Chapter 9

company cost of capital &

"expected return on a portfolio of all the company's outstanding debt and equity securities" Opportunity cost of capital for investment in the firm as a whole. The company cost of capital is the appropriate discount rate for an average-risk investment project undertaken by the firm (If the risk is the same as the average risk of the firm's projects). (Equity is not a direct claim on the firm's free cash flows.

The weighted average cost of capital (WACC) formula, for a firm with no debt or preferred stock will have a WACC of:

1 × Cost of equity

A company has a borrowing rate of 15 percent and a tax rate of 20 percent. What is its aftertax cost of debt?

12% Reason: 15% × (1 - .2) = 12.0%

If the risk-free rate is 3 percent, the market risk premium is 7 percent, the industry beta is 1, and the firm beta is 3, the cost of equity will be ____ percent less if the industry beta is used instead of the firm beta.

14% Less Reason: (1 - 3) × 7% = -14%

If the risk-free rate is 3 percent, the market risk premium is 7 percent, the industry beta is 1, and the firm beta is 2, the cost of equity will be ____ percent less if the industry beta is used instead of the firm beta.

7% Less Reason: (1 - 2) × 7% = -7%

Which of the following is true?

A company can deduct interest paid on debt when computing taxable income, but not dividends.

Direct mesaure of project risk

Asset beta (Asset Beta)= Debt Beta + Equity Beta

The slope of the fitted line is:

Beta

Firms with high standard deviations ___.

Correct Answer can sometimes have high betas can sometimes have low betas can sometimes have low betas or high betas

SmartKids, a textbook publisher, is considering investing in a software company that collects and stores data. What beta should SmartKids use to assess the risk of the project?

Correct Answer the beta for software companies that collect and store data the beta for software companies as a whole Reason: There are too many types of software companies that will have different betas; therefore, it is necessary to drill in to get an industry-specific beta. the beta for SmartKids Reason: It is necessary to evaluate project risk by using a beta with risk similar to the project. the beta for the textbook industry as a whole Reason: It is necessary to evaluate project risk by using a beta with risk similar to the project. the beta for software companies that collect and store data

Don't be fooled by diversifiable risk.

Diversifiable risks do not increase the cost of capital and should not affect the assets beta or discount rate of the project.

Warning of using WACC formula.

Equity does not get cheaper, Refer to pic.

On what type of returns does the CAPM focus?

Expected returns Actual returns Reason: The CAPM focuses on expected returns - actual returns don't need to be estimated because they've already happened. Real returns Reason: The CAPM focuses on expected returns. Real returns are net of inflation.

Which of the following are true?

Fixed costs never change. Reason: Fixed costs can change, but they don't change as a direct result of each unit increase in quantity. Variable costs change with changes in quantity. Fixed costs do not change as quantity changes. Variable costs never change. Reason: Variable costs depend on the number of units sold, so they change frequently. Correct Answer Variable costs change with changes in quantity. Fixed costs do not change as quantity changes.

Which two of these are the best examples of cyclical firms??

Luxury retailers Automakers Grocery chains Reason: Groceries are non cyclical - their sales are fairly stable because people always need to eat. Gas stations Reason: Gasoline is non cyclical - sales are fairly stable because people don't stop driving when the economy is in a downturn. Correct Answer Luxury retailers Automakers

2 Two ways financial mangers muddle through the probem of CAPM being a short term model.

Option 1: use the long term-risk free rate. But than the market risk premium but be restated as the average difference between market returns and returns on Long-term treasuries. Option 2: retains the usual defenition of the market risk premium as the difference betwwn market reurns and retturns on short-term treasury bill rates. But now you have to forcast the expected returns of holding the treasury bills over the life of the project. (Past century risk premium has averaged 1.5%

The market risk premium is defined as ___.

RM - RF

What is the CAPM formula?

RS = RF + β× (RM- RF)

According to the CAPM, what is the expected return on a stock if its beta is equal to zero?

Reason: Let's use an example. Say the risk-free interest rate is 4% and the expected market risk premium is 8%. If beta is equal to 0, then the expected return is 4% + 0 x 8% = 4%, which is the risk-free rate.

The market risk premium is defined as ___.

Reason: The market risk premium is the return on the market minus the risk free rate: RM - RF

True or false: Because distant cash flows are riskier they should be discounted at a higher rate than earlier cash flows.

Reason: Use of a constant risk adjusted discount rate assumes that risk accumulates at a constant rate as you look farther out into the future. False Correct Answer False

Which of the following are true?

