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# 33:390:400 Study Guide - Summer 2018, Comprehensive Midterm Notes - Advertisement Film, Net Present Value, Retained Earnings

Department
Finance
Course Code
33:390:400
Professor
J I N M O Kim
Study Guide
Midterm

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33:390:400
MIDTERM EXAM
STUDY GUIDE
Fall 2018

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Chapter 13: Cost of Capital
13.1 The Cost of Capital
Capital Structure: The mixture of debt and equity for a firm
When a company has extra cash, it can either give it to shareholders through dividends or it can
invest it in a new project
Cost of Capital = Required Return = Discount Rate
WACC: Weighted Average Cost of Capital
- WACC becomes the required return
- The discount rate of the project should be the expected return on a financial
asset of comparable risk
- WACC can only be used when the project’s risk is EQUAL to the risk of the company!
13.2 Estimating the Cost of Equity Capital with the CAPM
E(R) of Equity = (Risk Free rate) + [ Beta * (E(R) of Market Risk Free Rate) ]
- (E(R) of Market Risk Free Rate) also known as Market Risk Premium
- Beta is the systematic risk of the company
- Risk Free Rate is the riskless rate, Treasury Bill rate, bonds, etc.
- Government securities have never defaulted, have lowest possible risk
Security Market Line (SML) Graph: Positive linear relationship
- Y-axis: Expected Return
- X-axis: Beta
- Riskier the project, the higher expected return
- If project return is under the line you reject, if above you accept
Estimating the Cost of Equity Capital with the Dividend Growth Model
Current Price of a Stock (P0) = (Dvd1) / (R g) R = [ (Dvd1) / (P0) ] + g
- Dvd1 = Dvd0 x (1 + g)
- Dividend Yield = (Dvd1) / (P0)
- Capital Gains Yield = g
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13.3 Estimation of Beta
Normally we assume Beta is given, but if we have to estimate it ourselves we will use:
Beta of Security i = (Covariance of a security with the market) / (Variance of the market)
Beta of Security i = [ Cov (Ri, RM) ] / [ Var(RM) ]
Average beta across all stocks in an index = Average market beta = 1
A firm’s beta will change if it enters a new industry
A firm’s beta will incur small changes due to random variation if it stays in the same industry
Some think it is better to estimate the industry’s beta instead of a specific firm’s beta
- Greater chance of error in estimating beta of a single stock, than estimating for an entire
industry
- A company can still use either their beta or the industry beta, their preference
13.4 Determinants of Beta
- Cyclical nature of revenues, operating leverage, and financial leverage are the 3 determinants
Cyclicality of Revenues:
- Higher revenues during expansion phase of business cycle
- Lower revenues during contraction phase of business cycle
- Highly cyclical stocks high betas
- Cyclicality ≠ Variability
Operating Leverage: Deals with a firm’s fixed costs of production
- Fixed costs do not change with changes in quantity
- Variable costs do change with changes in quantity
- Firms might buy a factory but have low sales High FC, low VC
- Firms can outsource their production to others Low FC, high VC
- Firms w/ high fixed costs & low variable costs are said to have high operating leverage
- Firms w/ low fixed costs & high variable costs are said to have low operating leverage
- Operating leverage magnifies the effect of cyclicality of revenue
Financial Leverage and Beta: Deals with a firm’s fixed costs of finance
- Unlevered firm = all equity // Levered firm = Has debt
- Financial leverage: The extent to which a firm relies on debt
- It is obligated to pay interest on debt regardless of sales (fixed cost)
E + D = V
BetaPortfolio = BetaAsset = [ (BetaE) x (E/V) ] + [ (BetaD) x (D/V) ]
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