CHAPTER 14
COST OF CAPITAL
Answers to Concepts Review and Critical Thinking Questions
1. It is the minimum rate of return the firm must earn overall on its existing assets. If it earns more than this, value is created.
2. Book values for debt are likely to be much closer to market values than are equity book values.
3. No. The cost of capital depends on the risk of the project, not the source of the money.
4. Interest expense is tax-deductible. There is no difference between pretax and aftertax equity costs.
5. The primary advantage of the DCF model is its simplicity. The method is disadvantaged in that (1) the model is applicable only to firms that actually pay dividends; many do not; (2) even if a firm does pay
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10. If the different operating divisions were in much different risk classes, then separate cost of capital figures should be used for the different divisions; the use of a single, overall cost of capital would be inappropriate. If the single hurdle rate were used, riskier divisions would tend to receive funds for investment projects, since their return would exceed the hurdle rate despite the fact that they may actually plot below the SML and, hence, be unprofitable projects on a risk-adjusted basis. The typical problem encountered in estimating the cost of capital for a division is that it rarely has its own securities traded on the market, so it is difficult to observe the market’s valuation of the risk of the division. Two typical ways around this are to use a pure play proxy for the division, or to use subjective adjustments of the overall firm hurdle rate based on the perceived risk of the division.
Solutions to Questions and Problems
NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem.
Basic
1. With the information given, we can find the cost of equity using the dividend growth model. Using this model, the cost of
I do not think it is proper. Since hurdle rate is the key factor to determine whether we should accept a project, it is concerned with a specific investment opportunity belonging to a division. As we can see in Table 1, each of Midland`s divisions had its own target debt ratio. Those
We use Capital Asset Pricing Model (CAPM) approach to calculate the cost of equity. The formula of CAPM is re = rf + β × (E[RMkt] – rf).
INCLUDES SOLUTIONS INCLUDES MARKERS’ REPORTS This is a three (3) hour paper. You have ten (10) minutes reading time. There are seven (7) questions. There are eight (8) pages, including this one. You must answer all parts of all questions. The questions are not of equal value. All answers must be written in blue or black ink. Show all relevant working.
Therefore, the cost of common stock is obtained by using the dividends divided by the market price.
-Martin Industries just paid an annual dividend of $1.30 a share. The market price of the stock is $36.80 and the growth rate is 6.0 percent. What is the firm's cost of equity?
a. What risk-free rate and risk premium did you use in calculating the cost of equity for each division? Why did you choose these numbers?
Second City Options (SCO) is a small firm that specializes in option trading. Employing 35 people, SCO is located on LaSalle Street in the Chicago financial district. It is a member firm of the Chicago Board Options Exchange (CBOE), where it trades options on stocks and stock indices. It is also a member firm of the Chicago Mercantile Exchange Group (CME Group), where it trades options on futures and the underlying futures contracts.
Cost of Equity is the return that stockholders require for a company. A company’s cost of equity represents the compensation that the market demands in exchange for owning the assets and bearing the risk of ownership. Based on capital markets the cost of equity varies in direct relation to the assumed risk in that specific market. The distinctive of the firm is the sensitivity to market risk (β) which depends on everything from management to its business and capital structure. Therefore past performances and present conditions have a direct effect on the overall value. Applying calculations at a divisional level allows specified markets to be analysis based on present market conditions for that service or product. The formula used to calculate Cost of Equity is:
4) The Problem Set #1 (only the question solutions portion) is due at the end of the day on September 24th.
For this variable we take again the same risk free rate (4.66%) plus the equity market risk premium (5%) multiplied by the equity Beta of the E & P division (1.40). The beta we calculate with the comparables. The average equity beta in this industry is 1.15 and the average D/E ratio is 39.8%. With these information and the same formula as in question 3 we compute the asset beta
No. We discount project cash flows with a cost of capital that is the rate of
The standard method of calculating a stock price using the perpetual dividend growth model is done by assessing a company’s dividend one year into the future adding the future expected growth rate. The formula is written as: P0 = D1/(Ke − g), where Ke is the investor required return, D1 is next year’s dividend and g is the
To estimate the cost of equity, we need to compute the beta of equity for each division using comparable companies. As the betas of debt were not provided, we made 2 assumptions: a. same business lines have the same beta of debt; b. Expected return of debt = Rf + βb*[E(Rm) – Rf*(1-T)] (Rf: risk free rate, E(Rm): expected
The next step is determined the Risk-free Rates, Risk Premiums and Betas for lodging and restaurant divisions in order to calculate the Cost of Equity for both divisions. After finding out the cost of debt and the debt for lodging and restaurant divisions, the cost of equity will follow.
1. An international bank loaned money to an emerging country a few years ago. Because of the nonpayment of interest due on this loan, the bank is now negotiating with the borrower to exchange the loan for Brady bonds. The Brady bonds that would be issued would be either par bonds or discount bonds with the same time to maturity.