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.

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