Question

1. Is cost of capital of a firm determined by the source of the funds or the use of funds? Explain.
2. What are the advantages and disadvantages of using CAPM to calculate cost of equity.
3. The Gordon Growth Model can be used to estimate cost of equity. Why is this method not ideal?
4. Explain how you would calculate beta of a stock.
5. Can a firm’s beta change over time? How would you adjust your calculation of beta to reflect a change of business?
6. Why is the coupon rate of a bond not used for calculating cost of debt?
7. Why do we prefer to use market value weights of debt and equity when calculating WACC?
8. A firm has preferred shares and multiple bond issues. How do you adjust your WACC calculation?
9. When is it appropriate to use WACC as the discount rate when determining the NPV of a project?
10. What is a consequence of using WACC as the discount rate for all projects of a firm?

Answer 1

Answer:-

Q) Is cost of capital of a firm determined by the source of the funds or the use of funds? Explain.

Answer:- The cost of capital is determined by the use of funds.
The cost of capital is generally the WACC and it is calculated by the proportion of equity and debt in the capital structure.
WACC = Wt of equity x cost of equity + Wt of debt x cost of debt x ( 1 - tax rate)
The cost of capital changes when the proportion of debt and equity in capital structure changes.

Q) What are the advantages and disadvantages of using CAPM to calculate cost of equity.

Answer:-
The advantages of using CAPM to calculate cost of equity are

1) It is one of the most popular and easy method to use
2) It takes into account the systematic risk like GDP and economic risk which is non diversifiable.
3) It eliminates the unsystematic risk which can be diversified like firm specific risk

The disadvantages of using CAPM to calculate cost of equity are

1) It uses beta which is difficult to determine easily
2) It takes into consideration lot of assumptions
3) It includes risk free rate which takes the values of US short term treasuries that keeps on changing every day.

Q) The Gordon Growth Model can be used to estimate cost of equity. Why is this method not ideal?

Answer:-

The Gordon Growth model calculates the intrinsic value of a stock by evaluating the  series of dividends that grow at a constant rate. This model is not used to calculate the cost of equity. The cost of equity can be calculated by three methods
1) CAPM model
2) Dividend discount model (DDM)
3) Bond yield plus risk premium approach

Q) Explain how you would calculate beta of a stock.

Answer:-
Beta of a stock is calculated as the ratio of the co-variance of the excess stock or asset returns and excess market returns to the variance of the excess market returns over the risk-free rate of return. Beta is based on the systematic risk of the market.

Note- Kindly put other questions in separate posts