Topic 6 Opportunity Cost of Capital

Question 1

Opportunity Cost of Capital

Answer 1

Expected return for a particular investment
-discount rate for an investment based on its risk
-equals rf + compensation for systematic risk

Question 2

How to Estimate Beta

Answer 2

Regress stock realized equity excess returned on the realized market proxy excess returns

Question 3

Debt Cost of Capital

Answer 3

-The yield to maturity
-average rate of return that will be realized d on the bond -> only true with no defaults
-> Generally the cost of debt will be lower than YTM KEY YTM higher than the cost of debt with the probability of default

Question 4

“Twin method”

Answer 4

use a levered twin to find their cost of equity and debt
Steps:
De-lever the twin and solve with MM Prop II with taxes
Re-lever if the firm or project is debt-financed using the leverage ratio of the investment

Question 5

rU = (E/E+D)rE + (D/E+D)rD

Answer 5

Asset Cost of Capital

Question 6

Operating Leverage

Answer 6

higher fixed costs create a higher project cost of capital through a higher beta
higher operating leverage = higher fixed costs