Reading 36: Cost Of Captial

Question 1

Earnings Retention Rate

Answer 1

1 - D/EPS

Question 2

Payout Ratio

Answer 2

D/EPS

Question 3

Growth Rate

Answer 3

g = (1 - D/EPS) ROE

Question 4

Given D/E, find weight of debt:

Answer 4

Weight of debt = (D/E)/(1+D/E) Therefore: Weight of equity = 1 - (D/E)/(1+D/E)

Question 5

YTM Formula = ? (assume semi-annual interest)

Recall that YTM is the yeild, R_<em>d</em>, that equates the PV of the bond’s promised payments to its market price.

Answer 5

Question 6

Formula for cost of fixed rate perpetual preferred stock:

Recall, the cost of PS is the cost that a company has committed to pay preferred stockholders as a preferred dividend when it issues PS.

Answer 6

r_ps = D_ps / P_ps

Question 7

Formula for the value of a preferred stock:

Answer 7

P_ps = D_ps / r_ps

P_ps = current preferred stock price per share

D_ps = perferred stock dividend per share

r_ps = cost of preferred stock

Question 8

Premium for bearing a stock’s market risk:

Answer 8

ß_i (R_M - R_F)

ß_i = Beta. Return sensitivity of stock i to changes in the market return

R_M = expected return on the market

R_F = Risk free rate of interest

Question 9

Formula for (CAPM) multifactor model incorporating other sources of priced risk:

Answer 9

E(R_i) = R_F + ß_i1 (Factor Risk Premium)₁ + ß_i2 (Factor Risk Premium)₂

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

R_F = Risk free rate of interest

Question 10

Formula for current market value/intrinsic value of a share using Gordon DDM approach:

Answer 10

P₀ = D₁ / ( r_e - g )

Question 11

Formula for expected return/cost of equity, r_e, using Gordon DDM approach:

Answer 11

r_<em>e</em> = ( D_<em>1</em> / P₀ ) + g

Question 12

formula for sustainable growth rate:

Answer 12

g = ( 1 - D / EPS ) ROE

Question 13

5 issues to consider when estimating beta:

Answer 13

1. Estimation period
2. Periodicty of the return interval
   The smaller the return interval (daily vs monthly) the smaller standard error
3. Appropriate market index
   Market index affects estimate of beta
4. Smoothing
   Some analysts adjust beta to reflect reversion to 1
5. Adjustments for small-cap stocks
   beta’s for small caps may need to be adjusted upward due to greater risk/return over the long run

Question 14

The beta of a company or project is affected by the systematic components of:

Answer 14

business risk and financial risk

Question 15

Business risk consists of:

Answer 15

1. Sales risk - risk related to uncertainty of revenues
2. Operating risk - risk attributed to the company’s operating cost structure

Question 16

Financial risk is:

Answer 16

the uncertainty of net income and cash flow attributed to the use of financing that has a fixed cost, such as debt and leases.

Question 17

One method of estimating a breat for a company or project that is not publicly traded is via the pure play method. The pure play method requires using a comparable publicly traded company’s beta and adjusting it for ____ _____ differences.

Answer 17

financial leverage

Question 18

A comparable company is a company that has similar ____ ___.

Answer 18

business risk

Question 19

The unlevered beta is often refered to as the ___ beta becuase it reflects the ___ ___ of the assets.

Answer 19

asset

business risk

Futher info: The asset beta is levered to arrive at an estimate of the equity beta for the company or project of interest

Question 20

Sovereign yield spread =

Answer 20

Country gov’t bond yield (denominated in currency of developed country) - Treasury bond yield on similar maturity bond in developed country

Question 21

Country risk premium…adjusted for volatility of stock market relative to the bond market

Answer 21

soverign yield spread (annualized std deviation of equity index / annualized std deviation of sovereign bond mktl in developed mkt currency)