Concepts Review and Critical Thinking Questions

1. WACC On the most basic level, if a firm's WACC is 12 percent, what does this mean?

2. Book Values versus Market Values In calculating the WACC, if you had to use book values for either debt or equity, which would you choose? Why?

3. Project Risk If you can borrow all the money you need for a project at 6 percent, doesn't it follow that 6 percent is your cost of capital for the project?

4. WACC and Taxes Why do we use an aftertax figure for cost of debt but not for cost of equity?

5. DCF Cost of Equity Estimation What are the advantages of using the DCF model for determining the cost of equity capital? What are the disadvantages? What specific piece of information do you need to find the cost of equity using this model? What are some of the ways in which you could get this estimate?

6. SML Cost of Equity Estimation What are the advantages of using the SML approach to finding the cost of equity capital? What are the disadvantages? What are the specific pieces of information needed to use this method? Are all of these variables observable, or do they need to be estimated? What are some of the ways in which you could get these estimates?

7. Cost of Debt Estimation How do you determine the appropriate cost of debt for a company? Does it make a difference if the company's debt is privately placed as opposed to being publicly traded? How would you estimate the cost of debt for a firm whose only debt issues are privately held by institutional investors?

8. Cost of Capital Suppose Tom O'Bedlam, president of Bedlam Products, Inc., has hired you to determine the firm's cost of debt and cost of equity capital.

a. The stock currently sells for $50 per share, and the dividend per share will probably be about $5. Tom argues, "It will cost us $5 per share to use the stockholders' money this year, so the cost of equity is equal to 10 percent ($5/50)." What's wrong with this conclusion?

b. Based on the most recent financial statements, Bedlam Products' total liabilities are $8 million. Total interest expense for the coming year will be about $1 million. Tom therefore reasons, "We owe $8 million, and we will pay $1 million interest. Therefore, our cost of debt is obviously $1 million/8 million = 12.5%." What's wrong with this conclusion?

c. Based on his own analysis, Tom is recommending that the company increase its use of equity financing, because "debt costs 12.5 percent, but equity only costs 10 percent; thus equity is cheaper." Ignoring all the other issues, what do you think about the conclusion that the cost of equity is less than the cost of debt?

9. Company Risk versus Project Risk Both Dow Chemical Company, a large natural gas user, and Superior Oil, a major natural gas producer, are thinking of investing in natural gas wells near Houston. Both are all-equity-financed companies. Dow and Superior are looking at identical projects. They've analyzed their respective investments, which would involve a negative cash flow now and positive expected cash flows in the future. These cash flows would be the same for both firms. No debt would be used to finance the projects. Both companies estimate that their project would have a net present value of $1 million at an 18 percent discount rate and a -$1.1 million NPV at a 22 percent discount rate.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VI. Cost of Capital and Long-Term Financial Policy

15. Cost of Capital

© The McGraw-Hill Companies, 2002

CHAPTER 15 Cost of Capital

Dow has a beta of 1.25, whereas Superior has a beta of .75. The expected risk premium on the market is 8 percent, and risk-free bonds are yielding 12 percent. Should either company proceed? Should both? Explain.

10. Divisional Cost of Capital Under what circumstances would it be appropriate for a firm to use different costs of capital for its different operating divisions? If the overall firm WACC were used as the hurdle rate for all divisions, would the riskier divisions or the more conservative divisions tend to get most of the investment projects? Why? If you were to try to estimate the appropriate cost of capital for different divisions, what problems might you encounter? What are two techniques you could use to develop a rough estimate for each division's cost of capital?

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