Finance

CHAPTER 12

COST OF CAPITAL

Answers to Concepts Review and Critical Thinking Questions

1. It is the minimum rate of return the firm must earn overall on its existing assets. If it earns more than this, value is created.

2. Book values for debt are likely to be much closer to their market values than are book values for equity.

3. No. The cost of capital depends on the risk of the project, not the source of the money.

4. Interest expense is tax-deductible. There is no difference between pretax and aftertax equity costs.

5. The primary advantage of the DGM 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 DGM model requires a constant dividend growth rate forever; (3) the estimated cost of equity from this method is very sensitive to changes in g, 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 stock 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 firm’s available data.

6. 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 DGM model, since the SML doesn’t make any assumptions about the firm’s dividends. The primary disadvantages of the SML method are (1) estimating three parameters: the risk-free rate, the expected return on the market, and beta, 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...