Topic 8 - Cost of Capital

Question 1

2 methods for calculating equity cost of capital

Answer 1

1 - estimation from historical data
2 - fundamental approach

Question 2

Method 1:
how do we estimate risk premium

Answer 2

by using the historical avg excess return of the market / rf interest rate

Question 3

Method 1: how do we estimate beta

Answer 3

from historical returns

Question 4

considerations when estimating beta

Answer 4

• time horizon
• the market proxy
• beta variation and extrapolation
• outliers
• changes in the environment of the firm may cause the future to differ from the past

Question 5

drawbacks of using historical data

Answer 5

• standard error is huge
• backward looking may not represent current expectations

Question 6

what is the fundamental approach

Answer 6

solving for the discount rate that is consistent with the current level of the index

Question 7

2 methods for calculating debt cost of capital

Answer 7

1 - use the debt yield as an estimate of the debt cost of capital
2 - CAPM (using the debt beta to estimate the debt cost of capital)

Question 8

why do we need to make adjustments

Answer 8

to account for significant risk of default

Question 9

debt beta

Answer 9

this is a measure of systematic risk associated with a company’s risk. it reflects how sensitive the value of the debt is to changes in the market.

Question 10

CAPM

Answer 10

a pricing model that calculates the expected rate of return of an asset

Question 11

firm asset betas

Answer 11

these represent the market risk of the average project in a firm