Finance: Weighted Average Cost of Capital and Market Risk Premium

Topics: Weighted average cost of capital, Finance, Stock Pages: 5 (1179 words) Published: July 6, 2011
Cost of Capital questions
and practice problems

Questions

1. What does the WACC measure?

2. Which is easier to calculate directly, the expected rate of return on the assets of a firm or the expected rate of return on the firm’s debt and equity? Assume you are an outsider to the firm.

3. Why are market-based weights important?

4. Why is the coupon rate of existing debt irrelevant for finding the cost of debt capital?

5. Under what assumptions can the WACC be used to value a project?

6. How should you value a project in a line of business with risk that is different than the average risk of your firm’s projects?

7. Maltese Falcone, has not checked its weighted average cost of capital for four years. Firm management claims that since Maltese has not had to raise capital for new projects since that time, they should not have to worry about their current weighted average cost of capital since they have essentially locked in their cost of capital. Critique this statement.

8. Your manager just finished computing your firm’s weighted average cost of capital. He is relieved because he says that he cannot use that cost of capital to evaluate all projects that the firm is considering for the next four years. Evaluate this statement.

9. How should you adjust for the cost of raising external financing? (floatation costs)

10. Geothermal’s WACC I 11.4%. Executive Fruit’s WACC is 12.3 percent. Now executive Fruit is considering an investment in geothermal power production. Should it discount project cash flows at 12.3%? Why or why not?

11. An analyst at Dawn Chemical notes that its cost of debt is far below that of equity. He concludes that it is important for the firm to maintain the ability to increase its borrowing because if it cannot borrow, it will be forced to use more expensive equity to finance some projects. This might lead it to reject some project that would have seemed attractive if evaluated at the lower cost of debt. Comment on this reasoning.

12. A firm finance totally with common equity is evaluating two distinct projects. The first project has a large amount of nonsystematic risk and a small amount of systematic risk. The second project has a small amount of nonsystematic risk and a large amount of systematic risk. Which project, if taken will have a tendency to increase the firm’s cost of capital?

Problems

1. The total market value of equity of Greenvalley Real Estate Co is $6 million, and the total value of its debt is $4 million. The treasurer estimates that the beta of the stock currently is 1.2 and that the expected risk premium on the market is 10%. The T-bill rate is 4%. a. What is the required rate of return on Greenvalley stock? b. What is the beta of the company’s existing portfolio of asset? The debt is perceived to be virtually risk-free. c. Estimate the WACC assuming a tax rate of 40%.

d. Estimate the discount rate for an expansion of the company’s present business. e. Suppose the company wants to diversify into the manufacture of rose-colored glasses. The beta of optical manufacturers with no debt outstanding is 1.4. What is the required rate of return on Greenvalley’s new venture?

2. Nodebt is a firm with all-equity financing. It’s equity beta is 0.80. The T-bill rate is 4%, and the market risk premium is expected to be 10%. What is nodebt’s asset beta? What is nodebt’ WACC? The firm is exempt from paying taxes.

3. Micro Spin issued 20-year debt a year ago at par value with a coupon rate of 8%, paid annually. Today the debt is selling at $1050. If the firm’s tax bracket is 35%, what is its after-tax cost of debt?

4. Laurel has debt outstanding with a coupon rate of 6% and a YTM of 7%. Its tax rate is 35%. What is Laurel’s effective (after-tax) cost of debt?

5. Steady’s stock has a beta of 0.20. If the risk-free rate is 6% and the market risk...
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