p.3
Cost of Debt and Default Risk
How does perceived default risk affect lenders' charges?
As perceived default risk increases, lenders charge higher default spreads on top of the risk-free rate.
p.12
Cost of Debt and Default Risk
What is the common approach to categorizing interest-bearing liabilities in publicly traded firms?
Analysts often create separate categories for each type of debt, attaching different costs to each, but this is considered tedious and dangerous.
p.2
Implied Costs of Capital
What is the implied cost of capital for a firm?
The internal rate of return where the present value of cash flows to the firm equals the value of the firm.
p.18
Estimation Approaches for Cost of Capital
What is the preferred method for calculating net debt by analysts in Europe and Latin America?
Subtracting cash from gross debt.
p.1
Weighted Average Cost of Capital (WACC)
What is the cost of capital?
The weighted average of the costs of different components of financing, including debt, equity, and hybrid securities.
p.2
Unlevered Cost of Equity
What is a potential issue with using unlevered beta to estimate cost of equity?
It may yield an incorrect estimate of value as debt ratios change in the presence of taxes and default risk.
p.16
Impact of Financing Mix on Cost of Capital
How do financing weights change over time for young firms?
They often start as all equity funded and may increase debt as earnings and cash flows grow.
p.20
Estimation Approaches for Cost of Capital
What were the estimated costs of equity for oil companies in 1989 using CAPM and APM?
14.4 percent with CAPM and 19.1 percent using APM.
p.23
Unlevered Cost of Equity
What choice do we have regarding cash when estimating beta?
We can either exclude it or consider it as an asset with a beta of zero.
p.19
Estimation Approaches for Cost of Capital
Why is the cost of equity difficult to estimate?
Because it is an implicit cost and varies across equity investors.
p.24
Implied Costs of Capital
What does the book-to-price ratio represent?
The ratio of the book value of equity to the market value of equity.
p.17
Implied Costs of Capital
Why is the cost of capital estimated using total beta considered more realistic for Kristin Kandy?
It is more realistic when valuing the company for sale in a private transaction.
p.2
Weighted Average Cost of Capital (WACC)
What does the weighted average cost approach involve?
Estimating the costs of nonequity components of capital, including debt and preferred stock, and taking a weighted average.
p.15
Cost of Debt and Default Risk
What should be added to the market value of debt to compute the aggregate value for debt?
The present value of operating lease commitments.
p.7
Cost of Debt and Default Risk
Why might smaller firms have a lower average tax rate?
Because they may fall into lower income brackets, resulting in a lower average tax rate compared to the marginal tax rate.
p.7
Cost of Debt and Default Risk
What accounting practice do publicly traded firms in the U.S. often use?
They maintain two sets of books: one for tax purposes and one for reporting purposes.
p.23
Weighted Average Cost of Capital (WACC)
How is the enterprise value for each firm estimated?
By adding the market value of equity to the book value of debt and subtracting cash.
p.3
Measuring Default Risk
What do most models of default risk use to measure cash flow coverage?
Financial ratios that evaluate the magnitude of cash flows relative to obligations.
p.19
Estimation Approaches for Cost of Capital
What assumption allows us to measure equity risk?
That the marginal investor is well diversified.
p.23
Cost of Debt and Default Risk
How does the use of debt affect earnings per share?
It lowers the number of shares, thus benefiting earnings per share.
p.17
Cost of Debt and Default Risk
What is one advantage of using bottom-up betas?
The beta can be estimated as a function of the expected debt-to-equity ratio each year.
p.2
Implied Costs of Capital
How is the implied cost of equity computed for individual companies?
By taking the market price and expected cash flows to equity and solving for the internal rate of return.
p.23
Impact of Financing Mix on Cost of Capital
What happens to the operating income of the first firm when revenue increases by $10 million?
It doubles from $10 million to $20 million.
p.3
Cost of Debt and Default Risk
What factors influence the cost of debt?
