Chapter 17 - WACC

Question 1

Define the weighted average cost of capital (WACC).

Answer 1

WACC = (market value of debt * net cost of debt + market value of equity * cost of equity) / (market value of debt + equity)

Question 2

State Modigliani and Miller’s irrelevance propositions.

Answer 2

First irrelevance proposition:
The market value of any firm is independent of its capital structure.
Second irrelevance proposition:
The expected rate of return on the common stock of a leveraged firm increases in proportion to the debt-equity ratio, expressed in market values.
or equivalently:
The expected rate of return on the ordinary shares of a geared firm increases in proportion to the debt-equity ratio, expressed in market values.

Question 3

State three ways in which the strict Modigliani and Miller assumptions do not hold in practice in the capital markets.

Answer 3

1. Tax - interest payments on corporate debt are tax deductible making debt finance more attractive than equity finance.
2. Different borrowing availability and rates - companies have more access to capital and can borrow at lower rates of interest than individuals and different companies can borrow at different rates.
3. Restricted debt capacity - increased debt cannot be raised at the same cost. Typically the rate of return required by debt holders increases as the gearing ratio increases.

Question 4

Define
- specific risk
- systematic risk (or market risk).

Answer 4

• Risk that is specific to the return on investment in individual shares or an individual project. It can be eliminated by diversification.
• Cannot be diversified away. It reflects the variation in the return on investment in an individual share compared to the return on investment in the market as a whole (a portfolio of shares). In the case of projects, it reflects the variation in the return from the individual project compared to the return on investment in a portfolio of projects.

Question 5

List seven sources of systematic risk.

Answer 5

1. Business or trade cycle
2. Interest rates
3. Inflation
4. Tax
5. Currency
6. Political events
7. Physical events (including the impacts of climate change)

Question 6

Describe the beta of a share.

Answer 6

The beta can be regarded as a measure of the systematic risk associated with a particular share.
Beta_i = covariance_im / variance_m = phi_im * standard deviation_i / standard devation_m
Beta > 1: a share that amplifies the return of the whole market.
0 < beta < 1: a share with a return more stable than the market as a whole.
Beta < 0: a share with a counter cyclical return (offsetting the overall market).

Question 7

Give a formula for the cost of the equity market as a whole and the cost of equity for a particular company.

Answer 7

Cost of equity in the market = risk-free rate of return + equity risk premium
Cost of an equity share = risk-free rate of return + beta for share * equity risk premium

Question 8

State a formula that shows the effect on the beta of a company’s shares of changing the level of gearing of the company.

Answer 8

Beta_geared = Beta_ungeared * [1 + (debt / equity) * (1 - tax rate)]

Question 9

List three methods of measuring the beta of an equity.

Answer 9

1. Use historical returns and the formula:
   beta_i = covariance_im / variance_m
   i.e. use regression and the formula r_i = r_f + beta_i * (r_m - r_f)
2. Estimate based on expected performance of the share price in a given market environment.
3. Use an industry beta based on a group of similar companies, and allow for the difference in gearing.

Question 10

List four factors that will influence the cost of debt (including factors that affect the credit rating).

Answer 10

1. Interest and asset cover
2. Level of gearing
3. Beta of the shares
4. Tax treatment of the debt