Corporate Finance - Cost of Capital (WACC) & Valuation Flashcards

Question 1

State the general formula for the Weighted Average Cost of Capital (WACC).

Accepted Answer

$WACC = (E/V) 	imes r_e + (D/V) 	imes r_d (1 - T)$
Where:
$E$ = Market Value of Equity
$D$ = Market Value of Debt
$V = E + D$ = Total Market Value of Firm
$r_e$ = Cost of Equity
$r_d$ = Pre-tax Cost of Debt
$T$ = Corporate Tax Rate
(Note: If preferred stock exists, add $(P/V) 	imes r_p$ to the formula.)

Question 2

What is the Cost of Capital?

Accepted Answer

The rate of return a company must earn on an investment project to maintain its market value and attract new capital. It represents the required rate of return for investors.

Question 3

Why is the Cost of Capital important in corporate finance?

Accepted Answer

It's used as the discount rate for evaluating investment projects (e.g., in Net Present Value analysis), for valuing the entire firm, and for making capital budgeting decisions.

Question 4

What is the Weighted Average Cost of Capital (WACC)?

Accepted Answer

The average rate of return a company expects to pay to all its security holders (debt, preferred stock, common equity) to finance its assets. It's the overall required return on the firm as a whole.

Question 5

What are the main components of the Weighted Average Cost of Capital (WACC)?

Accepted Answer

The cost of equity ($r_e$), the cost of debt ($r_d$), and sometimes the cost of preferred stock ($r_p$). Each component is weighted by its proportion in the company's capital structure.

Question 6

What is the Cost of Equity ($r_e$)?

Accepted Answer

The rate of return required by the company's common equity investors. It compensates them for the risk they undertake by investing in the company's stock.

Question 7

What is the Capital Asset Pricing Model (CAPM)?

Accepted Answer

A model that describes the relationship between systematic risk and expected return for assets, particularly stocks. It's widely used to calculate the cost of equity.

Question 8

State the formula for the Cost of Equity using the Capital Asset Pricing Model (CAPM).

Accepted Answer

$r_e = r_f + \beta(r_m - r_f)$
Where:
$r_e$ = Cost of Equity
$r_f$ = Risk-Free Rate
$\beta$ = Beta (systematic risk)
$r_m$ = Expected Market Return
$(r_m - r_f)$ = Market Risk Premium

Question 9

What is the Risk-Free Rate ($r_f$) in the CAPM?

Accepted Answer

The theoretical rate of return of an investment with zero risk. Typically, the yield on long-term government bonds (e.g., U.S. Treasury bonds) is used as a proxy.

Question 10

Define the Market Risk Premium $(r_m - r_f)$ in the context of CAPM.

Accepted Answer

The additional return investors expect for taking on the average market risk, above the risk-free rate. It represents the compensation for bearing systematic risk.

Question 11

What is Beta ($\beta$) in the CAPM, and what does it measure?

Accepted Answer

Beta is a measure of a stock's volatility in relation to the overall market. It quantifies the systematic (non-diversifiable) risk of an asset.

Question 12

How is Beta ($\beta$) interpreted?

Accepted Answer

$\beta = 1$: The asset's price moves with the market.
$\beta > 1$: The asset is more volatile than the market (higher systematic risk).
$\beta < 1$: The asset is less volatile than the market (lower systematic risk).
$\beta = 0$: The asset's return is uncorrelated with the market.

Question 13

What are some limitations of the Capital Asset Pricing Model (CAPM)?

Accepted Answer

CAPM relies on several assumptions that may not hold in reality (e.g., rational investors, efficient markets). Estimating Beta, the market risk premium, and the risk-free rate can be challenging and subjective.

Question 14

What is the Cost of Debt ($r_d$)?

Accepted Answer

The effective interest rate a company pays on its borrowings. It's typically the yield to maturity (YTM) on the company's outstanding debt or the rate on new debt issues.

Question 15

Explain how the tax shield affects the Cost of Debt in WACC calculations.

Accepted Answer

Interest payments on debt are tax-deductible, creating a "tax shield" that reduces the company's taxable income and, consequently, its tax liability. This makes debt financing cheaper on an after-tax basis.

Question 16

State the formula for the after-tax Cost of Debt.

Accepted Answer

After-tax Cost of Debt $= r_d (1 - T)$
Where:
$r_d$ = Pre-tax Cost of Debt
$T$ = Corporate Tax Rate

Question 17

How are the weights (E/V and D/V) for WACC typically determined?

Accepted Answer

The weights should reflect the *market values* of equity and debt, not their book values. Market values better represent the current economic proportions of each financing source.

Question 18

What is the Dividend Discount Model (DDM)?

Accepted Answer

A valuation method that estimates the intrinsic value of a stock based on the present value of all its future dividend payments. It assumes the stock's value is derived from the dividends it will pay.

Question 19

State the formula for the Gordon Growth Model (a specific DDM).

Accepted Answer

$P_0 = D_1 / (r_e - g)$
Where:
$P_0$ = Current stock price (intrinsic value)
$D_1$ = Expected dividend per share in the next period
$r_e$ = Required rate of return (Cost of Equity)
$g$ = Constant growth rate of dividends
(Assumes $r_e > g$)

Question 20

What is Free Cash Flow to Firm (FCFF)?

Accepted Answer

The total amount of cash flow generated by a company's operations that is available to all providers of capital (both debt and equity holders) after accounting for operating expenses and capital expenditures.

Question 21

Outline the general steps to calculate Free Cash Flow to Firm (FCFF).

Accepted Answer

1. Start with EBIT (Earnings Before Interest and Taxes).
2. Subtract Taxes (EBIT * (1 - Tax Rate)).
3. Add back Depreciation and Amortization.
4. Subtract Capital Expenditures (CapEx).
5. Subtract changes in Net Working Capital (NWC).
FCFF = EBIT(1-T) + Depr - CapEx - $\Delta$NWC

Question 22

What is Enterprise Value (EV)?

Accepted Answer

A measure of a company's total value, often considered a more comprehensive alternative to market capitalization. It includes market capitalization, debt, minority interest, and preferred shares, minus cash and cash equivalents.

Question 23

How can Enterprise Value (EV) be calculated using Free Cash Flow to Firm (FCFF)?

Accepted Answer

EV is the present value of all future FCFFs, discounted at the Weighted Average Cost of Capital (WACC).
$EV = \sum_{t=1}^{n} \frac{FCFF_t}{(1 + WACC)^t} + \frac{TV_n}{(1 + WACC)^n}$
Where $TV_n$ is the Terminal Value at period $n$.

Question 24

What is Terminal Value (TV) in valuation models?

Accepted Answer

The estimated value of a company's operations beyond the explicit forecast period (when growth is assumed to stabilize). It represents the present value of all cash flows from the end of the forecast period into perpetuity.

Question 25

State the formula for calculating Terminal Value (TV) using the Gordon Growth Model approach.

Accepted Answer

$TV_n = FCFF_{n+1} / (WACC - g)$
Where:
$TV_n$ = Terminal Value at the end of the forecast period $n$
$FCFF_{n+1}$ = Free Cash Flow to Firm in the first year *after* the forecast period
$WACC$ = Weighted Average Cost of Capital
$g$ = Constant perpetual growth rate of FCFF
(Assumes $WACC > g$)

Corporate Finance - Cost of Capital (WACC) & Valuation

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