Lecture 4b cost of capital Flashcards
(14 cards)
Please provide the CAPM equation
Please explain debt betas and why they vary
Debt betas are the multiple by which the cost of debt is multiplied. Therefore the riskier the debt (company) the higher its debt beta as shown in the diagram included
Please explain why asset cost of capital is the same as the unlevered cost of capital. Also provide the formula
Asset cost of capital is the same as unlevered cost of capital because it takes into account the business’ cost of cap without considering the effects of leverage (debt).
Please provide the formula for asset (unlevered) beta
Net debt formula and impact on EV
Net debt = Debt - cash
Net debt is added to mkt cap to obtain enterprise value. As such, if a firm has excess cash (ie it surpasses its debt) it will bring down a company’s enterprise value
Would the unlevered cost of capital for a firm with debt be
higher/lower or equal to the equity cost of capital for the
same firm? Why?
The unlevered cost of capital is lower than the equity CoC because the cost of debt is lower than the cost of equity. Unlevered cost of capital is a weighted average of both the cost of equity and the cost of debt
Dell Inc. has a market capitalization of $21 billion, $8 billion in
debt, and $13 billion in cash. If its equity beta is 1.41, estimate the beta of Dell’s underlying business assets
Please differentiate between operating leverage and financial leverage
Operating leverage
* Is the relative proportion of fixed versus variable costs
* A higher proportion of fixed costs increases the sensitivity of
the project’s cash flows to market risk
* The project’s beta will be higher
* A higher cost of capital should be assigned
Financial leverage
* Is the degree to which the firm uses debt for financing.
* All else equal, the more financial leverage a firm has, the
higher its equity beta.
On project risk, please provide the formula for equity beta. Also explain why debt betas are assumed to be zero unless otherwise stated.
Business risk vs financial risk
- Business risk is the inherent or fundamental risk of a business, without regard to financial risk. It is also called operating risk.
- Financial risk is the risk created by debt in the capital structure of the firm.
Please answer the following:
* What types of risk do equity holders of an unlevered firm face?
* What types of risk do equity holders of a levered firm face?
* What happens to the cost of equity as financial leverage
increases?
- Since the firm has no debt, equity holders are exposed only to the risks related to the company’s operations and industry conditions (business risk and market risk)
- Additional risk due to debt financing - default risk. Higher volatility
- Cost of equity increases as the business becomes riskier
IDX Tech is looking to expand its investment in advanced
security systems. The project will be financed with equity.
You find data for a publicly traded firm in the same line of
business. You have the following information Debt
outstanding: $400 million Number of shares: 80 million
Stock price: $15 per share Book value of equity: $6 per
share Beta of equity: 1.2; Tax rate:35%. What is your
estimate of the project’s beta?
Thurbinar Design has a stock price of $20 per share, with 15
million shares outstanding. It also has $100 million in
outstanding debt, with a yield of 4.5%. Thurbinar’s equity
beta is 1.0. Calculate Thurbinar’s unlevered cost of capital.
Assume a tax rate of 35%. Rf = 0.04 and Rm = 0.09
Please provide the WACC formula
