Chap 9

Question 1

What is the company cost of capital?

Answer 1

• the expected return on a portfolio of all the company’s outstanding debt and equity securities
• It is the opportunity cost of capital for investment in all of the firm’s assets, and therefore the appropriate discount rate for the firm’s average-risk projects.

Question 2

What is the CAPM and its formula?

Answer 2

-implies an expected return rate

r = rf + β(rm − rf)

Question 3

Should a firm use the same opportunity cost of capital for all investments?

Answer 3

Each project should in principle be evaluated at its own opportunity cost of capital, like we see in the value additivity principle: each investment should be valued like a mini firm

Question 4

According to the SML, what projects should be accepted?

Answer 4

any project lying above the upward-sloping SML that links expected return to risk

Question 5

What can you say about the SML line in comparison to the C.O.C rule?

Answer 5

SML =upward sloping line, a function of beta
C.O.C = flat horizontal line at required return rate (on y -axis)

In general, the correct discount rate increases as project beta increases. We want to accept projects above the security market line, not just ones that offer a higher return than the company’s cost of capital

Question 6

What may happen if a firm uses only the C.O.C rule?

Answer 6

They arent taking risk into account, and in return it would reject many good low-risk projects and accept many poor high-risk projects

Question 7

What is a naked call option?

Answer 7

is an option purchased with no offsetting (hedging) position in the underlying stock or in other options.

Question 8

Does the true C.O.C depend on project risk or the company undertaking it?

Answer 8

project risk

Question 9

Why do company’s make a company C.O.C? Why did we learn about that?

Answer 9

they set a companywide cost of capital as a benchmark. This is not the right discount rate for everything the company does, but adjustments can be made for more or less risky ventures

Question 10

The cost of capital is estimated as a blend of…

Answer 10

cost of debt (the interest rate) and the cost of equity (the expected rate of return demanded by investors in the firm’s common stock).

Question 11

What do the values of debt and equity sum to?

Answer 11

D + E = V (where V is firm value and asset value)

Note that these figures are all market values

Question 12

Is the market value of equity or book value of equity larger?

Answer 12

The market value of equity is often much larger than the book value

Question 13

What is the order of riskiness for cost of equity, company and debt?

Answer 13

cost of debt

Question 14

How do you calculate company cost of capital (WACC)? and after tax WACC?

Answer 14

Company cost of capital WACC = rD D/V + rE E/V

After Tax WACC = After-tax WACC = (1 − Tc)rDD/V + rEE/V

Question 15

Do individual stock beta’s change over time?

Answer 15

Yes

Question 16

What size portion of each stock’s total risk comes from movements in the market? What is the rest of the risk made up of?

Answer 16

a small portion is from market movement, and the rest is firm-specific, diversifiable risk

Question 17

What does r^2 measure?

Answer 17

measures the proportion of the total variance in the stock’s returns that can be explained by market movements

Question 18

If the observations are independent, what does this say about the standard error?

Answer 18

The standard error of the estimated mean beta declines in proportion to the square root of the number of stocks in the portfolio

Question 19

Is industry beta or portfolio betas more reliable?

Answer 19

Industry beta’s

Question 20

What is the formula for expected long-term return from bills?

Answer 20

Expected long-term return from bills = yield on long-term bonds − 1.5%

Question 21

Does a flatter or more steep SML better reflect history?

Answer 21

Using a “flatter” SML is perhaps a better match to the historical evidence, which shows that the slope of average returns against beta is not as steeply upward-sloping as the CAPM predicts

Question 22

Is the cost of debt always less than the cost of equity?

Answer 22

yes

Question 23

Why is the WACC formula dangerous?

Answer 23

because it suggests that the average cost of capital could be reduced by substituting cheap debt for expensive equity
BUT THAT DOESNT WORK
As the debt ratio D/V increases, the cost of the remaining equity also increases, offsetting the apparent advantage of more cheap debt.

Question 24

The after-tax WACC depends on….

Answer 24

the average risk of the company’s assets, but it also depends on taxes and financing
-b/c debt has a tax advantage

Question 25

What is the definition of asset beta?

Answer 25

the direct measure of project risk

Question 26

What is the formula of asset beta?