The perceived default risk that lenders associate with the firm.
p.16
Impact of Financing Mix on Cost of Capital
What should be considered when analyzing mature firms regarding their financing strategies?
Expected changes as the firm moves toward target debt ratios.
p.2
Implied Costs of Capital
Why might using the implied cost of capital for individual firms be problematic?
It may lead to the conclusion that the firm is correctly valued, which is not particularly useful.
p.19
Implied Costs of Capital
What does factor analysis help identify?
Common patterns of price movements across investments.
p.23
Estimation Approaches for Cost of Capital
How can the beta of equity be modified to account for the beta of debt?
β L = β u [1 + (1 - t) D/E] - β D (1 - t) D/E.
p.1
Unlevered Cost of Equity
What is the unlevered cost of equity?
The cost of equity that results from using an unlevered beta, which assumes the company is fully equity financed.
p.7
Cost of Debt and Default Risk
How does deferring tax payments affect the effective tax rate?
It can cause the effective tax rate to lag behind the marginal tax rate during the deferral period.
p.15
Cost of Debt and Default Risk
How is the present value of operating lease commitments computed?
By discounting the lease commitment each year at the pretax cost of debt.
p.23
Implied Costs of Capital
What does a price multiple indicate?
It is obtained by dividing the market price by its earnings or book value.
p.24
Measuring Default Risk
What should be modified if a firm has operating leases outstanding?
The interest coverage ratio should be modified using the current year’s lease expense.
p.20
Cost of Debt and Default Risk
How can reducing the corporate borrowing rate by 1 percent affect estimates?
It yields reasonable estimates for the riskless rate.
p.18
Cost of Debt and Default Risk
What assumption is made when netting cash against debt?
Both debt and cash are riskless, and tax benefits from debt offset taxes on cash interest.
p.18
Cost of Debt and Default Risk
Why is it not advisable to net debt if the debt is very risky?
Because the interest rate earned on cash may be substantially lower than the interest rate paid on debt.
p.18
Unlevered Cost of Equity
What happens when a firm has a cash balance that exceeds its debt?
It will have negative net debt, leading to an unlevered beta that exceeds the levered beta.
p.19
Cost of Capital Definition
Why can founder/CEOs not be considered marginal investors?
They are restricted in trading by insider trading laws and the desire to maintain control.
p.7
Cost of Debt and Default Risk
What is the difference between effective tax rate and marginal tax rate?
The effective tax rate can be lower than the marginal tax rate due to factors like income brackets and accounting practices.
p.1
Estimation Approaches for Cost of Capital
What are the three estimation approaches for cost of capital mentioned?
Unlevered cost of equity approach, implied rate of return approach, and weighted average cost approach.
p.17
Weighted Average Cost of Capital (WACC)
What is the range of costs of capital for Disney's divisions?
From 7.90% for parks and resorts to 8.93% for studio entertainment.
p.1
Cost of Capital Definition
What argument did Modigliani and Miller make regarding capital structure?
The value of a firm should be independent of its capital structure.
p.19
Estimation Approaches for Cost of Capital
From whose perspective do we estimate the cost of equity for publicly traded firms?
From the perspective of the marginal investor in the equity.
p.12
Cost of Debt and Default Risk
What is the essential characteristic of debt?
It creates a tax-deductible obligation that firms must meet, risking bankruptcy or loss of equity control if not fulfilled.
p.7
Cost of Debt and Default Risk
What is necessary for firms to benefit from tax advantages of borrowing?
Firms must be profitable; there are no tax advantages from interest expenses if there are operating losses.
p.2
Weighted Average Cost of Capital (WACC)
What components are included in the weighted average cost of capital?
Costs of debt, preferred stock, and cost of equity.
p.20
Measuring Default Risk
What difference do ratings agencies typically assign between local currency and dollar borrowings?
Higher ratings for local currency borrowings and lower ratings for dollar borrowings.
p.20
Measuring Default Risk
Why might estimates of standard error be understated?
