Fđ Eia

Chapter 13

The Cost of Capital

Before You Go On Questions and Answers

Section 13.1

1. Why does the market value of the claims on the assets of a firm equal the market value of the assets?

The investors who own the debt and equity claims on the assets of a firm have the right to receive all of the after-tax cash flows that the assets of the firm produce. Since the market value of the assets equals the present value of the cash flows the assets produce, the market value of the assets must equal the value of the claims on those assets.

2. How is the WACC for a firm calculated?

The WACC is calculated as the weighted average of the different types of claims on the firm’s assets. The weights in this calculation are the fractions of the total value of the financing that is represented by each individual type of financing. Equation 13.2 is the general form of the WACC calculation.

3. What does the WACC for a firm tell us?

The WACC tells us the average cost of the money that has been used to finance the firm.

Section 13.2

1. Why do analysts care about the current cost of long-term debt when estimating a firm’s cost of capital?

Managers care about the current cost of long-term debt because the opportunity cost of capital that is relevant when discounting future cash flows is the opportunity cost of capital as of today. Managers focus on long-term debt because firms generally use it to finance their long-term assets, and it is the long-term assets that they are concerned about when they think about the value of a firm’s assets.

2. How do you estimate the cost of debt for a firm with more than one type of debt?

When a firm has more than one type of debt, its overall cost of debt is estimated as a weighted average of the costs of each type of debt. The weights in this calculation are the fractions of the total value of the debt represented by each individual type of debt.

3. How do taxes affect the cost of debt?...