Answer 26

Asset beta = βA = βD(D/V) + βE(E/V) where BD is beta of debt, and BE is beta of equity

Question 27

Why is debt beta positive?

Answer 27

1. debt investors worry about the risk of default. Corporate bond prices fall, relative to Treasury-bond prices, when the economy goes from expansion to recession. The risk of default is therefore partly a macroeconomic and market risk. 2. all bonds are exposed to uncertainty about interest rates and inflation. Even Treasury bonds have positive betas when long-term interest rates and inflation are volatile and uncertain.

Question 28

Are overall company C.O.C's useful for conglomerates?

Answer 28

Overall company costs of capital are ALMOST USELESS for conglomerates. This is bc conglomerates diversify into several unrelated industries, so they have to consider industry-specific costs of capital

Question 29

Sometimes good comparables are not available or not a good match to a particular project. What are the 3 things then a financial manager needs to consider?

Answer 29

1. Think about the determinants of asset betas. Often the characteristics of high- and low- beta assets can be observed when the beta itself cannot be. 2. Don’t be fooled by diversifiable risk. 3. Avoid fudge factors. Don’t give in to the temptation to add fudge factors to the discount rate to offset things that could go wrong with the proposed investment. Adjust cash- flow forecasts first.

Question 30

How does cyclicality determine asset beta's?

Answer 30

Cyclical firms—firms whose revenues and earnings are strongly dependent on the state of the business cycle—tend to be high-beta firms. Thus you should demand a higher rate of return from investments whose performance is strongly tied to the performance of the economy ex. airlines, resorts

Question 31

How does operating leverage determine asset betas?

Answer 31

High operating leverage means a high asset beta. A firm with high fixed costs, relative to its variable costs, is said to have high operating leverage.

Question 32

How can cash flows generated by an asset be broken down?

Answer 32

Cash flow = revenue − fixed cost − variable cost

Question 33

How can we break down an assets PV?

Answer 33

PV(asset) = PV(revenue) − PV(fixed cost) − PV(variable cost)

Question 34

Where is the cyclicality of revenues reflected in the asset beta formula? What does that say about the asset beta?

Answer 34

reflected in βrevenue the asset beta is proportional to the ratio of the present value of fixed costs to the present value of the project.

Question 35

What is the formula for DOL (degree of operating leverage) and what does it mean?

Answer 35

DOL = 1 + fixed costs/ profits DOL measures the percentage change in profits for a 1% change in revenue.

Question 36

Do diversifiable risks affect asset beta's?

Answer 36

NO, do not affect asset betas and should not affect the discount rate for the projects

Question 37

The most likely cash flow is the....

Answer 37

Unbiased one . Unbiased forecasts incorporate all risks, including diversifiable risks as well as market risks

Question 38

Why are fudge factors dangerous?

Answer 38

Fudge factors in discount rates are dangerous because they displace clear thinking about future cash flows The fudge factor overcorrects for bias and would penalize long-lived projects

Question 39

What are certainty equivalents?

Answer 39

an

Question 40

What are certainty equivalents?

Answer 40

an

Question 41

What are certainty equivalents?

Answer 41

- converted cash flows | - adjusts for a change in risk that happens over the course of the investment

Question 42

How do you calculate a certainty equivalent (CEQ)?

Answer 42

PV= C/(1+r)^t = CEQ/(1+ risk free rate)^t

Question 43

What is the difference between discounting cash flows with the risk adjusted discount rate method VS using the CEQ method?

Answer 43

- the risk adjusted discount rate adjusts for time and risk together - The certainty-equivalent method makes separate adjustments for risk and time

Question 44

What does hair cut for risk mean?

Answer 44

financial slang referring to the reduction of the cash flow from its forecasted value to its certainty equivalent

Question 45

Should distant cash flows (riskier cash flows) be discounted at a higher rate than earlier cash flows?

Answer 45

NO - Using the same risk-adjusted discount rate for each year’s cash flow implies a larger deduction for risk from the later cash flows - The reason is that the discount rate compensates for the risk borne per period. - The more distant the cash flows, the greater the number of periods and the larger the total risk adjustment