Topic 6- The Cost of Capital

Question 1

In corporate finance, what are the 4 main conditions for a ‘perfect world’?

Answer 1

• People trade actively in the market (marginal investors)
• Investors are risk-averse and well diversified
• Diversification has no cost
• Investors have homogeneous expectations

Question 2

What does the risk of a well-diversified portfolio depend on?

Answer 2

The market risk of the securities included in the portfolio

Question 3

What does the equilibrium security return depend on?

Answer 3

The asset’s systematic return and not its total risk

Question 4

What is β?

Answer 4

A measure of the non-diversifiable risk for any asset, as the covariance of its returns with returns on market portfolio divided by the variance of the returns on the market

Question 5

What is the market portfolio?

Answer 5

A theoretical bundle of investments that includes every type of asset available in the investment universe, with each asset weighted in proportion to its total presence in the market

Question 6

What do the different possible values of β indicate?

Answer 6

• β>1: security risk higher than market risk i.e the returns on the assets are more variable in response to systematic risk factors than is the overall market
• β=1: Security risk equal to market risk
• β<1: Security risk lower than market risk i.e the returns on the asset are less variable in response to systematic risk factors than is the overall market

Question 7

What is the formula for the Capital Asset Pricing Model (CAPM)?

Answer 7

r_i = r_f + β(r_m - r_f)

Question 8

What is the formula for market risk premium?

Answer 8

return of market - risk free rate or return

r_m - r_f

Question 9

What is the formula for risk premium on asset i?

Answer 9

expected return on asset i - risk free rate of return

r_i - r_f

Question 10

What happens when a stock’s return is lower than it’s supposed to be?

Answer 10

Everyone would be better off holding the market portfolio an no one wants the stock, hence driving down the price until the expected return matches what you could get elsewhere

Question 11

What happens when a stock’s return is higher than what it’s supposed to be?

Answer 11

The demand will increase, hence driving up the price and lower it’s expected return

Question 12

Give 3 main limitations of CAPM

Answer 12

• The model makes unrealistic assumptions
• The parameters of the model cannot be estimated precisely
• The relationship between betas and returns is weak

Question 13

What is the relationship between the market value of a firm’s debt and equity?

Answer 13

Market value of firm’s total assets = market value of firm’s debt + market value of firm’s equity
V = D + E

Question 14

What is a company’s cost of capital?

Answer 14

The minimum acceptable rate of return when the frim expands by investing in average-risk projects

Question 15

What is the formula for a company’s cost of capital?

Answer 15

r = (D/V x r_d) + (E/V x r_e)

Question 16

What is the Weighted Average Cost of Capital (WACC)?

Answer 16

To get a proper valuation we use the firm’s after-tax cash flows because interest is a tax-deductible expense for firms

Question 17

What is the formula for WACC?

Answer 17

WACC = (1-Tc) x r_d x D/V + r_e x E/V

Question 18

When must you use WACC?

Answer 18

If the company is (at least partly) debt financed

Question 19

When is it appropriate to use WACC?

Answer 19

Only for projects that have the same risk as the firm’s existing business

Question 20

What is the hurdle rate for a capital budgeting decision?

Answer 20

The cost of capital

Question 21

What is the only type of risk a well-diversified investor cares about?

Answer 21

Market risk

Question 22

How can you tell a stock is overpriced?

Answer 22

expected rate of return

Question 23

How can you tell a stock is underpriced?

Answer 23

expected rate of return>required rate of return