They assume annual returns are uncorrelated over time, which is often not the case.
p.18
Unlevered Cost of Equity
What does the unlevered beta reflect?
The beta of the business in which the firm operates.
p.6
Measuring Default Risk
What is the Altman Z-Score used for?
As a proxy for default risk.
p.5
Measuring Default Risk
What is a synthetic rating?
A rating assigned to a firm based on its financial ratios, mimicking the role of a ratings agency.
p.3
Cost of Debt and Default Risk
What is the cost of debt?
It measures the current cost to the firm of borrowing funds to finance its assets.
p.3
Measuring Default Risk
What are the two variables that determine a firm's default risk?
The firm's capacity to generate cash flows and the volatility of those cash flows.
p.3
Measuring Default Risk
How does cash flow generation relate to default risk?
Firms with high cash flows relative to their financial obligations have lower default risk.
p.16
Impact of Financing Mix on Cost of Capital
Why should the cost of capital be viewed as a year-specific number?
Because the weights attached to debt and equity, as well as estimates of beta, change over time.
p.20
Cost of Capital Definition
What is a characteristic of well-behaved term structures?
A normal upwardly sloping yield curve where long-term rates are at most 2 to 3 percent higher than short-term rates.
p.14
Estimating Approaches for Cost of Capital
What complication has arisen from the use of options as management compensation?
The need to estimate the value of these options.
p.21
Estimation Approaches for Cost of Capital
How is the compounded return calculated?
By taking the value of the investment at the start of the period (Value 0) and the value at the end (Value N).
p.9
Cost of Debt and Default Risk
How does the risk of preferred stock compare to common equity and debt?
Preferred stock is safer than common equity but riskier than debt.
p.20
Implied Costs of Capital
How can the 10-year Thai risk-free rate be estimated using current rates?
By solving for the Thai interest rate using the current spot rate, forward rate, and U.S. Treasury bond rate.
p.9
Cost of Other Hybrid Securities
What is an example of a hybrid security?
A convertible bond, which combines features of a straight bond and a conversion option.
p.9
Cost of Other Hybrid Securities
What are the two methods to value traded convertible bonds?
1. Use an option pricing model for the conversion option; 2. Value as a straight bond using the firm's borrowing rate.
p.9
Cost of Other Hybrid Securities
What must be done if a convertible security is not traded?
Both the straight bond and the conversion options must be valued separately.
p.5
Measuring Default Risk
Why do some companies choose not to get rated?
Many smaller firms and most private businesses fall into this category.
p.22
Cost of Capital Definition
What is the Treasury bond rate composed of?
Expected inflation and the expected real rate.
p.15
Cost of Debt and Default Risk
What is required for a more accurate computation of debt value?
Valuing each debt issue separately.
p.1
Cost of Capital Definition
Why is equity considered just one ingredient in the financing mix?
Because most businesses also use debt or a hybrid of equity and debt to finance their operations.
p.12
Cost of Debt and Default Risk
What is the recommended method for calculating the cost of debt?
Combine all debt types and attach the long-term cost of debt by adding the default spread to the long-term risk-free rate.
p.3
Measuring Default Risk
What role does cash flow stability play in default risk?
More stable cash flows result in lower default risk for the firm.
p.2
Implied Costs of Capital
What is the benefit of computing the average implied cost of capital across firms in a sector?
It can be used as the cost of capital for valuing individual firms within that sector.
p.17
Weighted Average Cost of Capital (WACC)
What factors are used to estimate the cost of capital for Embraer?
Estimated costs of equity and after-tax costs of debt.
p.24
Measuring Default Risk
What was the focus of the table updated in early 2004?
Listing all rated firms with market capitalization lower than $2 billion and their interest coverage ratios.
p.9
Cost of Other Hybrid Securities
What is a hybrid security?
A hybrid security shares characteristics of both debt and equity.
p.9
Cost of Other Hybrid Securities
How can hybrid securities be valued?
