Corporate Finance Chapter 13: The Cost of Capital
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Questions and Answers

What should be used to calculate the weights in McDonald's WACC?

  • Book value of equity
  • Historical cost of debt
  • Market values of debt and equity (correct)
  • Average past capital structure

What is the total market value of McDonald's firm when calculating WACC?

  • $52 billion
  • $70 billion (correct)
  • $36 billion
  • $18 billion

What weight corresponds to McDonald's cost of debt in its WACC calculation?

  • 40%
  • 50%
  • 30.1%
  • 25.7% (correct)

Why should the book value of equity be ignored in calculating WACC?

<p>Market values better reflect current investor assessments (D)</p> Signup and view all the answers

What is the formula for effective cost of debt?

<p>rD (1 - TC) (A)</p> Signup and view all the answers

What does the Yield to Maturity on a firm's debt represent?

<p>Yield bondholders would earn if held to maturity (A)</p> Signup and view all the answers

What percentage of McDonald's capital structure is financed through equity?

<p>74.3% (D)</p> Signup and view all the answers

Which part of the cost of capital does WACC combine?

<p>Cost of debt and cost of equity (D)</p> Signup and view all the answers

What is the formula for calculating WACC when a company has no preferred stock?

<p>rwacc = rE % + rD (1 - TC ) D% (D)</p> Signup and view all the answers

In the example provided, what percentage of AT&T's total value was attributed to common stock?

<p>52.4% (A)</p> Signup and view all the answers

What is the cost of equity estimated using the CAPM method in this example?

<p>6.6% (D)</p> Signup and view all the answers

Given Target's equity accounts for 82% of its total market value, what is the proportion of debt?

<p>18% (A)</p> Signup and view all the answers

Which of the following components is NOT considered when calculating WACC?

<p>Cost of retained earnings (C)</p> Signup and view all the answers

Which of the following is the growth rate used in the CDGM approach?

<p>3.5% (A)</p> Signup and view all the answers

If a company's tax rate is 25%, how is the cost of debt adjusted in the WACC formula?

<p>It is multiplied by (1 - TC) (A)</p> Signup and view all the answers

What assumption must be examined when the CAPM and CDGM produce different results?

<p>Assumptions made for each approach (B)</p> Signup and view all the answers

What was AT&T's calculated WACC according to the example provided?

<p>5.3% (A)</p> Signup and view all the answers

How can the two approaches yield the same cost of equity estimate?

<p>By adopting a dividend growth rate of 4.0% (C)</p> Signup and view all the answers

What is the calculated cost of equity using the CDGM method in this example?

<p>6.1% (D)</p> Signup and view all the answers

Which financial metric is used to estimate the cost of common stock in the WACC formula?

<p>CAPM (A)</p> Signup and view all the answers

What does the term 'equity beta' represent in the context of CAPM?

<p>The measure of the stock's volatility compared to the market (B)</p> Signup and view all the answers

What is the yield to maturity on Target’s debt as indicated in the example?

<p>6% (D)</p> Signup and view all the answers

Which variable is NOT needed for the calculation of the cost of equity using the CAPM?

<p>Expected dividend growth rate (C)</p> Signup and view all the answers

What is the risk-free rate used in calculating the cost of equity?

<p>3.0% (A)</p> Signup and view all the answers

What is the weighted average cost of capital (WACC) for Target as calculated?

<p>10.2% (D)</p> Signup and view all the answers

What does the term TC in the WACC formula represent?

<p>Corporate Tax Rate (B)</p> Signup and view all the answers

Which components are factored into the calculation of WACC?

<p>Cost of equity, cost of debt, and capital structure (D)</p> Signup and view all the answers

How is Net Debt calculated in the context of WACC?

<p>Debt - Cash and Risk-Free Securities (A)</p> Signup and view all the answers

Which metric is commonly used to assess the risk-free interest rate in WACC calculations?

<p>Long-term Treasury Bond Yields (C)</p> Signup and view all the answers

What average excess return has the S&P 500 historically produced since 1926 over the rate for one-year Treasury securities?

<p>7.7% (C)</p> Signup and view all the answers

How does Target need to adjust for the tax advantage of debt in its investment returns?

<p>Reduce expected returns by the corporate tax rate (B)</p> Signup and view all the answers

What does WACC stand for in the context of corporate finance?

<p>Weighted Average Cost of Capital (B)</p> Signup and view all the answers

Which of the following is NOT a method mentioned for calculating WACC?

<p>Assessing company growth rates (A)</p> Signup and view all the answers

In a market-value balance sheet, how is the market value of assets calculated?

<p>Market Value of Equity + Market Value of Debt (C)</p> Signup and view all the answers

When comparing unlevered and levered firms, how does the WACC generally change?

