be modified?

Answer 17

1) Thing trading - infrequently traded shares - the beta will be underestimated and in the regression and therefore are adjusted upward
2) Mean reversion - a move to the mean value of one over time

Question 18

What are the three factors that determine the beta?

Answer 18

Cyclicality: If revenues and expenses are heavily dependent on the state of the business cycle - will have a higher beta
Operating leverage: Higher operating leverage= high risk= higher beta
Other sources of risk: Longer term projects have a higher beta… exposed to more sifts caused by changes in risk free rate or market premium

Question 19

What is the asset beta? What is the formula?

Answer 19

The beta is the beta of a portfolio of the firms debts and securities:
b asset = b portfolio = b debt (d/v) + b equity (e/v)

Question 20

What effect will issuing more debt have on the asset beta?

Answer 20

Asset beta remains unchanged

• Higher debt ratio: increases the debt beta (risk of default)
• Higher debt ratio also increases the equity beta (increased risk to shareholders)
• However- weights will change (leverage) so therefore the overall asset beta will stay the same

Question 21

Do diversifiable risk affect asset betas and discount rates?

Answer 21

NO- as they can be diversified away

Question 22

How do we work out the fudge factor?

Answer 22

Determine the correct discount rate in order to get the correct present value
Fudge factor = (New discount rate - used discount rate)

Question 23

When will the fudge factor not be required?

Answer 23

When all cash flows have been thought through and an unbiased forecast is made