They can be broken down into their debt and equity components and treated separately.
p.24
Cost of Debt and Default Risk
How are coupons assumed to be structured in the analysis?
Assumed to be annual, but would be divided by 2 for semiannual coupons.
p.11
Market Value Weights in Cost of Capital
Why is the argument that book value is more reliable considered weak?
Because true value changes over time with new information, making market value a better reflection of true value.
p.11
Cost of Debt and Default Risk
What challenges do analysts face regarding what to include in debt?
Deciding on short-term vs. long-term, secured vs. unsecured, and floating vs. fixed rate liabilities.
p.8
Cost of Debt and Default Risk
What characteristics does preferred stock share with debt?
Preferred dividend is prespecified and paid out before common stock dividends.
p.6
Tax Advantages of Debt
Why is interest considered a tax advantage for firms?
Because it is tax deductible, reducing the cost of borrowing.
p.4
Estimating Default Risk and Default Spread of a Firm
What is the cost of debt for Disney with a BBB+ rating in 2004?
1.25 percent higher than the Treasury bond rate.
p.24
Implied Costs of Capital
What type of stocks tend to earn higher returns according to Fama and French?
Earnings multiples or low price-to-book value multiples.
p.12
Cost of Debt and Default Risk
Why is it problematic to use short-term debt rates for long-term investments?
Using short-term rates misses the point of computing the cost of debt, as it does not reflect the cost of long-term borrowing.
p.14
Estimating Approaches for Cost of Capital
What should be valued and added to the value of equity in a firm?
Warrants and conversion options in other securities.
p.12
Cost of Debt and Default Risk
How should lease commitments be treated in financial analysis?
All lease payments should be treated as financial expenses and converted into debt by discounting future lease commitments to present value.
p.7
Cost of Debt and Default Risk
When should tax benefits from debt be considered in financial assessments?
Only in future years when the firm is expected to have operating profits.
p.21
Cost of Debt and Default Risk
Where was the raw data on Treasury bill rates and stock returns obtained?
From the Federal Reserve data archives maintained by the Fed in St. Louis.
p.21
Measuring Default Risk
What is the significance of normalizing the default spread?
It helps counter the volatility of country bond spreads by averaging the spread over time.
p.19
Weighted Average Cost of Capital (WACC)
What is the cost of capital?
A weighted average of the costs of different components of financing.
p.13
Cost of Debt and Default Risk
What should be restated to complete the adjustment for operating leases?
The operating income of the firm.
p.11
Market Value Weights in Cost of Capital
Why is consistency in using book value for accounting returns and cost of capital considered flawed?
It does not make economic sense, as funds can earn market rates elsewhere, necessitating the use of market rates and values.
p.4
Measuring Default Risk
What does a rating of AAA from Standard & Poor’s signify?
The highest rating granted to firms with the lowest default risk.
p.6
Measuring Default Risk
What is a key disadvantage of using credit or Z-Scores for estimating synthetic ratings?
Changes in ratings are more difficult to explain than those based on interest coverage ratios.
p.22
Implied Costs of Capital
What is the most difficult input to estimate for emerging markets?
Long-term expected growth rate.
p.22
Measuring Default Risk
What is the nontrading bias?
Returns in nontrading periods are zeros, affecting correlation and beta.
p.7
Cost of Debt and Default Risk
What should be considered when determining the marginal tax rate for companies operating in multiple locales?
The average of different marginal tax rates, weighted by operating income by locale.
p.9
Cost of Debt and Default Risk
Are preferred dividends tax deductible?
No, preferred dividends are not tax deductible.
p.2
Impact of Financing Mix on Cost of Capital
What is a potential problem when using industry averages for cost of capital?
There may be significant differences in operating and financial risk across companies in the sector.
p.21
Measuring Default Risk
What time period was used to compute the standard deviations for U.S. and Brazilian returns?
Weekly returns for two years from the beginning of 2003 to the end of 2004.
p.21
Measuring Default Risk
Why might daily standard deviations be less reliable?
