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</p> Signup and view all the answers

    What is the formula for effective cost of debt?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

    What does the term TC in the WACC formula represent?

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

    How is Net Debt calculated in the context of WACC?

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

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

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

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

    <p>Assessing company growth rates</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</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.</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.</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.</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.</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</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.</p> Signup and view all the answers

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

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

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

    <p>8.1%</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%</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</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.</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.</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%</p> Signup and view all the answers

    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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