FIN 300 Ch 14 (Cost of Capital)
What are the 2 disadvantages of the SML approach in estimating the cost of equity?
1. The SML approach requires that the market risk premium and beta coefficient be estimated 2. As with the dividend growth model, we essentially rely on the past to predict the future when we use the SML approach.
If the IRR is greater than the WACC should you accept or reject?
Accept
In calculating the WACC, if you had to use book values for either debt or equity, which would you choose? Why?
Book values for debt are likely to be much closer to market values than are equity book values
Formula for adjusted cash flow from assets
CFA* = EBIT + Deprecitation -- Taxes* -- Change in NWC --- Capital Spending
The return that lenders require on the firm's debt
Cost of debt
The return that equity investors require on their investment in the firm
Cost of equity
If the overall firm WACC were used as the hurdle rate for all divisions of a firm, would the riskier divisions or the more conservative divisions tend to get most of the investment projects? Why?
If the single hurdle rate were used, riskier divisions would tend to receive more funds for investment projects, since their return would exceed the hurdle rate despite the fact that they may actually plot below the SML and, hence, be unprofitable projects on a risk-adjusted basis
Why do we use an aftertax figure for cost of debt but not for cost of equity?
Interest expense is tax-deductible, but dividends are no
On the most basic level, if a firm's WACC is 12%, what does this mean?
It is the minimum rate of return the firm must earn overall on its existing assets. If it earns more than this, value is created
Regarding flotation costs, when you are calculating the true cost after taking these costs into account, does it matter if the entire amount is being raised from debt?
No. Even if the specific funds are actually being raised completely from debt, the flotation costs, and hence true investment cost, should be valued as if the firm's target capital structure is used.
If you can borrow all the money you need for a project at 6%, doesn't it follow that 6% is your cost of capital for the project?
No. The cost of capital depends on the risk of the project, not the source of the money
When is it appropriate to use the WACC as the discount rate for future cash flows?
Only when the proposed investment is similar to the firm's existing activities
The use of a WACC that is unique to a particular project, based on companies in similar lines of business
Pure play approach
If the IRR is less than the WACC should you accept or reject?
Reject
Formula for adjusted taxes (Taxes*)
Taxes* = EBIT *Tc
READ
The cost of capital on an investment depends primarily on the use of the funds, not the source
What specific pieces of information do you need to estimate the cost of equity capital using the SML approach? What are some of the ways you could get these estimates?
The risk-free rate is usually estimated to be the yield on very short maturity T-bills and is, hence, observable; the market risk premium is usually estimated from historical risk premiums and, hence, is not observable. The stock beta, which is unobservable, is usually estimated either by determining some average historical beta from the firm and the market's return data, or by using beta estimates provided by analysts and investment firms.
If you were trying to estimate the appropriate cost of capital for different divisions, what problems might you encounter? What are two techniques you could use to develop a rough estimate for each division's cost of capital?
The typical problem encountered in estimating the cost of capital for a division is that it rarely has its own securities traded on the market, so it is difficult to observe the market's valuation of the risk of the division. Two typical ways around this are to use a pure play proxy for the division, or to use subjective adjustments of the overall firm hurdle rate based on the perceived risk of the division.
What are the advantages of using the SML approach to finding the cost of equity capital? What are the disadvantages?
Two primary advantages of the SML approach are that the model explicitly incorporates the relevant risk of the stock and the method is more widely applicable than is the dividend discount model, since the SML doesn't make any assumptions about the firm's dividends The primary disadvantages of the SML method are (a) three parameters (the risk-free rate, the expected return on the market, and beta) must be estimated, and (b) the method essentially uses historical information to estimate these parameters.
When is the only time you might use accounting values, instead of market values, in estimating total value (E + D) of a company?
Under certain circumstances, such as when calculating figures for a privately owned company, it may not be possible to get reliable estimates of market values. In this case, we might go ahead and use the accounting values for debt and equity
The weighted average of the cost of equity and the aftertax cost of debt
WACC
Under what circumstance would it be appropriate for a firm to use different costs of capital for its different operating divisions?