They tend to have much more noise in them compared to weekly returns.
p.11
Market Value Weights in Cost of Capital
What is the implication of using book value for estimating debt ratios?
It leads to lower cost of capital estimates, which are less conservative than those using market value ratios.
p.5
Cost of Debt and Default Risk
What are the two alternatives to estimate the cost of debt when no rating is available?
1. Recent borrowing history. 2. Estimate a synthetic rating and default spread.
p.6
Tax Advantages of Debt
Why can estimating the marginal tax rate be problematic?
Firms seldom report it in their financials.
p.22
Impact of Financing Mix on Cost of Capital
What is the impact of fixed versus variable costs on operating income?
It affects the operating leverage and profitability of firms.
p.23
Unlevered Cost of Equity
Why was cash ignored in computing the beta for Disney’s equity?
It represented only about 1.71 percent of firm value, having a negligible impact.
p.24
Cost of Debt and Default Risk
What is defined as a financial obligation?
Any payment that the firm has legally obligated itself to make, such as interest and principal payments.
p.3
Measuring Default Risk
How do industry effects influence default risk evaluation?
Models control for industry effects to assess variability in cash flows.
p.14
Estimating Approaches for Cost of Capital
What are the two choices for estimating the value of equity for private businesses?
1. Estimate market value using multiples of revenues and net income from publicly traded firms. 2. Use the market debt ratio of publicly traded firms as the debt ratio for private firms.
p.21
Measuring Default Risk
What is the relationship between good years and poor years in stock returns?
Good years are more likely to be followed by poor years and vice versa, indicating negative serial correlation.
p.24
Measuring Default Risk
Where can default spreads for industrial firms be found?
On the website www.bondsonline.com.
p.24
Cost of Debt and Default Risk
What rate was used to compute the pretax cost of debt?
A 10-year Treasury bond rate.
p.13
Market Value Weights in Cost of Capital
Why is it not good practice to use average stock prices over time for market value calculations?
Because it measures the cost of raising funds today.
p.1
Cost of Capital Definition
According to Modigliani and Miller, how should the cost of capital behave with changes in debt ratio?
It should not change as the debt ratio changes; the cost of capital at 0% debt should be the same at any other debt ratio.
p.20
Cost of Debt and Default Risk
What is a potential issue when using long-term bonds as risk-free rates?
Estimating default spreads and equity risk premiums is more challenging for longer maturities.
p.17
Market Value Weights in Cost of Capital
How are the weights for debt and equity computed for Embraer?
Using the estimated market value of debt and equity.
p.19
Estimation Approaches for Cost of Capital
What are the three ways to estimate the cost of equity?
Using a risk and return model, analyzing return differences across stocks, and backing out an implied cost of equity from stock prices.
p.21
Measuring Default Risk
What did Fama and French find regarding one-year and five-year stock return correlations?
One-year correlations are low, while five-year serial correlations are strongly negative for all size classes.
p.19
Measuring Default Risk
How can default risk be measured?
Using a bond rating or financial ratios.
p.19
Tax Advantages of Debt
What effect does tax-deductible interest have on the cost of borrowing?
It reduces the after-tax cost of borrowing.
p.13
Cost of Debt and Default Risk
What can be added to the value of conventional debt to arrive at a total debt figure?
The debt value of operating leases.
p.4
Measuring Default Risk
What is the most widely used measure of a firm's default risk?
Bond rating assigned by independent ratings agencies.
p.13
Market Value Weights in Cost of Capital
What is the market value of equity generally calculated as?
The number of shares outstanding times the current stock price.
p.5
Measuring Default Risk
What financial ratio is commonly used to assess a firm's synthetic rating?
The interest coverage ratio (operating income to interest expense).
p.4
Estimating Default Risk and Default Spread of a Firm
How can costs of debt be estimated for firms with bonds that do not trade regularly?
