Finance and Capital Structure Quiz

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Questions and Answers

What is the beta of AMAZON Inc.?

1.50

1.75

1.25 (correct)

1.10

What is the current yield on a U.S. 10-year treasury?

2.5% (correct)

2.0%

3.0%

3.5%

Using the CAPM, what is the expected return on AMAZON Inc.?

9.25%

10.25%

9.75% (correct)

8.75%

What is the cost of equity of AMAZON Inc. using the CAPM?

9.75% Signup and view all the answers

IML Co is financed by:

All equity Signup and view all the answers

What is the average excess historical annual return for U.S. stocks?

7.5% Signup and view all the answers

What is the WACC of IML Co?

The cost of equity Signup and view all the answers

What is the cost of debt calculated using?

The interest rate on debt Signup and view all the answers

What is the cost of capital that a company must pay to satisfy its providers of funds?

The rate of return that the enterprise must pay to satisfy the providers of funds Signup and view all the answers

What is the estimated equity beta of Backwoods?

1.18 Signup and view all the answers

What is the after-tax cost of debt of the medium- and long-term bank loans?

7% Signup and view all the answers

What is the capital structure of the main German competitor by book values?

35% equity and 65% debt Signup and view all the answers

What is the formula used to estimate the cost of equity using the dividend growth model?

Ke = D1 / P0 + g Signup and view all the answers

What is the purpose of calculating the Weighted Average Cost of Capital (WACC)?

To determine the discount rate for investment decisions Signup and view all the answers

What is the systematic risk of debt assumed to be in the case of Backwoods?

0 Signup and view all the answers

What is the formula used to calculate the cost of equity using the Capital Asset Pricing Model (CAPM)?

Ke = Rf + β × (Rm - Rf) Signup and view all the answers

What is the formula for calculating the cost of equity using the Capital Asset Pricing Model?

E(r) = Rf + β x (Rm-Rf) Signup and view all the answers

What is the beta of a company that has a required rate of return on equity of 17% and the market return is 15%?

1.2 Signup and view all the answers

What is the cost of preference shares in a company?

The required rate of return by the company's preference investors Signup and view all the answers

What is the Weighted Average Cost of Capital (WACC) used for?

To calculate the cost of capital for a company Signup and view all the answers

What is the Country Risk Premium (CRP) used for?

To adjust for country-specific risks in the Capital Asset Pricing Model Signup and view all the answers

What is the formula for calculating the Weighted Average Cost of Capital (WACC)?

WACC = (E/V x Ke) + (D/V x Kd x (1 - T)) Signup and view all the answers

What is the cost of debt (Kd) in a company?

The required rate of return by the company's debt investors Signup and view all the answers

What is the main limitation of the Capital Asset Pricing Model (CAPM)?

It assumes that markets are perfectly efficient Signup and view all the answers

Study Notes

Cost of Capital

The cost of capital is the rate of return that an enterprise must pay to satisfy the providers of funds.
It is used to evaluate investment decisions and determine the required rate of return on equity.

Cost of Equity (Ke)

Can be estimated using the dividend growth model, assuming market value is based on expected future dividend.
Can be calculated using the Capital Asset Pricing Model (CAPM), which incorporates systematic risk measured by beta.
The CAPM formula is: E(r) = Rf + β x (Rm - Rf)

Cost of Debt (Kd)

After-tax cost of debt is 9% for the current market price of $120 bonds.
Other medium- and long-term bank loans have an after-tax cost of debt of 7%.

Weighted Average Cost of Capital (WACC)

The company's WACC is required to be estimated for its proposed investment in eastern Germany.

Case Study Analysis

Backwoods' equity beta is 1.18, and the company's ordinary shares are currently trading at 376c.
The risk-free rate is 7.75%, and the market return is 14.5%.
The estimated equity beta of the main German competitor in the same industry is 1.5, with a capital gearing of 35% equity and 65% debt by book values, and 60% equity and 40% debt by market values.

Capital Asset Pricing Model (CAPM)

The CAPM is used to estimate the required rate of return on equity, incorporating systematic risk measured by beta.
The CAPM formula is: E(r) = Rf + β x (Rm - Rf)
Examples of calculating the required rate of return on equity using the CAPM:
- AZT Co: equity beta = 0.7, risk-free rate = 4.5%, market return = 15%
- BOR Co: equity beta = 1.0, risk-free rate = 4.5%, market return = 15%
- IML Co: required annual rate of return on equity = 17%, equity beta = ?, risk-free rate = ?, market return = ?

Country Risk Premium

Country Risk Premium (CRP) is an additional factor to consider when estimating the cost of equity in a specific country.
Source: Damodaran Online, New York University.

Industry Beta

Industry betas are used to estimate the cost of equity for companies in a specific industry.
Examples of industry betas:
- Services: 0.90
- Household Products: 1.01
- Cable TV: 1.03
- Restaurant/Dining: 1.04
- Software (System & Application): 1.08
- Healthcare Support Services: 1.28
- Oil/Gas Distribution: 1.33
- Software (Internet): 1.34
- Advertising: 1.49
- Retail (Building Supply): 1.76
- Homebuilding: 1.78
- Precious Metals: 1.89

Practice Questions

What is the cost of equity of AMAZON using the CAPM, given the following information:
- Current yield on a U.S. 10-year treasury is 2.5%
- The average excess historical annual return for U.S. stocks is 7.5%
- The beta of the stock is 1.25

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Description

This quiz tests your understanding of finance concepts such as cost of debt, equity beta, and capital structure. Calculate the weighted average cost of capital for a company given its after-tax cost of debt and equity beta.