Lecture 5

Question 1

What is the conceptual definition of “cost of capital”

Answer 1

opportunity cost that reflects the returns investors expect from other investments of similar risk

Question 2

How is WACC calculated?

Answer 2

E/(D*E) * r +D/(D+E) * r * (1- taxshield)

Question 3

How to get an estimate of the cost of equity

Answer 3

Using the CAPM

Question 4

Out of which two components does the total risk of a company consist?

Answer 4

total risk = market risk + company specific risk

aka
total risk = systematic risk + unsystematic risk

Question 5

give the formula for CAPM

Answer 5

E(R) = Rf + ß * (E (Rm)-Rf)

Question 6

what are the three “financing alternatives” that a firm can choose to reduce the cost of capital?

Answer 6

• straight debt (loans, bonds)
• straight equity (retained earnings, new equity issues)
• hybrid instruments (convertibles, preferred shares)

Question 7

Which are factors for debt-equity choice?

Answer 7

• tax shield (from interest payments)
• cost of financial distress
• agency cost (shareholder; manager conflicts)
• asymmetric information (capital structure serving as informative signal for the market)

Question 8

what are direct and indirect costs of financial distress?

Answer 8

direct: payment of lawyer, accountants, … for reorganization, debt renegotiation, avoidance of bankruptcy

indirect: loff of reputation and confidence, inability to raise new capital for projects