Reading 36: Cost of Capital

Question 1

Weighted Average Cost of Capital (WACC)

36.1

Cost of Capital

Answer 1

Where:

w_d = the proportion of debt that the company uses when it raises new funds

r_d = the before-tax marginal cost of debt

t = the company’s marginal tax rate

w_p = the proportion of preferred stock the company uses when it raises new funds

r_p = the marginal cost of preferred stock

w_e = the proportion of equity that the company uses when it raises new funds

r_e = the marginal cost of equity

Question 2

Yield to Maturity (YTM)

36.2

Cost of Capital

Answer 2

Where:

P₀ = the current market price of the bond

PMT_t = the interest payment in period t

rd = the yield to maturity

n = the number of periods remaining to maturity

FV = the maturity value of the bond

Question 3

Cost of Preferred Stock

(from the company’s perspective)

36.3

Cost of Capital

Answer 3

Where:

Pp = the current preferred stock price per share

D_p = the preferred stock dividend per share

r_p = the cost of preferred stock

Derived from value of preferred stock, P_p = D_p / r_p

Question 4

Expected Return

CAPM

36.4

Cost of Capital

Answer 4

Where:

B_i = the return sensitivity of stock i to changes in the market return

E(R_M) = the expected retun on the market

E(R_M) - R_F = the expected market risk premium

Question 5

Expected Return Multi-Factor Model

CAPM

36.5

Cost of Capital

Answer 5

Where:

B_ij = stock i’s sensitivity to changes in the jth factor

(Factor risk premium)_j = expected risk premium for the jth factor

Question 6

Expected Return

Derived from Gordon Growth Model

36.6

Cost of Capital

Answer 6

Where:

P₀ = current market value of the equity market index

D₁ = dividedns expected next period on the index

r_e = the required rate of return on the market

g = expected growth rate of dividends

Derived from P₀ = D₁ / (r_e - g)

Question 7

Sustainable Growth Rate

36.7

Cost of Capital

Answer 7

The term (1 - D / EPS) is the company’s earnings retention rate

Question 8

Bond Yield Plus Risk Premium Approach

36.8

Cost of Capital

Answer 8

r_d = before tax cost of debt

r_e = cost of equity

Question 9

Company’s Creditors’ Market Risk

36.9

Cost of Capital

Answer 9

We generally assume a company’s debt does not have market risk, so B_debt = 0 for this one.

Question 10

Market Risk of Company’s Equity

36.10

Cost of Capital

Answer 10

The market risk of a company’s equity is affected by both the asset’s market risk, Basset, and a factor representing the nondiversifiable portion of thecompany’s financial risk, [1 + ((1 - t)(D / E))]

Question 11

Estimating Asset Beta for Comparable Company

Pure Play Method

36.11

Cost of Capital

Answer 11

Question 12

Estimating Equity Risk for Comparable Company

Pure Play Method

36.12

Cost of Capital

Answer 12

Question 13

Country Equity Premium

36.13

Cost of Capital

Answer 13

Question 14

Calculating Break Point

36.14

Cost of Capital

Answer 14

Question 15

Cost of External Equity

36.15

Cost of Capital

Answer 15

F = flotation costs in monetary terms on a per share basis

Question 16

Cost of External Equity

(as a percentage of issue price)

36.16

Cost of Capital

Answer 16

F = flotation costs in monetary terms on a per share basis