By using their ratings and associated default spreads.
p.22
Measuring Default Risk
How can the nontrading bias be reduced?
Using statistical techniques suggested by Dimson and Scholes-Williams.
p.9
Cost of Debt and Default Risk
How is the cost of preferred stock typically calculated?
It is calculated assuming the dividend is constant in dollar terms forever and that the stock has no special features.
p.12
Cost of Debt and Default Risk
What risk does a firm face if it fails to meet lease commitments?
The risk of losing assets or facing bankruptcy.
p.14
Market Value Weights in Cost of Capital
Why is the market value of debt difficult to obtain directly?
Because very few firms have all of their debt in the form of bonds trading in the market.
p.11
Market Value Weights in Cost of Capital
What is one argument analysts use to justify book value weights?
Book value is more reliable than market value because it is not as volatile.
p.13
Cost of Debt and Default Risk
How should unfunded pension plan and health care obligations be treated in cost of capital calculations?
They should not be considered as debt.
p.10
Market Value Weights in Cost of Capital
Why should weights in cost of capital computation be based on market values?
Because the cost of capital is a forward-looking measure capturing the cost of raising new funds.
p.11
Cost of Debt and Default Risk
What is the general recommendation for what to include in debt?
Include specific items that accurately reflect the firm's debt without being overly conservative.
p.13
Market Value Weights in Cost of Capital
How should market values for nontraded shares be handled?
They should be estimated and added to the aggregate equity value.
p.14
Estimating Approaches for Cost of Capital
What assumption was made for Kristin Kandy regarding debt-to-equity ratio?
The industry average debt-to-equity ratio for the food processing business was used.
p.19
Cost of Debt and Default Risk
What does the cost of debt depend on?
The default risk embedded in the firm.
p.14
Market Value Weights in Cost of Capital
What simplifying assumption do analysts make regarding book value of debt?
That the book value of debt is equal to its market value.
p.14
Market Value Weights in Cost of Capital
When can assuming book value equals market value be a mistake?
When interest rates and default spreads are volatile.
p.14
Market Value Weights in Cost of Capital
How can book value debt be converted into market value debt?
By treating the entire debt as a coupon bond valued at the current cost of debt.
p.14
Market Value Weights in Cost of Capital
What is the formula to estimate the market value of debt?
Value the coupon bond with interest expenses as the coupon and maturity as the face-value weighted average maturity.
p.13
Cost of Debt and Default Risk
What types of liabilities should not be counted as debt?
Accounts payable, supplier credit, and other non-interest-bearing liabilities.
p.4
Measuring Default Risk
Which two agencies are best known for assigning bond ratings?
Standard & Poor’s and Moody’s.
p.4
Estimating Default Risk and Default Spread of a Firm
How can the cost of debt be estimated for firms with widely traded long-term bonds?
By using the market price of the bond, its coupon, and maturity to compute a yield.
p.10
Market Value Weights in Cost of Capital
What are the two choices for computing weights in cost of capital?
Book value weights and market value weights.
p.11
Cost of Debt and Default Risk
What is a common temptation when including liabilities as debt?
To be conservative and include all potential liabilities, which can be counterproductive.
p.4
Measuring Default Risk
What is categorized as investment grade by Standard & Poor’s?
A rating at or above BBB.
p.5
Cost of Debt and Default Risk
How can recent borrowing history help estimate the cost of debt?
By looking at the most recent borrowings made by a firm to determine the default spreads being charged.
p.22
Estimation Approaches for Cost of Capital
What method was used to estimate individual firm earnings?
The average of analyst estimates (bottom-up).
p.13
Market Value Weights in Cost of Capital
What should be done if there are multiple classes of shares outstanding?
Aggregate the market values of all classes and treat them as equity.
p.22
Measuring Default Risk
What type of regression is typically used in this context?
Ordinary least squares (OLS) regression.
p.22
Measuring Default Risk
Why do many services adjust regression betas toward 1?
To reflect the long-term tendency of betas to move toward the market average.