Reason: Variable costs depend on the number of units sold, so they change frequently. Fixed costs do not change as quantity changes. Fixed costs never change. Reason: Fixed costs can change, but they don't change as a direct result of each unit increase in quantity. Correct Answer Fixed costs do not change as quantity changes.

Which of the following variables is NOT required when using the CAPM to compute the cost of equity capital?

The rate of inflation

Noise in returns can obscure true beta. Therefore statisticians calculate the standard error of the estimated beta to show the extent of possible mismeasurement.

They set up a confidence interval of the estimated value + or - two standard errors.

True or false: Risky projects can be evaluated by discounting certainty-equivalent (CEQ) cash flows at the risk-free interest rate.

True False Reason: Since CEQ is the value equivalent of a safe cash flow it is discounted at the risk-free rate. Correct Answer True

True or false: Projects with great amounts of diversifiable risk should generally have higher company costs of capital.

True Reason: Diversifiable risk should not affect the discount rate for a project. False Correct Answer False

True or false: A sensible way for a manager to account for overoptimistic cash-flow forecasts is to adjust the discount rate.

True Reason: The cash flows should be adjusted instead. False Correct Answer False

WACC is used to discount ______ ______.

cash flows

A firm should only undertake a project if its expected return is ______ that of a financial asset of comparable risk.

equal to or greater than

If the operations of a firm are similar to its industry, the ______ beta should be used to estimate the firm's cost of equity capital.

industry's

cost of debt

interest rate on the firms debt

Debt has a tax advantage because interest _______ a tax deductible expense.

is always

If a firm issues no debt, its average cost of capital will equal ___.

its cost of equity

The WACC is the minimum return a company needs to earn to satisfy ___.

its stockholders its bondholders (Both Debt and equity holders)

The industry beta may be a better estimate than the firm's own beta due to the ______ standard error of the firm estimate.

larger

Standard error or R^2

measures the range of possible error in the beta estimate. The proportion of the total variance in the stock's return that can be explained by market movements.

Companies that specialize in one line of business or activity are called ______________.

pure plays

Risky projects can be evaluated by discounting expected cash flows at a __________ rate.

risk-adjusted discount

The fitted line's _______ measures a stock's systematic risk.

slope beta

To estimate a firm's equity cost of capital using the CAPM, we need to know the ___.

stock's beta risk-free rate market risk premium Reason: To estimate a firm's equity cost of capital using the CAPM, we need to know the risk-free rate, the market risk premium, and the stock's beta. The dividend is not included in the CAPM calculation.

The CAPM can be used to estimate:

the expected (Required) return

cost of equity

the return required by equity investors given the risk of the cash flows from the firm

In a firm with no outstanding debt, the company cost of capital is ______ the expected rate of return to the shareholders.

the same as

True or false: Projects should always be discounted at the firm's cost of debt capital.

False Reason: Projects' discount rates should reflect their particular level of risk.

Suppose the risk-free rate is 5%, the market rate of return is 10%, and beta is 2. Find the expected rate of return using the CAPM.

Reason: 5% + 2 × (10% - 5%)

If a firm uses its overall cost of capital to discount cash flows from higher risk projects, it will accept ______ projects.

Reason: If a firm uses its overall cost of capital to discount cash flows from higher risk projects, it will accept too many high-risk projects - and will reject too many low-risk projects. too many high-risk Correct Answer too many high-risk

True or false: A high beta always goes along with a high standard deviation.

True Reason: There is no fixed relationship between standard deviation and beta. False Correct Answer False

The sales of ________ firms are more sensitive to the business cycle than are the sales of ________ firms.

cyclical, non-cyclical non-cyclical, cyclical Reason: The sales of cyclical firms are more sensitive to the business cycle than are the sales of non-cyclical firms. The sales of defensive firms are less sensitive to the business cycle than are the sales of non-cyclical firms. Correct Answer cyclical, non-cyclical

Which two of the following are the best examples of non cyclical goods?

diapers milk automobiles Reason: Automobiles are a cyclical item - their sales are higher when the economy is expanding. luxury handbags Reason: Luxury handbags are a cyclical item - their sales are higher when the economy is expanding. Correct Answer diapers milk

The sales of cyclical firms are ______ sensitive to the business cycle than are the sales of non-cyclical firms.

less Reason: The sales of cyclical firms are more sensitive to the business cycle than are the sales of non-cyclical firms. The sales of defensive firms are less sensitive to the business cycle than are the sales of non-cyclical firms. more Correct Answer more

Which of the following are components used in the construction of the WACC?

the cost of debt the cost of equity

Which of the following are components used in the construction of the WACC? Weighted Average cost of capital or WACC Pictured

the cost of debt and the cost of equity