LECTURE 5

Question 1

2 limitations of CAPM

Answer 1

1. doesn’t show us how to estimate Beta

2. Only considers EQUITY cost of capital - NOT DEBT.

Question 2

What discount rate do most companies use?

Answer 2

COMPANY cost of capital = risk adjusted average rate of return demanded by investors on company’s debt and equity.

Question 3

2 reasons why beta is important

Answer 3

1. idea about company cost of K

2. idea about vulnerability of company to business cycles

Question 4

2 ways to estimate beta

Answer 4

1. Plot company’s stock excess returns against market excess returns and estimate slope by regression on past data
2. Use beta for whole industry

Question 5

Regression to estimate beta: how does it relate to SML and what is alpha?

Answer 5

Alpha = historical performance of the security relative to what predicted by SML.
Alpha = 0 = on SML - can use CAPM.

Question 6

If debt =0, company cost of K=

Answer 6

equity cost of K predicted by CAPM/SML

Question 7

V =

Answer 7

D + E

Question 8

Debt cost of capital shows…

Answer 8

the IR a firm must pay creditors on its debt i.e the minimum expected ROR the debt holder accepts for the risk taken.

Question 9

When risk of default is LOW, what can we use for debt cost of K?

Answer 9

YTM

- The r that makes price of bond = PV

Question 10

When risk of default is HIGH, is YTM suitable for debt cost of K?

Answer 10

NO - it oVERESTIMATED.

Question 11

How can we calculate debt cost of K using probability theory?

Answer 11

2 different returns with different probabilities
r or r - L if default
p = prob default
r = r - PL
= YTM - prob(default)* expected loss rate

Question 12

How can we calculate debt cost of K WITHOUT using probability theory?

Answer 12

rD = rF + credit risk rate

aka default premium

Question 13

How does default premium change with amount of debt?

Answer 13

more debt = higher default premium

Question 14

We have to adjust the cost of debt for…

Answer 14

TAX

proportional (1 - t)

Question 15

The company cost of K is also called

Answer 15

rWACC = weighted average cost of K

Question 16

Asset beta measures…

Answer 16

average systematic risk of the company

Question 17

3 determinants of asset beta

Answer 17

1. Business cycles - luxury vs necessity
2. Operating leverage - FC to VC
3. Changes in confidence/state of econ

Question 18

Unlevered equity means…

Answer 18

100% equity financed

NO DEBT

Question 19

Levered equity means..

Answer 19

equity and debt

Question 20

MM theory:

Answer 20

the total value of the firm should NOT depend on K structure in perfect K markets.

Question 21

By LOOP, how does leverage affect value of firm?

Answer 21

It does NOT - cash flows of debt + cash flows of equity still = cash flows of project

Question 22

How does levered equity affect rE? Why?

Answer 22

Levered equity = higher risk for shareholders since creditors paid first of bankrupt –> demand higher return on equity to compensate.

Question 23

Does levered equity affect overall cost of K?

Answer 23

NO - debt cost of K lower, but equity cost of K rises = no change in overall cost of K.

Question 24

3 MM assumptions

Answer 24

1. Investors and firms can trade the same set of securities at competitive market prices = PV of future cash flows.
2. No taxes/transaction costs/insurance costs
3. Financing decisions do NOT affect total cash flow.

Question 25

MM proposition 1

Answer 25

In perfect K markets, the total value of the firm = market value of the total cash flows generated by its assets and is NOT affected by K structure

Question 26

Price of share in levered company = Price of share in unlevered company AS LONG AS...

Answer 26

Investors can borrow or lend on their own account on the same terms as the firm.

Question 27

MM proposition 2

Answer 27

Leverage increases expected flow of earnings per share but NOT share price since increased expected flow exactly offset by increased rE so PV unchanged. --> Expected ROR on common stock of a levered firm increases with D/E.

Question 28

How does rD change with D/E according to MM?

Answer 28

Almost unchanged except slightly increase at very high D/E due to higher risk of default.

Question 29

How does rE change with D/E according to MM?

Answer 29

Increases, but at a decreasing rate since higher D/E means more risk transferred to creditors

Question 30

How does rA change with D/E according to MM?

Answer 30

Unchanged - flat

Question 31

How does rD change with D/E according to traditionalists?

Answer 31

similar to MM but greater increase at high D/E

Question 32

How does rE change with D/E according to traditionalists?

Answer 32

Increasing at an increasing rate because irresponsible firms borrow excessively

Question 33

How does rA change with D/E according to traditionalists?

Answer 33

Declines, reaches a minimum, then rises

Question 34

according to traditionalists, can individuals borrow on the same terms as firms?

Answer 34

NO - firms can borrow more cheaply = investors can't replicate a firm's leverage by borrowing shares.

Question 35

After-tax WACC may be affected by K structure when....

Answer 35

Tax shields on IR may mean after-tax WACC declines as D rises.