Cost of Capital Flashcards
According to the CAPM, what is the cost of capital (required return) of a project?
rf + ßproject x (E[Rmkt] - rf)
Why are no transaction needed to readjust the market portfolio when the the price of a security changes?
The market portfolio is PASSIVE
Every security is weighted by its market value which changes automatically when the price of a security changes.
Name a common proxy for the market portfolio.
S&P 500
Name the two approaches that can be used to calculate the risk premium.
- Historical approach
2. Fundamental approach
Explain the historical approach used to determine the risk premium.
Average the excess return of the market over the risk premium over a historical period. (Arithmetic average is used.)
Explain the fundamental approach used to determine the risk premium.
- Make some assumption on the dividend growth.
- Using the formula for the present value of the market (FCF/(Rmkt-g)) = Po, find Rmkt
- Once Rmkt is isolated, subtract rf to find the risk premium
When can you use the yield on a bond or a loan as the cost of debt capital?
When the loan/debt is risk-free
Why can’t we use the yield of a bond as the cost of capital if it isn’t risk-free?
We must consider the probability of default on the bond.
Can you use the CAPM to estimate the debt cost of capital?
Yes.
What is the company’s “Enterprise value”?
Equity + Debt - Cash
Or : Equity + Net Debt (where net debt = D-C)
Is the ß of net debt always equal to the ß of debt?
No. The ß of cash is 0 so the ß of net debt and the ß of debt may be different.
What is “operating leverage”?
Relative proportion of fixed vs variable costs.
Fixed costs are risk-free -> their ß is 0 and they get discounted at a lower rate than variable costs.
What is the effect of discounting the fixed costs at a lower rate on the present value of the project?
Higher costs so lowers the project value.