<p>WACC can be lower for levered firms due to debt financing. (B)</p> Signup and view all the answers

Which of the following best defines capital structure?

<p>The proportion of debt and equity in a firm. (B)</p> Signup and view all the answers

What is the role of opportunity cost in determining the overall cost of capital?

<p>It reflects the return foregone on investments in favor of financing options. (C)</p> Signup and view all the answers

What does an unlevered firm typically imply about its capital structure?

<p>It has no debt in its capital structure. (A)</p> Signup and view all the answers

How is the equity cost of capital represented in the formula for unlevered firms under WACC?

<p>rWACC = Equity Cost of Capital (C)</p> Signup and view all the answers

What is a primary advantage of using debt in a firm's capital structure?

<p>May lower the WACC due to tax benefits. (C)</p> Signup and view all the answers

What WACC should AT&T use when valuing Netflix for an acquisition?

<p>Netflix’s WACC (C)</p> Signup and view all the answers

When AT&T creates a new streaming division, which proportion should they use for financing?

<p>Proportion used by Netflix (B)</p> Signup and view all the answers

What is Microsoft’s WACC mentioned in the example for evaluating energy drinks?

<p>8.1% (C)</p> Signup and view all the answers

What risk-free rate is given in the scenario for estimating the cost of capital for Microsoft’s energy drink business?

<p>3% (D)</p> Signup and view all the answers

Which company is identified as a benchmark for evaluating the cost of capital for the energy drink business?

<p>Monster Beverage Corporation (A)</p> Signup and view all the answers

What is the effect of different systematic risks on the cost of capital for a new line of business?

<p>It will likely differ from the parent company's WACC. (B)</p> Signup and view all the answers

Why is AT&T’s WACC inappropriate for valuing Netflix?

<p>The risks associated with the two companies are different. (D)</p> Signup and view all the answers

What market risk premium is provided for estimating the cost of capital for Microsoft's energy drink business?

<p>6% (C)</p> Signup and view all the answers

Flashcards

WACC Weights

Fractions of a company's assets financed by debt and equity, based on market values.

Market Value Weights

Weights used in WACC calculations, reflecting current investor valuations.

Debt Market Value

The current market value of a company's outstanding debt.

Equity Market Value

The current market value of a company's outstanding common stock.

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Total Value of Firm

The sum of the market values of a company's debt and equity.

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Cost of Debt Capital

The yield investors demand to hold the company's debt.

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Yield to Maturity (YTM)

Rate of return on a bond if held until maturity, receiving all promised payments.

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Effective Cost of Debt

The after-tax cost of debt for a company.

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Cost of Equity (CAPM)

Calculated using the Capital Asset Pricing Model. It's the rate of return a company needs to earn on its investments to maintain its market value.

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Cost of Equity (CDGM)

Calculated using the Constant Dividend Growth Model. It estimates the required return based on dividend growth.

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Risk-free rate

The theoretical rate of return of an investment with no risk.

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Equity beta

Measures the volatility of a stock's returns relative to the overall market.

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Market risk premium

The additional return investors expect from investing in the market over a risk-free investment.

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Constant Dividend Growth Model (CDGM)

A valuation model that assumes dividends grow at a constant rate.

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Dividend (in one year)

The expected dividend payment for the upcoming year.

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Dividend Growth Rate

The expected growth rate of dividends.

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Capital Structure

The mix of debt and equity financing used by a company.

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Weighted Average Cost of Capital (WACC)

The average cost of financing a company's assets from all sources, weighted by the proportion of each source.

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Market Value Balance Sheet

A balance sheet based on the market values of assets, equity, and debt, rather than historical costs.

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Leverage

The use of debt financing to increase the return on equity.

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Unlevered Firm

A company that finances its assets only through equity.

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Levered Firm

A company that finances its assets through both equity and debt.

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Equity Cost of Capital

The return required by equity investors; it represents the opportunity cost of using equity financing.

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Market Value of Equity + Market Value of Debt = Market Value of Assets

Fundamental equation showing the relationship between the market values of debt, equity, and assets.

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WACC Equation (no preferred)

The weighted average cost of capital (WACC), when there's no preferred stock, is calculated by multiplying the cost of equity (rE) by the equity percentage (E%), adding the product of the cost of debt (rD) multiplied by (1 - tax rate (TC)) and the debt percentage (D%).

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WACC Equation (general)

The weighted average cost of capital (WACC) considers all capital sources (common stock, preferred stock, and debt) and weights each by its proportion of the firm's total financing.

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WACC Calculation Example

Using AT&T's 2022 data, the WACC was calculated by applying the specific amounts and costs of funding sources into the WACC formula.

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WACC Component: Cost of Equity

Represents the return required by common equity investors. Often estimated using the Capital Asset Pricing Model (CAPM).

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WACC Component: Cost of Debt

Represents the return paid to the firm's debt holders.

