Lecture 8 - Cost of capital

Which of the following usually determines the optimal capital structure for an organisation

• Maximum degree of financial gearing

• Maximum degree of operating gearing

• Lowest weighted average cost of capital

• Capital structure used by competitors

Answer explanation

after value creation - minimizing cost of capital can maximize shareholder wealth

Which of the three elements are needed to estimate the cost of equity using the dividend growth model?

• Current dividends per share, expected growth rate in earnings per share nd current market price per share

• Current earnings per share, expected growth rate in dividends per share and current market price per share

• Current earnings per share, expected growth rates in earnings per share and current book value per share

• Current dividends per share, expected growth rate in dividends per share and current market price per share.

A firm's weighted average cost of capital is minimised when its debt to equity ratio is 4:1.

Which of the following statements is most accurate?

• The value of the firm is maximised when it uses more equity than debt

• A higher rate than 4:1 means debt holders will require a lower return

• A higher ratio than 4:1 means equity holders will require a higher return

• The value of the firm will maximised if its 75% debt financed

Answer explanation

An increase in financial gearing will create additional financial risk for shareholders, thereby pushing up the cost of equity

Which of the following measures business risk?

• Equity beta

• Debt beta

• Volatility of net income

• Asset beta

Answer explanation

A firm's asset beta (ungeared beta) measures the underlying risk of the firm's operations (business risk)

When calculating the weighted average cost of capital (WACC) and adjustment is made for taxes because

• interest on debt is tax deductible

• dividends paid are tax deductible

• dividends are taxable to the shareholder

Answer explanation

The cost of debt capital is adjusted for taxed because interest paid by the firm is typically tax deductible.

The cost of equity are not adjusted for taxes because dividends are not deductible for corporate taxes. Taxes owed by shareholders do not affect a firm's cost of capital.

Why might a firm be 'unlevered'?

• To reduce the company's actual debt level

• To evaluate the company's business risk separate from its financial risk

• To increase the company's tax shield

• To increase the company's financial leverage

As financial leverage increases, what will be the impact on the expected rate of return and financial risk?

• One will rise while the other falls

• Both will rise

• Both will fall

Answer explanation

Increased interest cost associated with debt financing increases the risk of the company.

Why are firms 'unlevered' in financial analysis?

• To increase the amount of debt in their capital structure

• To assess the impact of the company's debt on its profitability

• To eliminate the impact of capital structure on the company's operations and make companies more comparable

• To encourage firms to increase their leverage

What is a key benefit of unleveling a firm when conducting risk analysis?

• It increases the company's business risk

• It combines the company's business and financial risk

• It allows for an examination of the business risk independent of the financial risk

• It increases the company's financial risk

What does the term ' cost of debt' refer to?

• The interest rate the company pays on its issued bonds and/or loans

• The return required by equity shareholders

• The cost of issuing new stocks

• The cost associated with retained earnings