cost of capital

Question 1

describe risk independence

Answer 1

nThe cost of capital for a project does not depend on the characteristics of the company considering the project.

The value of a project depends on what the project is, not who the investor is.

Question 2

Capital markets lead to risk independence because

Answer 2

nbecause investors can diversify through markets; , diversification by a company does not provide any investment opportunity that is not already available to investors

Question 3

estimates of current share price based on the dividend growth model are

Answer 3

extremely sensitive to estimates of the future growth rate in dividend per share. The same problem arises when the model is used to estimate the cost of equity.

so the CAPM may be preferred.

Question 4

what are issue costs

Answer 4

costs that are incurred when raising new capital such as underwriters’ fees, legal and administrative fees

• it is not included in cost of capital for project evaluation

Question 5

what does the cost of capital depend on?

Answer 5

the cost of capital is an opportunity cost that depends on the risk of the project in which the capital is invested. It does not depend on the source of the funds

Question 6

nThe cost of capital should only be used as an estimate of the cost of capital for a new project if:

Answer 6

¡The risk of the new project is identical to the risk of existing projects.

¡

¡The new project will not cause the company’s optimal or target capital structure to change.

Question 7

If a firm uses its WACC to make accept/reject decisions for all types of projects,

Answer 7

, it will have a tendency towards incorrectly accepting risky projects and incorrectly rejecting less risky projects.

Question 8

draw a diagram of what happens if WACC is used to accept/reject decisions for all types of projects

Answer 8

Question 9

describe this diagram

Answer 9

a single WACC is applied across all projects. Project proposed by retail is incorrectly rejected and he project suggested by the exploration division will be incorrectly accepted

• accept some projects with negative NPV and reject some proejcts with positive NPV
• high-systematic-risk divisions are more likely to have their projects accepted

Question 10

explain why that WACC should be used only if the new project is not expected to change the company’s optimal or target capital structure.

Answer 10

The company’s cost of capital is also based on its existing capital structure. If the debt capacity of a new project differs from that of the existing projects, then this difference could affect the project’s cost of capital

Question 11

cost of capital for diversified companies

If a company’s operations are in more than one industry, and the industries differ in risk?

discuss in terms of cost of capital

Answer 11

company’s cost of capital will not be appropriate for project evaluation b/c discount rate will not reflect the risk of the reject and incorrect investment decisions will be made

Question 12

learning objective: Estimate the cost of capital for a division of a diversified company

pure play company?

Answer 12

a company that operates almost entirely in only one industry

Question 13

conceptual problems with pure play approach

Answer 13

how to best adjust equity betas for financial leverage.

¡Appropriate leverage adjustment depends on company’s capital structure policy.

Question 14

practical problems with pure-play approach

Answer 14

¡Pure play companies are rare.

¡Ignores valuable information from diversified co.

Possible to estimate divisions cost of capital from diversified company WACCs

Question 15

cons of WACC in project evaluation

Answer 15

1. only be estimated directly for a whole company, and a company’s cost of capital should only be used to evaluate new projects that are identical to the company’s existing operations.
2. should not be used to analyse financial decisions
3. it only includes cash flows directly associated with the project. It does not include strategic options that may be associated with the project

Question 16

why should WACC not be used to make financial decisions

Answer 16

t makes debt appear to be cheaper than equity

e. g. the cost of equity was more than 11 per cent, but the cost of debt was less than 8 per cent.
1. observer might conclude debt should be increased BUT this is wrong b/c increase in debt –> risk of borrowing increases –> increase in interest rate by lender

also shareholders face increased risk –> cost of equity increases (demand for higher return for the risk)

SO WACC increases

Question 17

For diversified company, use of single WACC

Answer 17

nFor diversified company, use of single WACC for all projects is likely to result in wrong investment decisions.

Question 18

adv of WACC

Answer 18

flexibility and simplicity compared to estimating it using CAPM where it is difficult to estimate betas of projects

Question 19

for a company’s WACC to be acceptable

Answer 19

a new project should generate net cash flows that are sufficient to meet the after-tax cost of debt used to finance the project,as well as provide at least the required rate of return on the equity used to finance the project.

Question 20

The interest rate on the debt is not a valid measure of the new project’s cost of capital b/c

Answer 20

the interest rate on the debt depends on the risk of the company and its existing assets, and does not depend solely on the risk of the new project

Question 21

if a company makes a share issue to raise the cash needed for a new project, why is the required rate of return of equity not a valid measure of company’s cost of capital?

Answer 21

he cost of equity will depend on the average risk of all the company’s assets and on its financial leverage, not just on the characteristics of the new project

Question 22

when would a company’s cost of capital be a valid measure of the cost of capital of the new project?

Answer 22

when the risk of the proposed project is the same as the risk of the company’s existing assets (most likely b/c it is an expansion of company’s existing operations –> NO CHANGE IN RISK)

Question 23

the market value of a bank overdraft will

why?

Answer 23

he market value of a bank overdraft will always equal its book value, b/c

Bank overdrafts carry a variable interest rate, which is adjusted in accordance with fluctuations in market rates.

Question 24

what is Y in calculating the effective tax rate?

pays maximum possible franked dividends then?

Answer 24

proportion of the tax collected from the company that is claimed as tax credits by shareholders,

Y =1

Question 25

the cost of capital is an opportunity cost that depends on

Answer 25

he risk of the project in which the capital is invested. It does not depend on the source of the funds.

Question 26

are issue costs included?

Answer 26

issue costs are not included in cost of capital but it is included in in the cash flows associated with the project.

Question 27

weighted average issue cost is used b/c

Answer 27

company’s projects are effectively financed by a ‘pool’ of funds consisting of both debt and equity

Question 28

why is accounts payable excluded?

Answer 28

their costs are accounted for in other ways.

e.g. the cost of trade credit (the difference between the price of goods purchased with cash on delivery and the price when purchased on credit) will flow through into a company’s COGs and is therefore deducted in calculating the company’s profit and net operating cash flow

Question 29

main assumptions when using the direct estimation approach

Answer 29

(i) The cost of capital is uniform within each industry.
(ii) The data on the proportion of assets in each industry accurately reflect the market values of the companies’ divisions.

Question 30

adv of direct estimation approach over pure play approach

disadv?

Answer 30

(i) It is not necessary to find companies that operate in only one industry.
(ii) There is no need to employ any model to adjust equity betas or the cost of equity capital for differences in leverage.

CON: may be difficult to estimate the market value of each division of a diversified company.

Question 31

importance of risk independence

Answer 31

allows managers to evaluate projects on a project-by-project basis.

Question 32

Factors that will increase γ include the

Answer 32

the proportion of after-tax earnings distributed by a company as well as the proportion of investors that can claim back the tax credits that are distributed

Question 33

if a diversified company uses the company’s cost of capital for all investments regardless of their divisision, what may happen?

Answer 33

(a) the high-risk divisions finding it much easier than the low-risk divisions to have their projects accepted
(b) some projects incorrectly accepted and rejected