Module 33.2: Project Cost of Capital Flashcards
What is a project’s beta?
measure of its systematic or market risk. It is the difference between a specific project risk and the average risk of the firm.
What is the pure-play method of determining a project’s beta?
basing the project beta on the equity beta of a publicaly traded firm that is engaged in a business similar to the project. and has similar risk.
How is the beta of a firm determined?
based on the business risks of its projects and the risks of the financial structure. greater reliance on debt financing equals a higher equity beta.
What is the formula to get the beta of a publicly traded firm?
B equity * [1 / [1 + (1-t) * D/E ] ]
D/E = comparable company's debt to equity ratio t = marginal tax rate
What is the formula to get the beta of a project?
B subject firm * [1 + ( (1 - t) * D/E)]
What are four challenging issues involved with estimating the beta of a comparable company equity?
1) beta is estimated using historical returns data. sensitive to length of time and frequency.
2) the estimate is affected by which index is chosen to represent the market return
3) betas are believed to revert toward 1 over time and may need to be adjusted
4) estimates of beta for small-capitalization firms may need to be adjusted upward to reflect risk inherent in small firms that is not captured by the usual estimation methods
what is the country risk premium?
added to the market risk premium when using the CAPM because cost of equity in developing countries does not adequately reflect the country risk.
What is sovereign yield spread?
the difference between yields between the developing country’s government bond and treasury bonds.
What is the CAPM formula adjusted for country risk?
risk free rate + beta[expected market return - risk free rate + CRP]
CRP = country risk premium
CRP = soverign yield spread x (annualized standard deviation of equity index in dev country / annualized standard deviation of soverign bond market in terms of developed country)
What is the marginal cost of capital schedule? What is a break point? what is the formula?
shows the WACC for different amounts of financing.
break point occur any time the cost of one components of the company’s WACC changes.
break point = amount of capital at which the component’s cost of capital changes / weight of the component in the capital structure.
What are flotation costs?
fees charged by investment bankers when a company raises external equity capital.
What is the correct treatment of flotation costs vs. the incorrect method?
flotation costs are not an ongoing expense of the firm so should not be considered in WACC.
Correct way to handle will be to adjust the initial project cost.
