THE COST OF CAPITAL

Question 1

LEVERED VALUE of a project

Answer 1

The value of an investment, including the benefit of the interest tax deduction, given the firm’s leverage policy.

Question 2

WACC VALUATION METHOD (for a project)

Answer 2

Discounting future incremental free cash flows using the firm’s WACC, which produces the levered value of a project.

VL(Time 0) FCF0 + FCF1/ (1+rwacc) + FCF2/ (1+rwacc)^2 + FCF3 / (1+rwacc)^3

Question 3

Key assumptions of WACC

Answer 3

AVERAGE RISK
-We assume initially that the market risk of the project is equivalent to the average market risk of the firm’s investments.

CONSTANT DEBT-EQUITY RATIO
-We assume that the firm adjusts its leverage continuously to maintain a constant ratio of the market value of debt to the market value of equity.

LIMITED LEVERAGE EFFECTS
-We assume initially that the main effect of leverage on valuation follows from the interest tax deduction and that any other factors are not significant at the level of debt chosen.

Question 4

Assumptions of WACC in practice

Answer 4

• These assumptions are reasonable for many projects and firms.
• The first assumption is likely to fit typical projects of firms with investments concentrated in a single industry. (AVERAGE RISK)
• The second assumption reflects the fact that firms tend to increase their levels of debt as they grow larger. (Constant debt-equity ratio)
• The third assumption is especially relevant for firms without very high levels of debt where the interest tax deduction is likely to be the most important factor affecting the capital budgeting decision. (Limited leveraging effects).

Question 5

COST OF EQUITY (CAPM)

Answer 5

= risk free rate + (equity Beta*market risk premium)

Question 6

COST OF EQUITY (Constant dividend growth model)

Answer 6

= (dividend(in one year) / current price) + Dividend growth rate

Question 7

COST OF PREFERRED STOCK CAPITAL

Answer 7

Preferred dividend/ preferred stock price

Question 8

COST OF DEBT CAPITAL

Answer 8

A firm’s cost of debt is the interest rate it would have to pay to refinance its existing debt, such as through new bond issues.
Differs from coupon rate on existing debt, the coupon rate reflects the interest rate the firm had to offer at the time the debt was issued.

Question 9

YIELD TO MATURITY

Answer 9

The yield to maturity is the yield that investors demand to hold the firm’s debt (new or existing)

Question 10

EFFECTIVE COST OF DEBT

Answer 10

rD(1-Tc)

Tc is corporate tax

Question 11

PROJECT BASED COST OF CAPITAL IN REALITY

Answer 11

In reality, specific projects often differ from the average investment made by the firm. There are different market risks.

Question 12

COST OF CAPITAL OF A NEW ACQUISTION

Answer 12

Different risks so one company’s WACC would not be appropriate for the other.

Question 13

DIVISIONAL COST OF CAPITAL

Answer 13

In most cases, firms with more than one division should not use a single company wide WACC to evaluate projects.

Question 14

Costs of issuing new equity or bonds?

Answer 14

Issuing new equity or bonds carries a number of costs.

• Issuing costs should be treated as cash outflows that are necessary to the project.
• They can be incorporated as additional costs (negative cash flows) in the NPV analysis.