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WACC Component: Tax Rate

The corporate tax rate used in the calculation; it reduces the cost of debt as interest is tax deductible.

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WACC Application

Used to evaluate the feasibility and profitability of projects. A project's return should exceed the WACC for the firm to accept it.

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Importance of Market Values (WACC)

The proportion of each financing source (equity, preferred, and debt) in the overall company value.

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WACC for Acquisitions

When acquiring a company, the acquiring firm should use the target company's WACC to evaluate the acquisition, not its own.

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WACC for New Divisions

When creating a new division within a company, use the WACC of a comparable company in the same industry to determine the cost of capital for the new division.

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Project-Based Cost of Capital

The cost of capital for a specific project should be calculated based on the risk of that particular project, not the overall company's WACC.

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Finding Comparable WACC

To determine the cost of capital for a new project or division, identify a company in the same industry that is similar in terms of risk and use its WACC as an estimate.

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Cost of Capital for New Business Lines

When expanding into a new line of business, it's crucial to calculate the cost of capital specifically for that new business, as it might differ from the company's overall WACC.

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WACC for Streaming Division

If AT&T creates a streaming division, it should use Netflix's WACC as its cost of capital, assuming similar debt financing.

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WACC for Energy Drinks

If Microsoft wants to enter the energy drink market, it should find a comparable company like Monster Beverage and use its WACC as a proxy for its new energy drink business.

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Using Comparable Companies

When calculating the cost of capital for a new project or division, use the WACC of a publicly traded company with similar risk and financial structure as a proxy.

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WACC Formula

The weighted average cost of capital (WACC) represents the average return a company must earn on its investments to satisfy both its debt and equity holders. It's calculated by weighting the cost of equity and the after-tax cost of debt by their respective proportions in the capital structure.

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WACC Components

The WACC comprises two key components: the cost of equity (rE) and the after-tax cost of debt (rD*(1-TC)). The cost of equity is the return required by equity holders, while the after-tax cost of debt accounts for the tax shield benefits of debt financing.

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Net Debt

Net debt is the company's total debt minus its cash and risk-free securities. It represents the actual debt burden the company carries after accounting for readily available funds.

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Risk-Free Interest Rate

The risk-free interest rate represents the return on a theoretical investment with no associated risk. Usually, it's approximated by the yield on long-term treasury bonds.

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WACC Calculation

The WACC formula calculates the weighted average cost of capital, reflecting the company's financial structure. It's computed by multiplying the cost of each capital source by its respective weight and summing the results.

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Study Notes

Corporate Finance Chapter 13: The Cost of Capital

  • This chapter covers the cost of capital for corporations.
  • The firm's capital structure encompasses capital and capital structure.
  • A basic balance sheet displays assets (current and long-term) and liabilities & equity (debt, preferred stock, and equity).
  • Capital structures of Tesla, Amazon, and Verizon exhibit different debt to equity ratios.
  • Weighted Average Cost of Capital (WACC) calculations are a core concept.
  • The WACC is calculated using market values of assets, equity, and debt.
  • Weighted Average Cost of Capital (WACC) calculations include considering leverage (levered and unlevered).
  • The formula for WACC for a levered firm is Fraction of Firm Value Financed by Equity x Cost of Equity + Fraction of Firm Value Financed by Debt x Cost of Debt.
  • The cost of debt is determined by the yield to maturity and must account for taxes. Effective Cost of Debt = rD(1 - Tc), where Tc is the tax rate.
  • The cost of preferred stock capital equals its preferred dividend divided by its preferred stock price.
  • The cost of common stock depends on the Capital Asset Pricing Model (CAPM) and the Constant Dividend Growth Model (CDGM).
  • The CAPM formula is Risk-free Rate + Equity Beta x Market Risk Premium.
  • The CDGM formula is Dividend (in one year)/ Current Price + Dividend Growth Rate.)
  • Estimating the cost of equity involves several inputs and assumptions, including risk-free rate, equity beta, market risk premium, current stock price and expected dividend.
  • The WACC is used for valuing projects using future incremental free cash flows.
  • WACC equation for a company without preferred stock (rwacc = reE% + rd(1 − Tc)D%
  • The cost of capital varies depending on the line of business, and it is crucial to use the correct cost of capital for a specific project.
  • In acquisitions, the cost of capital for the acquired company should be used for the valuation, not the acquirer's cost of capital.
  • Issuing new equity or bonds has related costs (cash outflows), which must be accounted for in NPV analysis.

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Description

Explore the crucial concepts of cost of capital as outlined in Chapter 13 of Corporate Finance. This chapter examines the components of a firm's capital structure, including weighted average cost of capital (WACC) and how it varies among major corporations like Tesla and Amazon. Understand the implications of leverage and the formula used to calculate WACC for better financial decision-making.

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