Cost of Capital

Question 1

Company cost of capital: WACC

Answer 1

The discount rate for the firm’s average-risk projects

The company’s cost of capital can be understood as the expected return on a portfolio of all the company’s existing securities

Question 2

Weighted Average Cost of Capital (WACC): calculation

Answer 2

WACC = ra = E / D + E x re + D / D + E x rd

Question 3

company cost of capital (beta) : name

Answer 3

weighted average of the equity and debt beta

Question 4

weighted average of the equity and debt beta: calcul

Answer 4

Ba = E / D + E x Be + D / D + E x Bd

Question 5

Estimating an asset beta requires…

Answer 5

estimates of the equity and debt
betas

Question 6

Equity beta (use the CAPM) : calcul

Answer 6

Beta(e) = covariance (re, rm) / variance (rm)

Question 7

Debt beta

Answer 7

• For investment grade debt often
  assumed to be zero
• However, even nearly risk-free
  bonds have a positive beta

Question 8

Determinants of asset betas

Answer 8

1. Cyclicality
2. Operating leverage
3. Time horizon of the project

Question 9

Cyclicality

Answer 9

Cyclical firms, i.e., firms whose revenues and earnings strongly depend on the state of the business cycle tend to be high-beta firms. Examples include airlines, luxury products, and construction

Question 10

Operating leverage (= fixed costs / variable costs of project)

Answer 10

Other things being equal, a project that has higher relative fixed costs and/or higher commitments to invest will have a higher
project beta

Question 11

Time horizon of the project

Answer 11

Projects with long-term cash flows are more sensitive to changes in the risk-free rate or market risk premium

Question 12

Equity: definition

Answer 12

shareholders are entitled to receive what is left after all claimants are paid off (“residual claimants”)
–> Upside potential

Question 13

Debt

Answer 13

bondholders are entitled to receive a promised payment each year (interest) and repayment of the principal at maturity
–> No upside potential, only downside risk

Question 14

A major source of risk of debt is … ?

Answer 14

default (repayment) risk
–> Borrowers with higher default risk should pay higher interest rates on debt

Question 15

Default risk: definition

Answer 15

is the probability that companies or individuals will be unable to make the required payments on their debt obligation

Question 16

Bond rating agencies: definition

Answer 16

their creditor ratings largely on an
analysis of the level and trend of the issuer’s financial ratio
− coverage ratios (company earnings to fixed costs),
− leverage ratio (debt-to-equity ratio),
− liquidity ratios (e.g., current, quick ratio),
− profitability ratios (e.g., return on equity, return on assets), and
− cash flow-to-debt ratio

Question 17

Bond default risk, so-called credit risk, is measured by ?

Answer 17

1. Moody’s
2. Standard & Poor’s (S&P)
3. Fitch

Question 18

The rating of these companies (bond default risk) what is issued?

Answer 18

estimate a bond’s riskiness (or safety)

Question 19

Higher ratings are associated with (bonds)…

Answer 19

lower credit spreads and thus lower
costs of debt

Question 20

the cost of debt rD is estimated as (calculation)

Answer 20

rd = rf + default spread

Question 21

For investment grade debt, default spread = 0 (assumption)

Answer 21

rd = rf

Question 22

Estimate default spreads (steps)

Answer 22

1. Build a sample of bonds comparable to the debt we want to value:
   - Similar industry, similar ratings or financial ratios, similar maturity etc
   - Focus on liquid bonds without features such as convertibility etc
2. Estimate average yield of sample:
   - Estimate yield to maturity of the bonds
   - Apply weighting if similarity among bonds is not given

Question 23

Weighted Average Cost of Capital (WACC) with tax (calculation)

Answer 23

WACC = E / D + E x re + D /D + E x rd x (1 - T)

Question 24

What does the WACC covers?

Answer 24

overall risk of the firm and the tax shield of debt

Question 25

What is the problem with WACC?

