CHAPTER 12 RISK, COST OF CAPITAL, AND CAPITAL BUDGETING
Answers to Concepts Review and Critical Thinking Questions 1. 2. 3.
No. The cost of capital depends on the risk of the project, not the source of the money. Interest expense is tax-deductible. There is no difference between pretax and aftertax equity costs. You are assuming that the new project’s risk is the same as the risk ofthe firm as a whole, and that the firm is financed entirely with equity. Two primary advantages of the SML approach are that the model explicitly incorporates the relevant risk of the stock and the method is more widely applicable than is the DCF model, since the SML doesn’t make any assumptions about the firm’s dividends. The primary disadvantages of the SML method are (1) three parameters (therisk-free rate, the expected return on the market, and beta) must be estimated, and (2) the method essentially uses historical information to estimate these parameters. The risk-free rate is usually estimated to be the yield on very short maturity T-bills and is, hence, observable; the market risk premium is usually estimated from historical risk premiums and, hence, is not observable. The stockbeta, which is unobservable, is usually estimated either by determining some average historical beta from the firm and the market’s return data, or by using beta estimates provided by analysts and investment firms. The appropriate aftertax cost of debt to the company is the interest rate it would have to pay if it were to issue new debt today. Hence, if the YTM on outstanding bonds of the company isobserved, the company has an accurate estimate of its cost of debt. If the debt is privately-placed, the firm could still estimate its cost of debt by (1) looking at the cost of debt for similar firms in similar risk classes, (2) looking at the average debt cost for firms with the same credit rating (assuming the firm’s private debt is rated), or (3) consulting analysts and investment bankers. Evenif the debt is publicly traded, an additional complication arises when the firm has more than one issue outstanding; these issues rarely have the same yield because no two issues are ever completely homogeneous. a. b. c. This only considers the dividend yield component of the required return on equity. This is the current yield only, not the promised yield to maturity. In addition, it is based onthe book value of the liability, and it ignores taxes. Equity is inherently riskier than debt (except, perhaps, in the unusual case where a firm’s assets have a negative beta). For this reason, the cost of equity exceeds the cost of debt. If taxes are considered in this case, it can be seen that at reasonable tax rates, the cost of equity does exceed the cost of debt.
7.RSup = .12 + .75(.08) = .1800 or 18.00% Both should proceed. The appropriate discount rate does not depend on which company is investing; it depends on the risk of the project. Since Superior is in the business, it is closer to a pure play.
CHAPTER 12 B-287 Therefore, its cost of capital should be used. With an 18% cost of capital, the project has an NPV of $1 million regardless of who takesit.
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 more funds for investment projects, since their return would exceed the hurdle ratedespite 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...
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