The answer to question 8 is false. Question 9: Make a true statement out of the false statement, which was as follows: A declining WACC is not a good sign, as it indicates the value of the capital in which the company has invested is declining. The answer to question 9 is declining WACC is a good thing if it increases the spread with return on investment capital. End of activity. Question 1: From what variables is the capital asset pricing model (CAPM) calculated? Answer 1: A company's cost of capital, also known as its risk adjusted discount rate, or hurdle rate, is dependent on two factors: the risk, as it is perceived by investors, of the company's ability to maintain and grow its profits; and the market rates of return. The formula is as follows: KE = Rf + Beta x (Rm – Rf) KE: Cost of capital Rf: Risk-free rate of return Beta: Measure of a company's risk Rm: Return on the market The cost of capital (KE) represents the minimum return shareholders expect from their investment. Question 2: What exactly is the risk-free rate of return? Answer 2: The risk-free rate of return (Rf) is the return an investor can earn on riskless investments, such as on Treasury Bills or Treasury Bonds. These investments are considered risk- free because these securities are backed by the U.S. government. One can debate whether there is actually risk present in a government-backed security (even one backed by a stable government such as the United States), but the bottom line is that the investor is not compensated for default risk in this scenario; the investor is only compensated for purchasing power loss over time as represented by the inflation rate.
Question 3: How is the beta, or measure of a company's risk, derived? Answer 3: Beta is the measure of company specific risk in capital asset pricing model (CAPM). It is the only element of CAPM that is company-specific; the other components of CAPM are market rates. The calculation of beta is straightforward. A regression of the company's excess returns versus the market's excess returns is run, and beta is the slope of this regression line (the line of best fit). The standard deviation of a company's returns is a measure of volatility; to calculate beta, you must compare that company's volatility to the volatility of the market. Question 4: How do return on market and market risk premium factor in the CAPM equation? Answer 4: The return on the market (Rm) is the expected average return on the equity market, and the term (Rm – Rf) is known as the market risk premium . This is the excess return (excess over the risk-free rate) that an investor receives for taking on risk.
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