Chapter 14: Cost of Capital

14.3a Why is the coupon rate a bad estimate of a firm's cost of debt?

The coupon rate measures what the firm's initial cost of debt. It does not estimate the current cost or yield.

14.2b What are the two approaches to estimating the cost of equity capital?

The dividend growth model approach and the SML approach.

14.5a What are the likely consequences if a firm uses its WACC to evaluate all proposed investments?

The likely consequences include accepting projects with more risk than the overall firm and rejected projects with less risk than the firm.

14.7b How are flotation costs included in an NPV analysis?

The true cost of funding the new plant [x/(1-fa)] is deducted from the project's PV of cash flows giving the true NPV of the project.

14.3c How can the cost of preferred stock be calculated?

The cost of preferred stock is the dividend yield on the preferred stock. It can also be determined by observing the required returns on similarly rated preferred stock.

14.4c Under what conditions is it correct to use the WACC to determine NPV?

It is correct to use the WACC to determine NPV is the proposed investment is a replica of the firm's existing operations or if the investment is closely related to the firm's operations.

14.5b What is the pure play approach to determining the appropriate discount rate? When might it be used?

The pure play approach uses a WACC that is unique to a project based on other companies in similar lines of business. It might be used when a company is looking into a project outside of its current operations (a new line of business) and is estimating the required return of the new investment.

14.2a What do we mean when we say that a corporation's cost of equity capital is 16 percent?

This means that the required return for investors in the firm is 16 percent.

14.6a Why do we adjust a firm's taxes when we do a firm valuation?

We adjust the taxes to removed the effects of debt financing. Debt financing causes a reduction in taxes due to interest paid which is tax deductible.

14.7a What are flotation costs?

Flotation costs are the costs incurred when a firm issues new stocks or bonds to finance projects.

14.4b Why do we multiply the cost of debt by (1-Tc) when we compute the WACC?

Interest paid to bondholders is tax deductible. We multiply the cost of debt by (1-Tc) to factor in the portion of the interest that the government pays. This is the post-tax cost of debt.

14.4a How is the WACC calculated?

The WACC is calculated by adding the products of the cost of equity by its capital structure weight and the cost of debt by its capital structure weight. If the firm is financed by preferred stock, then the product of the cost of preferred stock and its capital structure weight must be added to the equation. WACC = (E/V) * Re + (D/V) * Rd (1-Tc)

14.3b How can the cost of debt be calculated?

The cost of debt can be calculated by observing the current interest rate the firm must pay on new borrowing or the interest rate on similarly rated bonds.

14.1b What is the relationship between the required return on an investment and the cost of capital associated with that investment?

The required return and the cost of capital are essentially the same. The required return is what the firm must earn to compensate the investors for their use of capital required to finance the project.

14.1a What is the primary determinant of the cost of capital for an investment?

The use of the funds.

14.6b Why do you think we might prefer to use a ratio when calculating the terminal value when we do a firm valuation?

Using a ratio allows for the comparison of different firm valuations.