Questions and Answers
What impact does an increase in the risk-free rate have on the cost of debt?
An increase in the risk-free rate will increase the cost of debt.
What impact does an increase in the risk-free rate have on the cost of equity?
An increase in the risk-free rate will increase the cost of equity.
How should capital structure weights used to calculate the WACC be determined?
They should be based on market values.
Should the WACC be used to evaluate all potential projects?
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The cost of retained earnings is lower than the cost of __________.
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How do project classifications aid the capital budgeting process?
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What are three flaws of the regular payback method?
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Why is the NPV of a long-term project more sensitive to changes in the WACC?
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What is a mutually exclusive project?
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In comparing mutually exclusive projects, how should managers rank them?
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What does a high cost of capital favor regarding project duration?
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How do NPV and IRR methods relate when projects are independent?
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Why might a small firm prefer the payback method over the NPV method?
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Which project should be chosen if Project X has an NPV of $3 million and Project Y has an NPV of $2.5 million?
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What reinvestment rate assumption is made by the NPV method?
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Should the short-run effects on EPS influence the choice between two projects with the same capital budget?
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Study Notes
Cost of Debt and Equity
- An increase in the risk-free rate raises the cost of debt due to the formula r = rRF + DRP + LP + MRP.
- The cost of equity also increases with a higher risk-free rate as shown in the CAPM equation: rs = rRF + (rM - rRF)b.
Capital Structure and WACC
- An optimal capital structure maximizes a firm's stock price, mixing debt, preferred stock, and common equity.
- WACC (weighted average cost of capital) can be calculated using target proportions based on market value, though book values can be a proxy if close.
Adjusting WACC for Project Risk
- WACC should not be used uniformly across projects with varying risks; it's crucial for adjusting costs based on project risk.
- For average-risk projects, use the firm's WACC; for higher-risk projects, a cost of 12% may be applicable, while lower-risk projects might see a cost of 9%.
Impact of Equity Source on WACC
- The cost of retained earnings is lower than that of issuing new stock, so raising new equity increases WACC.
- WACC is influenced by capital budget size; budgets below the retained earnings breakpoint utilize lower-cost retained earnings.
Project Classification in Capital Budgeting
- Project classification aids in determining necessary analysis, approval levels, and appropriate costs of capital for calculating NPV.
Flaws of Payback Method
- The regular payback method treats all cash flows equally, neglects cash flows post-payback, and does not indicate project profitability.
- The discounted payback method corrects the first flaw but does not address the other two.
NPV Sensitivity to WACC
- NPV of long-term projects is more sensitive to WACC changes since future cash flows are discounted more heavily over time.
Mutually Exclusive Projects
- Mutually exclusive projects allow acceptance of only one option. Ranking should be based on the NPV decision rule to select the project with the highest positive NPV.
Cost of Capital and Project Duration
- High costs of capital favor shorter-term projects; declining costs lead to increased investment in longer-term projects.
- IRR rankings of mutually exclusive projects remain unchanged regardless of WACC fluctuations.
NPV and IRR Method Comparison
- NPV and IRR yield identical decisions for independent projects under constant WACC and normal cash flows, but may differ for mutually exclusive projects.
- Changes in project conditions could affect the reliability of IRR versus NPV.
Payback Method for Small Firms
- Smaller firms may prefer the payback method for liquidity insights, as shorter paybacks indicate better cash flow management.
Project Selection Based on NPV
- Between mutually exclusive projects X (NPV $3 million) and Y (NPV $2.5 million), Project X is favored despite its higher risk, if risks are properly calibrated in NPV analyses.
Reinvestment Rate Assumptions
- NPV assumes reinvestment at the cost of capital; IRR assumes reinvestment at IRR; MIRR adopts reinvestment at the cost of capital for both positive and negative cash flows.
Short-Run EPS versus Long-Term Value
- Short-run EPS should not overly influence project selection; maximizing long-term value is crucial, as calculated NPVs reflect potential growth.
- Firms may resort to payback methods to manage perceptions of immediate profitability over long-term gains.
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Description
This quiz covers the impact of changes in the risk-free rate on the cost of debt and cost of equity. Understanding how these rates affect financial calculations is crucial for assessing investment risks. Test your knowledge of Chapter 6's concepts related to financial rates.
