Final Exam - Cost of Capital Questions &
Answers 2023-24
Cost of capital - ANSWER-The rate of return which a firm must earn on funds currently being invested to
justify raising the funds to finance those assets. Alternatively, it is the rate of return that leaves the
market price of the firm's common stock unchanged
Factors determining the firm's cost of capital - ANSWER-Inside
- Risk the firm has
- Leverage the firm has
- What the project looks like
Outside
- Interest rate level
- What's happening in the economy
- Risk in the economy
Risk free rate - ANSWER-The rate of return an investor could expect to earn where there is no risk that
the return on the investment or the money invested will not be received
Common stock beta coefficient - ANSWER-Beta, as we learned, is a measure of the systematic risk of the
common stock's returns. Systematic risk reflects how the returns earned by a risky investment co-vary
with the returns earned by the market portfolio of all risky investments
Market risk premium - ANSWER-The difference in the rate of return that an investor expects to earn from
investing in the market portfolio comprised of all risky investments and the risk free rate
Advantages of the CAPM approach - ANSWER-- The model is simple and easy to understand and
calculate
- The model does not rely on dividends or any assumptions about the growth rate in dividends
, Specifying the risk free rate - ANSWER-Treasury securities with maturities from 30 days to 30 years are
readily available, but CAPM offers no guidance as to the appropriate choice
Estimating beta - ANSWER-Beta estimates from various sources generally differ
Estimating the market's risk premium - ANSWER-The analyst can estimate the market risk premium by
looking at the history of stock returns and premium earned over the risk free rate of interest
What to do about flotation costs? - ANSWER-When firms raise money to finance new investments by
selling bonds and socks, they incur flotation costs
Flotation costs - ANSWER-Feeds that are paid to an investment banker and costs incurred when
securities are sold at a discount to the current market price
Weighted average cost of capital - ANSWER-Incorporates the required rate or return demanded by the
firm's lenders and investors along with the particular mix of financing sources that the firm uses
The riskiness of a firm affects its WACC in two ways - ANSWER-- The required rate of return on the debt
and equity securities that the firm issues will be higher if the firm is riskier
- Risk influences how the firm chooses the extent to which it is financed with debt and equity securities
The firm's WACC is used in a number of ways - ANSWER-- To value entire firms
- Firms often use their WACC as the starting point for determining the discount rate for individual
investment projects they might undertake
- Firms sometimes use their WACC to evaluate their performance
There are two things that can drive a wedge between the firm's cost of capital and the investors'
expected rate of return - ANSWER-- Transaction costs
- Taxes
3 step procedure for estimating the firm's WACC - ANSWER-1. Define the firm's capital structure
2. Estimate the cost of each of the sources of financing
Answers 2023-24
Cost of capital - ANSWER-The rate of return which a firm must earn on funds currently being invested to
justify raising the funds to finance those assets. Alternatively, it is the rate of return that leaves the
market price of the firm's common stock unchanged
Factors determining the firm's cost of capital - ANSWER-Inside
- Risk the firm has
- Leverage the firm has
- What the project looks like
Outside
- Interest rate level
- What's happening in the economy
- Risk in the economy
Risk free rate - ANSWER-The rate of return an investor could expect to earn where there is no risk that
the return on the investment or the money invested will not be received
Common stock beta coefficient - ANSWER-Beta, as we learned, is a measure of the systematic risk of the
common stock's returns. Systematic risk reflects how the returns earned by a risky investment co-vary
with the returns earned by the market portfolio of all risky investments
Market risk premium - ANSWER-The difference in the rate of return that an investor expects to earn from
investing in the market portfolio comprised of all risky investments and the risk free rate
Advantages of the CAPM approach - ANSWER-- The model is simple and easy to understand and
calculate
- The model does not rely on dividends or any assumptions about the growth rate in dividends
, Specifying the risk free rate - ANSWER-Treasury securities with maturities from 30 days to 30 years are
readily available, but CAPM offers no guidance as to the appropriate choice
Estimating beta - ANSWER-Beta estimates from various sources generally differ
Estimating the market's risk premium - ANSWER-The analyst can estimate the market risk premium by
looking at the history of stock returns and premium earned over the risk free rate of interest
What to do about flotation costs? - ANSWER-When firms raise money to finance new investments by
selling bonds and socks, they incur flotation costs
Flotation costs - ANSWER-Feeds that are paid to an investment banker and costs incurred when
securities are sold at a discount to the current market price
Weighted average cost of capital - ANSWER-Incorporates the required rate or return demanded by the
firm's lenders and investors along with the particular mix of financing sources that the firm uses
The riskiness of a firm affects its WACC in two ways - ANSWER-- The required rate of return on the debt
and equity securities that the firm issues will be higher if the firm is riskier
- Risk influences how the firm chooses the extent to which it is financed with debt and equity securities
The firm's WACC is used in a number of ways - ANSWER-- To value entire firms
- Firms often use their WACC as the starting point for determining the discount rate for individual
investment projects they might undertake
- Firms sometimes use their WACC to evaluate their performance
There are two things that can drive a wedge between the firm's cost of capital and the investors'
expected rate of return - ANSWER-- Transaction costs
- Taxes
3 step procedure for estimating the firm's WACC - ANSWER-1. Define the firm's capital structure
2. Estimate the cost of each of the sources of financing
