Reading 45 - Cost of Capital

Question 1

What is the cost of capital?

Answer 1

The rate of return that the suppliers of capital - bondholders and owners - require as compensation for their contribution of capital.

Question 2

What is an alternative way of looking at the cost of capital?

Answer 2

It is the opportunity cost of funds for the suppliers of capital: a potential supplier of capital will not voluntarily invest in a company unless its return meets or exceeds what the supplier could earn elsewhere in an investment of comparable risk.

Question 3

The rate of return required by suppliers of capital for an individual source of a company’s funding, such as debt or equity is called the:

Answer 3

component cost of capital.

Question 4

What is the weighted average cost of capital?

Answer 4

A weighted average of the after-tax required rates of return on a company’s common stock, preferred stock, and long term debt, where the weights are the fraction of each source of financing in the company’s target capital structure.

Question 5

In the WACC equation, we adjust the expected before-tax cost on new debt financing, Rd, by a factor of:

Answer 5

(1 - t)

Question 6

Multiplying Rd by (1-t) results in an estimate of the:

Answer 6

after-tax cost of debt.

Question 7

What is a target capital structure?

Answer 7

A company’s chosen proportion of debt and equity.

Question 8

A simple way of transforming a debt-to-equity ratio D/E into a weight - that is D/(D+E) - is to:

Answer 8

Divide D/E by 1 + D/E.

Question 9

Investment Opportunity Schedule

Answer 9

A graphical depiction of a company’s investment opportunities ordered from highest to lowest expected return. A company’s optimal capital budget is found where the investment opportunity schedule intersects with the company’s marginal cost of capital.

Question 10

Expected rate of return

Answer 10

The return that analysts’ calculations suggest a security should provide, based on the market’s rate of return during the period and the security’s relationship to the market.

Question 11

What is the net present value (NPV)?

Answer 11

The present value of an investment’s cash inflows (benefits) minus the present value of its cash outflows (costs).

Question 12

What is the simplified version of NPV?

Answer 12

Present value of inflows - Present value of outflows

Question 13

What is a useful way to think of net present value?

Answer 13

Think of net present value as the difference between the present value of the cash inflows, discounted at the opportunity cost of capital applicable to the specific project, and the present value of the cash outflows, discounted using that same opportunity cost of capital:

NPV = Present value of inflows - Present value of outflows

Question 14

If the investment’s NPV is positive, should the company undertake project?

Answer 14

Yes

Question 15

If we choose to use the company’s WACC in the calculation of the NPV of a project, we are assuming that the project:

Answer 15

has the same risk as the average-risk project of the company; and

will have a constant target capital structure throughout its useful life.

Question 16

The cost of equity is equal to the

Answer 16

rate of return required by stockholders.

Question 17

The cost of debt is the cost of debt financing to a company when it issues a _________ or takes out a ________ __________.

Answer 17

bond; bank loan

Question 18

The yield to maturity is the:

Answer 18

annual return that an investor earns on a bond if the investor purchases the bond today and holds it until maturity.