ch13sm

ch13sm - Chapter 13 The Cost of Capital Critical Thinking...

Info iconThis preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
Page 1 of 17 Chapter 13 The Cost of Capital Critical Thinking Questions 13.1 Explain why the required rate of return on a firm’s assets must be equal to the weighted average cost of capital associated with its liabilities and equity. Solution: In order to conceptualize the answer to this question, it helps to think of the case in which the firm has raised all of its capital needs from a single source who owns all of the liability and all of the equity claims on the firm. Assume that this source has no other investments. If we were to measure the rate of return on the combined portfolio of investments for this source, we would find that it is exactly equal to the return on the total assets of the firm since that is the ultimate source of the returns. Therefore, the weighted return of that portfolio, which is the weighted average cost of capital for the firm (if for the time being we abstract away tax effects), is the return on the assets of the firm. 13.2 Which is easier to calculate directly, the expected rate of return on the assets of a firm or the expected rate of return on the firm’s debt and equity? Assume that you are an outsider to the firm. Solution: As an outsider to the firm, you will not be privy to the complete information about the projected cash flows of each of the firm’s assets, and so that is a somewhat difficult proposition. However, the collective market has made an inference concerning the expected cash flows of each of the financing claims of the firm, and by pricing those cash flows has given us an expected return for each of those claims. Therefore, finding the expected return on the debt and equity claims of the firm is much easier than finding the expected return on the assets of the firm, although that return can then be calculated from the expected return on the financing claims of the firm. 13.3 With respect to the level of risk and the required return for a firm’s portfolio of projects, discuss how the market and firm’s management can have inconsistent information and expectations. Solution: Firm management will be fully informed concerning the firm’s project risks, but their ability to accurately predict the required return for the firm’s projects depends on the market’s assessment of those project risks. Alternatively, the collective market is not fully informed (as outsiders) concerning the firm’s project risks and yet uses its incomplete information set to dictate a required return for the firm’s projects. This suggests that if the firm were able to better inform the market, and thereby reduce the market’s perceived risk on the firm’s projects, then the firm might be able to reduce the required rate of return on the firm’s projects.
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Page 2 of 17 13.4 Your friend has recently told you that the federal government effectively subsidizes the cost of debt (compared to equity use) for corporations. Do you agree with that statement?
Background image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

This note was uploaded on 05/06/2011 for the course FIN 300 taught by Professor Olander during the Spring '08 term at ASU.

Page1 / 17

ch13sm - Chapter 13 The Cost of Capital Critical Thinking...

This preview shows document pages 1 - 3. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online