Cost of Capital

Question 1

What is the difference between the cost of capital and the required rate of return?

Answer 1

RRR is from the viewpoint of the investor & COC is from the viewpoint of the firm

Question 2

What are the interpretations of the WACC?

Answer 2

1. The overall return the firm must earn on its existing assets to maintain the value of its securities
2. The required return on any investments by the firm that essentially have the same risks as existing operations

Question 3

What is the Cost of Debt (Kd)?

Answer 3

Kd = risk free rate + default spread

Question 4

What is the Company Effective Tax Rate?

Answer 4

Te = Tc•(1-L)
where L is the proportion of corporate tax claimed by shareholders (depends on number of overseas shareholders)

Question 5

What does the Beta say about a stock?

Answer 5

The Beta reflects how the underlying stock moves with the market (correlation or diversification measure). Stocks with higher risk (higher beta) require a higher expected rate of return for an investor.

Question 6

Are the weightings of the WACC calculated in book or market values)?

Answer 6

Market values

Question 7

How does WACC apply to diversified firms?

Answer 7

The company cost of capital should only be used as a benchmark rate of return for a new project if the project has the same basic risk as the rest of the company. Using a company wide WACC will bias the acceptance of riskier industries.

Question 8

What is the Optimal Capital Structure?

Answer 8

When the value of a firm is maximised, which occurs when the cost of capital is minimised.

Question 9

If the debt ratio increases what happens to the WACC?

Answer 9

1. Cost of debt increases with leverage because default risk goes up and bond ratings will go down
2. Cost of equity will also increase with leverage because shareholders need to bear business risk and financial risk

Question 10

What is the Cost of Capital Approach to calculate the Optimal Capital Structure?

Answer 10

1. Estimate the cost of equity at different levels of debt using levered beta calculations
2. Estimate the cost of debt at different levels of debt using bond ratings
3. Calculate the cost of capital at different levels of debt and choose the optimal level, where COC is minimised
4. Calculate the effect on firm value and stock price - V = CF1/(COC-g)

Question 11

What does M-M’s Irrelevance Theorem suggest about the value of a firm?

Answer 11

The value of a firm should be independent of its capital structure given that financing decisions do not matter. The value of a firm is that of its generated cash flows.

Question 12

What is the Trade-Off Theory?

Answer 12

The optimal target capital structure is determined by balancing taxes and expected costs of financial distress.