Topic III. The Cost of Capital

Question 1

What is a discount rate fundamentally based on?

Answer 1

All discount rates are based on the riskiness of the asset being price

Question 2

What is the financial definition of risk?

Answer 2

In finance, risk refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision.

Question 3

What is the definition of WACC?

Answer 3

The WACC is the expected return on a portfolio comprised of the debt and equity in the firm’s capital structure.

Question 4

What is the process for calculating WACC?

Answer 4

1. Identify all of the sources of long-term capital that have been used to finance operations.
2. Adjust each component cost of capital for the risk specific to it.
3. Use nominal rates of return because we forecast expected actual future cash flows.
4. Weight each component cost of capital using target market value weights.
5. Calculate a weighted average of the marginal costs of all sources of capital - debt, equity, etc.

Question 5

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

Answer 5

Question 6

True/False:

A firm’s capital structure determines how it allocates cash flows between creditors and shareholders.

Answer 6

True

Question 7

Does the use of debt impact the free cash flow a business generates?

Answer 7

No!

The free cash flows are allocated between creditorsand shareholders. Using more or less debt doesn’t change the amount of cash the business generates.

Question 8

Why aren’t non-interest baring debts included in the WACC calculation?

Answer 8

Non-interest-bearing liabilities, such as accounts payable, are excluded from the calculation of WACC to avoid inconsistencies and simplify

the calculation.

Question 9

Calculate the WACC

A firm has a long-run debt-asset ratio of 40%, the marginal corporate tax rate is 20%, and its bonds have a AA bond rating. If the current yield on a AA bond of comparable risk is 5% and the required return on equity is 10%.

What is the companies overall WACC?

Answer 9

WACC = (2/5)*(4/5)*(1/20) + (3/5)*(1/10)

.: WACC = 7.6%

Question 10

Calculate the WACC

If a firm has a cost of capital of 8% when using 40% debt, would the WACC go up or down if the company shifted to using 60% debt?

Note:

Cost of Debt - 5%

Cost of Equity - 10%

Answer 10

WACC would go down