Advanced Corporate Finance – Exam 3, Lecture Notes, 2026 – Study
Material and Practice Questions
Cost of capital = - correct answer ✔✔ Expected return on firms' stock
Expected Return = - correct answer ✔✔ Risk free rate + Risk premium
Risk free rate (Rf) - correct answer ✔✔ this reflects the pure time value of money - reward for
waiting for your money
Market risk premium (Rm-Rf) - correct answer ✔✔ this reflects the reward the market offers for
bearing an average amount of systematic risk
beta for firm's stock (B) - correct answer ✔✔ this reflects the amount of systematic risk a firm
has relative to the average
Concerns in estimating company's betas - correct answer ✔✔ - betas vary over time
- sample size may be inadequate
- betas are influenced by changing financial leverage and business risk
Beta partial solutions - correct answer ✔✔ - more sophisticated statistical techniques
- adjustments for changes in leverage or risk
- using average B estimates for firms in the same industry can be more accurate than individual
company B estimates
Determinants of Beta - correct answer ✔✔ - Cyclicality of revenues: highly cyclical stocks have
high betas
- Operating leverage: ratio of fixed costs to variable costs
,Beta example - correct answer ✔✔ Firm A - high operating leverage
- Sales down
- Costs unchanged
- Profits down sharply
Firm B - low operating leverage
- Sales down
- Scale back on variable costs, costs down
- Profits go down moderately
Firm A tend to have a higher beta
Financial leverage - correct answer ✔✔ Beta of a firm's assets is the beta on the portfolio of the
firm's securities, reflects systematic riskiness of operating cash flows
As leverage increases, the beta on the stock increases
Cost of Debt - correct answer ✔✔ - Is the required return on the firm's debt
- Usually focus on the cost of long-term debt or bonds
- Is NOT the coupon rate
Cost of preferred stock - correct answer ✔✔ - Generally, pays a constant dividend each period
- Dividends are expected to be paid every period forever
- Is a perpetuity, so solve for Rp
, Weighted Average of Cost of Capital (WACC) - correct answer ✔✔ - Get our "average" cost of
capital for the firm
- This "average" is the required rate of return on the firm's assets, based on the market
perception of the risk of those assets
- Weights are determined by how much of each type of financing is used
Capital structure weights - correct answer ✔✔ Notation
E = market value of equity = # of outstanding shares x price per share
D = market value of debt = # of outstanding bonds x bond price
V = market value of the firm = D + E
Weights
We = E/V = percent financed with equity
Wd = D/V = percent financed with debt
Taxes and WACC - correct answer ✔✔ Interest expense reduces our tax liability
- This reduction in taxes reduces our costs of debt
- After-tax cost of debt = Rd (1-Tc)
Company Risk vs Project Risk - correct answer ✔✔ - The correct discount rate for a project
should reflect the systematic risk of the projects cash flows
- The Bequity you estimate for a firm reflects the systematic risk of the company's existing assets
and cash flows and past financial choices
- If a project is of the same systematic risk as existing assets and will be financed in the same
way, using estimated Bequity to calculate discount rates is valid
Material and Practice Questions
Cost of capital = - correct answer ✔✔ Expected return on firms' stock
Expected Return = - correct answer ✔✔ Risk free rate + Risk premium
Risk free rate (Rf) - correct answer ✔✔ this reflects the pure time value of money - reward for
waiting for your money
Market risk premium (Rm-Rf) - correct answer ✔✔ this reflects the reward the market offers for
bearing an average amount of systematic risk
beta for firm's stock (B) - correct answer ✔✔ this reflects the amount of systematic risk a firm
has relative to the average
Concerns in estimating company's betas - correct answer ✔✔ - betas vary over time
- sample size may be inadequate
- betas are influenced by changing financial leverage and business risk
Beta partial solutions - correct answer ✔✔ - more sophisticated statistical techniques
- adjustments for changes in leverage or risk
- using average B estimates for firms in the same industry can be more accurate than individual
company B estimates
Determinants of Beta - correct answer ✔✔ - Cyclicality of revenues: highly cyclical stocks have
high betas
- Operating leverage: ratio of fixed costs to variable costs
,Beta example - correct answer ✔✔ Firm A - high operating leverage
- Sales down
- Costs unchanged
- Profits down sharply
Firm B - low operating leverage
- Sales down
- Scale back on variable costs, costs down
- Profits go down moderately
Firm A tend to have a higher beta
Financial leverage - correct answer ✔✔ Beta of a firm's assets is the beta on the portfolio of the
firm's securities, reflects systematic riskiness of operating cash flows
As leverage increases, the beta on the stock increases
Cost of Debt - correct answer ✔✔ - Is the required return on the firm's debt
- Usually focus on the cost of long-term debt or bonds
- Is NOT the coupon rate
Cost of preferred stock - correct answer ✔✔ - Generally, pays a constant dividend each period
- Dividends are expected to be paid every period forever
- Is a perpetuity, so solve for Rp
, Weighted Average of Cost of Capital (WACC) - correct answer ✔✔ - Get our "average" cost of
capital for the firm
- This "average" is the required rate of return on the firm's assets, based on the market
perception of the risk of those assets
- Weights are determined by how much of each type of financing is used
Capital structure weights - correct answer ✔✔ Notation
E = market value of equity = # of outstanding shares x price per share
D = market value of debt = # of outstanding bonds x bond price
V = market value of the firm = D + E
Weights
We = E/V = percent financed with equity
Wd = D/V = percent financed with debt
Taxes and WACC - correct answer ✔✔ Interest expense reduces our tax liability
- This reduction in taxes reduces our costs of debt
- After-tax cost of debt = Rd (1-Tc)
Company Risk vs Project Risk - correct answer ✔✔ - The correct discount rate for a project
should reflect the systematic risk of the projects cash flows
- The Bequity you estimate for a firm reflects the systematic risk of the company's existing assets
and cash flows and past financial choices
- If a project is of the same systematic risk as existing assets and will be financed in the same
way, using estimated Bequity to calculate discount rates is valid
