Seminar 6 N1591

Valuation of Companies and Cash Flow Generating Assets (N1591)

Autumn Term 2019/20

Seminar 6: Estimating the Cost of Capital (McK Chap 13)

Essay and Calculation Questions

1. Briefly explain two important methods of estimating market returns.

2. Company XYZ is a UK based brewery. You have been supplied with the following
information about the company:

Equity
Current Share Price (p) 125
Number of Shares Outstanding (m) 100

Bonds
Maturity (Years) Price Amount (mGBP) Yield
7 1.05 75 4%
10 0.92 60 5%

The tax rate is 25% and we assume that tax shields have the same risk as debt.

Additionally, you have done some research and found out the following:

Government
Yields
5 Year 0.5%
10 Year 0.75%

Equity Market Returns

Historical 2000-18 (Credit Suisse) 2.0%
Implied 8%

Finally, you have established that the unlevered median industry beta is 0.95.

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Using this information, address the following questions and explain your answers.

2.1 Estimate the cost of equity

2.2 Estimate the cost of debt

2.3 Compute the WACC

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Multiple Choice Questions

3. Which of the following is/are FALSE regarding risk-free rates?

I) The 30-year Treasury bonds match the cash flow streams of a company better, and
therefore should be used over 10-year bonds in estimating the risk-free rate.
II) One should use government bond yields denominated in the same currency as the
company’s cash flow to estimate the risk-free rate.
III) One should ensure that the inflation rate embedded in the cash flows is consistent
with the inflation rate embedded in the government bond rate being used.

A. I only.
B. II only.
C. III only.
D. I and III only.

4. An analyst gathers the following information for Firm A and Firm B

Firm A: CAPM beta = 0.9; Debt/Equity ratio = 0.4

Firm B: CAPM beta = 1.2; Debt/Equity ratio = 2

Use this information to compute the industry unlevered beta, what is the appropriate beta for
each company’s equity beta? (Assume that the debt beta for each firm equals zero, the firms
pay no tax and are of equal value.)

A. 0.73; 1.56
B. 0.90; 1.20
C. 0.52; 0.52
D. 1.12; 1.65

5. A firm has 5,000,000 shares of stock outstanding with a price per share equal to $ 20. There
are 300,000 bonds outstanding each priced at $ 950 each (face value $ 1,000). The cost of
equity is 15%, the cost of debt is 7%, and the corporate tax rate is 30%. What is the WACC?

A. 7.3%
B. 7.5%
C. 7.7%
D. 7.9%

6. The weights to use in the WACC should reflect the:

A. Current book values.

B. Current market values.
C. Target-market-based values.
D. Book values in the case of bonds and market values in the case of equity.

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7. Which of the following is NOT a property necessary for a consistent estimate of the WACC?

A. It uses book-value-based weights.

B. It includes the opportunity cost of all investors.
C. It includes related costs/benefits such as the interest tax shield.
D. The duration of the securities used in estimating the WACC equals the duration of the free
cash flows.