generally agreed that its key inputs—beta, the risk-free rate, and the market risk premium—can be estimated with very little error. b. The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF model’s logical appeal and also because accurate estimates for its key input, the growth rate, are easy to obtain. c. The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm’s own cost of debt and the firm’s risk premium, can be found by using standardized and objective procedures. d. The CAPM is probably the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, then decision makers can have more confidence in the estimated cost of equity. e. The DCF model is preferred by academics and finance people over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield. CAPM and DCF estimation Answer: a HARD 46 . Which of the following statements is CORRECT? a. Beta measures market risk, which is the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm’s stockholders are well diversified. b. If the calculated beta underestimates the firm’s true investment risk (i.e., the forward-looking beta that investors think exists), then the CAPM method will produce an estimate of r s and thus WACC that is too high. c. The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever. d. An advantage shared by both the DCF and CAPM methods is that little or no judgment is required when they are used to estimate the cost of equity. e. The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach. Chapter 10: The Cost of Capital Page 69
WACC Answer: a HARD 47 . Which of the following statements is CORRECT? a. The WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm’s target capital structure. b. The WACC is calculated using a before-tax cost for debt equal to the interest rate that must be paid on new debt, along with the after-tax cost for common stock and for preferred stock if it is used.