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(2013-S2) - FINS1613 - Week 10 Tutorial Solutions (from Chapter 12).pdf

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CHAPTER 12 COST OF CAPITALAnswers to Critical Thinking and Concepts Review Questions1 It is the minimum rate of return the firm must earn overall on its existing assets If it earns more than this value is created2 Book values for debt are likely to be much closer to their market values than are book values for equity3 No The cost of capital depends on the risk of the project not the source of the money4 In a classical tax system interest expense is taxdeductible and there is no difference between pretax and aftertax equity costs In an imputation system tax is tax deductible reducing its cost however for the shareholder the dividend does generate a franking credit if the company has paid tax in Australia or New Zealand and the shareholder is a resident This has the effect of reducing the cost of equity for the firm for these shareholders5 The primary advantage of the DCF model is its simplicity The method is disadvantaged in that 1 the model is applicable only to firms that actually pay dividends many do not 2 even if a firm does pay dividends the DCF model requires a constant dividend growth rate forever 3 the estimated cost of equity from this method is very sensitive to changes in growthg which is a very uncertain parameter and 4 the model does not explicitly consider risk although risk is implicitly considered to the extent that the market has impounded the relevant risk of the share into its market price While the share price and most recent dividend can be observed in the market the dividend growth rate must be estimated Two common methods of estimating g are to use analysts earnings and payout forecasts or determine some appropriate average historical g from the firms available data6 Two primary advantages of the SML approach are that the model explicitly incorporates the relevant risk of the share and the method is more widely applicable than is the DCF model since the SML doesnt make any assumptions about the firms dividends The primary disadvantages of the SML method are 1 estimating three parameters the riskfree rate the expected return on the market and beta and 2 the method essentially uses historical information to estimate these parameters The riskfree rate is usually estimated to be the yield on very short maturity risk free debt and is hence observable the market risk premium is usually estimated from historical risk premiums and hence is not observable The share beta which is unobservable is usually estimated either by determining some average historical beta from the firm and the markets return data or using beta estimates provided by analysts and investment firms In a dividend imputation system the additional value of the tax credits on dividends needs be accounted for and this will depend on the level of franking credits generated and the ability of the shareholders to use them7 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 is observed 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 firms private debt is rated or 3 consulting analysts and investment bankers Even if the debt is publicly traded an additional complication is when the firm has more than
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