Answer 25

1. The WACC formula is correct only for projects that are just like the firm undertaking them (same risk and debt ratio). Hence, the WACC formula works for the “average” project. 2. WACC is incorrect for projects which are riskier or safer than the average of the firm’s existing assets. It is also incorrect for projects which would change the firm’s (target) debt ratio 3. WACC is based on a firm’s current characteristics, but managers use it to discount future cash flows. This is only correct if the firm’s business risk and debt ratio are expected to remain constant

Question 26

FCFs of the entire firm

Answer 26

Free cash flow = Profit after tax + depreciation – investment in fixed assets – investment in working capital

Question 27

WACC – Warning

Answer 27

Check validity of results by looking at “comparable” firms in terms of: − Multiples (such as price-earnings, or market-to-book), − Revenue figures and expected growth. ⇒ Validate rE using stock market data of these “comparables”. --> Most of the firm value stems from the terminal value. Growth rate and profitability assumptions must be made carefully and prudently

Question 28

Adjusting WACC when leverage or business risk differs

Answer 28

Leverage might differ between the company and its new project

Question 29

For example, assume the project has a higher debt ratio

Answer 29

- Financing weights will change – Both cost of equity and cost of debt will increase since financial risk will be higher – The WACC will, however, decrease overall due to the tax shield on debt interest payments --> For WACC to be valid, the debt ratio must be held constant and actively rebalanced if equity value increases or falls!

Question 30

One key assumption of using the WACC

Answer 30

The firm actively rebalances in order to maintain its debt ratio

Question 31

APV

Answer 31

method calculates a series of present values: First, the PV if the firm was all-equity financed. Second, the PVs of the costs and benefits associated with the firm’s financing

Question 32

APV (calculation)

Answer 32

base-case NPV + sum of PVs of financing side-effects --> sum of PVS : + Tax shield + Loan subsidies - Issuance costs - Costs of fin. distress

Question 33

To value a project we need to use the expected return for projects ...

Answer 33

with similar risk characteristics

Question 34

The company cost of capital works only for projects that..

Answer 34

They are carbon copies of the firm.

Question 35

Find firms that are “pure plays”:

Answer 35

– in the same line of business as the project considered – not involved in any other type of business – publicly traded

Question 36

The cost of capital (or asset beta) of a pure play best reflects..

Answer 36

the industry-specific costs of capital, i.e., the cost of capital (asset beta) of the project you are considering --> Pure plays are sometimes also called focused firms. Firms that are not pure plays are also called conglomerates

Question 37

segment reporting

Answer 37

differentiate between focused companies and conglomerates

Question 38

industry classification (SIC, NAICS, FF12, FF48

Answer 38

Segments (lines of business) are usually differentiated

Question 39

Problems of using such industry codes

Answer 39

– The assignment of standardized industry codes often seems arbitrary. – Segment reporting by companies is subject to significant leeway. – Depending on the project, common sense and industry knowledge are superior to any standardized industry classification

Question 40

Present value (PV): definition

Answer 40

The present value PV0 equals the sum of all discounted payoffs

Question 41

Net present value (NPV)

Answer 41

Investment decisions are generally based on the net present value (NPV), which subtracts the required investment from the present value

Question 42

Internal rate of return (IRR), or yield (y)

Answer 42

is the discount rate at which the net present value is equal to zero. A simple investment rule is then: Accept investments that offer an IRR in excess of their opportunity cost of capital

Question 43

3 ways to calculate the IRR

Answer 43

1. graphical method 2. trial and error method 3. using a financial calculator

Question 44

if the internal rate of return is larger than the required rate of return (i.e., cost of capital), we choose the project or not?

Answer 44

yes

Question 45

For cash flows with more than one change in sign, there can be..

Answer 45

multiple IRRs

Question 46

Are the WACC assumptions a problem in the real world?

Answer 46

- Survey evidence suggests that many firms use only one discount rate to value all of their projects - we cannot observe the discount rate used by thousands of listed US firms - we cannot observe the discount rate used by thousands of listed US firms