WACC

Question 1

What is WACC?

Answer 1

It is the minimum rate of return that companies must obtain from their investments in order to meet the minimum returns required by its investors

Question 2

Should we use market or book value when computing WACC?

Answer 2

Market value

Question 3

What does Ke mean to investors?

Answer 3

Opportunity cost

Question 4

In emerging markets, can we use gov bond rates as Rf?

Answer 4

No

Question 5

What is the Beta of a company?

Answer 5

It is a measure of the volatility of a security/portfolio to the market as a whole

Question 6

How is the Beta estimated?

Answer 6

By a linear regression of company’s historical return and market index performance

Question 7

What is the Kd?

Answer 7

The rate at which a company can borrow or renegotiate its debt

Question 8

What is Kd for investors?

Answer 8

Required returns

Question 9

Does default spread increase or decrease as rating diminishes?

Answer 9

Increases

Question 10

What interpretation can we give to Kd if the company has bonds outstanding?

Answer 10

Kd = interest rate (YTM)

Question 11

What interpretation can we give to Kd if the company has recently borrowed long term from a bank?

Answer 11

We can use i as Kd

Question 12

What is the SML?

Answer 12

A linear relationship from what I should expect on a stock and its systematic risk. It is what you expect to earn in the long-term

Question 13

What happens to the expected return if B=0?

Answer 13

Expected return = risk free rate

Question 14

What is the slope of the SML?

Answer 14

ERP

Question 15

What happens to/on the SML line when Beta decreases?

Answer 15

There is a movement along the line and returns decrease

Question 16

What happens to/on the SML line when Beta increases?

Answer 16

There is a movement along the line and returns increase

Question 17

What happens to/on the SML line when Risk free increases?

Answer 17

There is a parallel upward shift on the line and returns increase

Question 18

What happens to/on the SML line when Risk free decreases?

Answer 18

There is a parallel downward shift on the line and returns decrease

Question 19

What happens to/on the SML line when ERP increases?

Answer 19

There is a pivotal upward shift and return increases

Question 20

What happens to/on the SML line when ERP decreases?

Answer 20

There is a pivotal upward shift and return decreases

Question 21

Does ERP increase or decreases with risk-aversion?

Answer 21

Increases

Question 22

How can we compute ERP?

Answer 22

We look at historical data on the average of market and riskless assets over the same period and calculate the difference
Stocks - bonds
Mkt % - Rf %

Question 23

When computing ERP from historical data what should we do?

Answer 23

Make it:

• Long term because of standard deviation
• Consistent with risk-free
• Compounded average

Question 24

What is the ratio used to compute Beta?

Answer 24

Covariance of asset w market/ mkt variance:

Cov (Ri, Rm)/var(Rm)

Question 25

What are the three Beta determinants?

Answer 25

Product type, Operating leverage and Financial leverage

Question 26

How does product type influences on the Beta?

Answer 26

-It depends on the sensitivity of the demand for the firms G/S, thus:

• The more discretionary the product, the higher the B
• Cyclical companies have higher B
• Growth firms too

Question 27

How does operating leverage influences on the Beta?

Answer 27

OP leverage is the proportion of FC a firm has, that is, how rigid is their cost structure:

• Depends on the sector
• Higher OP leverage = greater income variability = higher B
• Smaller and young firms have H B

Question 28

How does financial leverage influences on the Beta?

Answer 28

As firms borrow, they create fixed payments (I) that make their E/Q more volatile, which increases income volatility = higher B

Question 29

Does the beta increases with the targeted D/E?

Answer 29

Yes

Question 30

What does the unlevered beta tells us?

Answer 30

The riskiness of being in the business/ the firm’s assets

What is the B of the company if it has zero debt

Question 31

Where in the WACC do we see Fin leverage risk?

Answer 31

Levered beta

Question 32

Where in the WACC do we see Business risk?

Answer 32

Unlevered beta

Question 33

Where in the WACC do we see Country risk?

Answer 33

in ERP

Question 34

Where in the WACC do we see the influence of the currency choice?

Answer 34

On the Rf

Question 35

What is the variance of an investment?

Answer 35

The variance on any investment measures the disparity between actual and expected returns

Question 36

What are the CAPM assumptions?

Answer 36

• Investors act rationally and have at their disposal
  all relevant information on financial securities
• There are homogeneous expectations among investors
• All the investors hold the same portfolio, called market portfolio

Question 37

Which risk can be minimized by diversification?

Answer 37

Firm-specific

Question 38

How does diversification minimizes firm-specific risk?

Answer 38

1- Each investment is a much smaller percentage of the portfolio, muting the effect (positive or negative) on the overall portfolio.
2- Firm-specific actions can be either positive or negative. In a large portfolio, it is argued, these effects will average out to zero. (For every firm, where something bad happens, there will be some other firm, where something good happens.

Question 39

How can we estimate ERP?

Answer 39

Historical ERP: Assume that the actual premium delivered over long time periods is equal to the expected premium - i.e., use historical data.
• Survey investors on their desired risk premiums and use the average premium from these surveys.
• Estimate the implied premium in today’s asset prices.

Question 40

How does debt affects cost of equity?

Answer 40

By borrowing more, you increase your financial leverage, making equity riskier

Question 41

How does debt affects cost of debt?

Answer 41

It will increase your DS pushing up Kd