If the different operating divisions were in much different risk classes, then separate cost of capital figures should be used for the different divisions; the use of a single, overall cost of capital would be inappropriate
The _____ for a firm reflects the risk and the target capital structure of the firm's existing assets as a whole. As a result, strictly speaking, the firm's ____ is the appropriate discount rate ONLY if the proposed investment is a replica of the firm's existing operating activities
WACC WACC
What specific pieces of information do you need to use the DCF approach to determine the cost of equity capital, and what are some ways in which you could get this estimate?
While the share price and the most recent dividend can be observed in the market, the dividend growth rate must be estimated. 2 common ways of estimating the growth rate are to use analysts' earnings and payout forecasts or to determine some appropriate average historical growth rate from the firm's available data
What are the 2 ways to estimate the cost preferred stock?
1. The dividend yield of the preferred stock (D/P0) 2. Because preferred stocks are rated in much the same way as bonds, the cost of preferred stock can be estimated by observing the required returns on other, similarly rated shares of preferred stock
When estimating the cost of equity, if you get different costs of capital from the dividend growth approach and the SML approach what are the 2 solutions to come to a conclusion?
1. We could ignore one of the estimates. We would look at each estimate to see if one of them seemed too high or too low to be reasonable 2. We could average the two estimates.
What are the 2 advantages of the SML approach in estimating the cost of equity?
1. It explicitly adjusts for risk. 2. It is applicable to companies other than just those with steady dividend growth.
What are the two interpretations of the WACC?
1. It is the overall return the firm must earn on its existing assets to maintain the value of its stock 2. It is the required return on any investments by the firm that have essentially the same risks as existing operations.
What is the advantage of the dividend growth model in estimating the cost of equity?
1. It simplicity. It is both easy to understand and easy to use
What are the disadvantages of the dividend growth model in estimating the cost of equity?
1. It's only applicable to companies that pay dividends 2. Even for companies that pay dividends, the key underlying assumption is that the dividend grows at a constant rate, which will never be exactly the case. The model is really applicable only to cases in which reasonably steady growth is likely to occur 3. The estimated cost of equity is very sensitive to the estimated growth rate. 4. This approach does not explicitly consider risk. Unlike the SML approach, there is no direct adjustment for the riskiness of the investment. For ex, there is no allowance for the degree of uncertainty or certainty surrounding the estimated growth rate for dividends. As a result, it is difficult to say whether or not the estimated return is commensurate with the level of risk
What are the advantages of using the DCF model for determining the cost of equity capital? What are the disadvantages?
The primary advantage of the DCF model is its simplicity. The disadvantages are that (a) the model is applicable only to firms that actually pay dividends, (b) even if a firm does pay dividends, the DCF model requires a constant dividend growth rate forever; (c) the estimated cost of equity from this method is very sensitive to changes in the dividend growth rate, which is a very uncertain parameter; (d) the model does not explicitly consider risk, although risk is implicitly considered to the extent that the market has impounded relevant risk of the stock into its market price
How do you determine the appropriate cost of debt for a company? Does it make a difference if the company's debt is privately held as opposed to being publicly traded? How would you estimate the cost of debt for a firm whose only debt issues are privately held by institutional investors?
The appropriate aftertax cost of debt to the company is the interest rate it would have to pay if it were to issue new debt today. Hence, if the YTM on outstanding bonds of the company is observed, the company has an accurate estimate of its cost of debt. If the debt is privately placed, the firm could still estimate its cost of debt by (a) looking at the cost of debt for similar firms in similar risk classes, (b) looking at the average debt cost for firms with the same credit rating (assuming the firm's private debt is rated), or (c) consulting analysts and investment bankers. Even if the debt is publicly traded, an additional complication occurs when the firm has more than one issue outstanding; these issues rarely have the same yield because no two issues are ever completely homogeneous.
