Final exam - Chapter 10

Question 1

Why Cost of Capital Is Important

Answer 1

 The return to an investor is the same as the cost to the company. Thus cost of capital is the rate of return required by investors.

Question 2

Since the required rate of return on investment depends

on the investment risk, the cost of capital provides us

Answer 2

with an indication of how the market views the risk of firm’s assets

Question 3

Knowing the cost of capital can also help us determine

Answer 3

the required return for capital budgeting projects

Question 4

 Firm needs to earn at least the _____ ____ to compensate our investors for the financing they have
provided

Answer 4

required return

Question 5

What is the Financial structure (3)

Answer 5

1. Current Liabilities
2. Long term Debts
3. Shareholders’ Equity

Question 6

What is the Capital structure

Answer 6

1. Long Term Debts

2. Shareholders’ Equity

Question 7

What does the current asset change into after deducting the current liabilities?

Answer 7

Net working capital

Question 8

What are the fixed assets

Answer 8

1. Tangible assets

2. Intangible Assets

Question 9

What is CFFA

Answer 9

Cash flow from Assets

Question 10

What is CFFA formula

Answer 10

Cash from from assets (CFFA)

Cash flow to creditors + Cash flow to Stockholders

Question 11

Value of the firm=

Answer 11

Market value of Equity + Market Value of Debt

Question 12

Cash flow From Assets=

Formula

Answer 12

Operating Cash Flow - Net Capital Spending - Change in NWC

Question 13

Divided Growth model Approach

From Stock Valuation model,

Answer 13

P^lower 0 = 
D^lower1 
/
(R^Lower E - G )
\+
P^lower 0 = 
D^lower2
/
(R^Lower E - G )^2

Question 14

Dividends grows at a constant rate of g

Special case

Answer 14

P^lower 0 =
D^lower 1
/
(R^Lower E - G )

Question 15

The SML Approach

Answer 15

information to compute

our cost of equity

Question 16

What is Risk free rate variable?

Answer 16

R^Lower F (italics)

Question 17

Market risk premium,

Formula

Answer 17

E(R^LowerM) – Rf

Question 18

Systematic risk of asset,

Answer 18

B (Italics)

Beta

Question 19

What is the SML Approach Formula?

Answer 19

R^Lower Advantages and Disadvantages of SML
E = Rf + B^lowerE
(E(R^lowerM) - R^lower f)

Question 20

Advantages of SML (2)

Answer 20

Explicitly adjusts for systematic risk
Applicable to all companies, as long as we can
compute beta

Question 21

Disadvantages of SML (3)

Answer 21

Have to estimate the expected market risk
premium, which does vary over time
Have to estimate beta, which also varies over
time
We are relying on the past to predict the future,
which is not always reliable

Question 22

Cost of Debt

Answer 22

 The cost of debt is the required return on our

company’s debt

Question 23

For the Cost of Debt, what do we focus on?

Answer 23

 We usually focus on the cost of long-term debt

or bonds

Question 24

 The required return is best estimated by
computing the ______ on the existing
debt

Answer 24

yield-to-maturity

Question 25

Cost of debt | What is the best way to find out the required return (estimated)

Answer 25

yield to maturity

Question 26

We may also use estimates of ______ _____ based on the bond rating we expect when we issue new debt

Answer 26

current rates

Question 27

True or false: The cost of debt is the coupon rate

Answer 27

False |  The cost of debt is NOT the coupon rate

Question 28

Preferred stock is a ________

Answer 28

perpetuity

Question 29

Cost of Preferred Stock Formula

Answer 29

R ^ Lower P = D / P^lower0 Dividend / Price

Question 30

Cost of Preferred Stock, answers comes to what? A. Decimal B. % C. fraction

Answer 30

%

Question 31

What is the Weighted Average Cost of Capital

Answer 31

We can use the individual costs of capital that we have computed to get our “average” cost of capital for the firm.

Question 32

What is the "Average" | in WAAC?

Answer 32

This “average” is the required return on our assets, based on the market’s perception of the risk of those assets

Question 33

How are the weights are determined? | In WAAC

Answer 33

The weights are determined by how much | of each type of financing that we use

Question 34

Capital Structure Weights Notation What is E=

Answer 34

market value of equity | = # outstanding shares times price per share

Question 35

Capital Structure Weights Notation What is D=

Answer 35

D = market value of debt = # outstanding bonds times bond price

Question 36

Capital Structure Weights Notation What is V=

Answer 36

V = market value of the firm = D + E

Question 37

Capital Structure Weights Weights What is W ^ Lower E=

Answer 37

= E/V = percent financed with equity

Question 38

Capital Structure Weights Weights What is W ^ Lower D=

Answer 38

= D/V = percent financed with debt

Question 39

What are we interested in for the cash-flows?

Answer 39

We are interested in after-tax cash flows, so we need to consider the effect of taxes on the various costs of capital

Question 40

What reduces our tax liability?

Answer 40

Interest | Interest expense reduces our tax liability

Question 41

What does the reduction in taxes reduce?

Answer 41

cost of debt | This reduction in taxes reduces our cost of debt

Question 42

What are not a tax deductible? What does this lead to?

Answer 42

Dividends are not tax deductible, so there | is no tax impact on the cost of equity

Question 43

WAAC Formula

Answer 43

``` WACC = w^lowerE R^lowerE + w^LowerD R^lowerD (1-T^lower C) ```

Question 44

R^lower A ( ROA ) = | Formula for ROA

Answer 44

``` RA (ROA)= w^lowerE R^lowerE + w^LowerD R^lowerD ```

Question 45

Project Costs of Capital and WACC | When do we use the WAAC as our discount rate?

Answer 45

Using the WACC as our discount rate is only appropriate for projects that are the same risk as the firm’s current operations

Question 46

Project Costs of Capital and WACC | What should we do when it is NOT the same risk as the firm current operations

Answer 46

If we are looking at a project that is NOT the same risk as the firm, then we need to determine the appropriate discount rate for that project

Question 47

Pure Play Approach

Answer 47

 Find one or more companies that specialize in the product or service that we are considering  Compute the beta for each company  Take an average  Use that beta along with the CAPM to find the appropriate return for a project of that risk  Often difficult to find pure play companies.

Question 48

Often can’t avoid Subjective Approach

Answer 48

 Consider the project’s risk relative to the firm | overall

Question 49

 If the project is more risky than the firm,

Answer 49

use a discount rate greater than the WACC

Question 50

 If the project is less risky than the firm,

Answer 50

use a discount rate less than the WACC

Question 51

Should you accept projects that you shouldn't and reject projects you should accept

Answer 51

Yes - You may still accept projects that you shouldn’t and reject projects you should accept, but your error rate should be lower than not considering differential risk at all

Question 52

What is the Risk Level? Discount Rate | WAAC - 8%

Answer 52

Very Low Risk

Question 53

What is the Risk Level? Discount Rate | WAAC - 3%

Answer 53

Low Risk

Question 54

What is the Risk Level? Discount Rate | WAAC + 5%

Answer 54

High Risk

Question 55

What is the Risk Level? Discount Rate | WAAC + 10%

Answer 55

Very High Risk

Question 56

Same Risk as Firm

Answer 56

WAAC