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CHAPTER 7 – RISK AND THE COST OF CAPITAL

Key terms cần nhớ:
1. Market risk premium = 𝑟𝑚 − 𝑟𝑓
2. Generally, the value to use for the risk-free interest rate is short-term Treasury bill rate.
3. Cost of capital is the same as cost of equity for firms financed entirely by equity.
4. The cost of capital for a project depends on the use to which the capital is put, i.e. the project.
5. The hurdle rate for capital budgeting decisions is the cost of capital.
6. Weighted average cost of capital (WACC): is the company cost of capital when debt as well
as equity is used for financing.
7. The after-tax weighted average cost of capital (WACC) is calculated using the formula:
𝐷 𝐸
𝑊𝐴𝐶𝐶 = 𝑟𝐷 × (1 − 𝑇𝑐 ) × + 𝑟𝐸 ×
𝑉 𝑉
where: V = D + E
8. Using the company cost of capital to evaluate a project is correct for projects that are about as
risky as the average of the firm's other assets.
9. Cost of equity can be estimated using: Discounted cash flow (DCF) approach, Capital Asset
Pricing Model (CAPM), Arbitrage Pricing theory (APT), The Fama-French three-factor model
A. Market risk premium
1. The historical returns data for the past three years for Stock B and the stock market portfolio
are: Stock B: 24%, 0%, 24%, Market Portfolios: 10%, 12%, 20%. If the risk-free rate is 4%,
calculate the market risk premium.
 10%
2. The historical data for the past three years for the market portfolio are 10%, 10% and 16%. If
the risk-free rate of return is 4%, what is the market risk premium?
 8%
B. Expected rate of return and Discount rate
1. The historical returns data for the past three years for Stock B and the stock market portfolio
are: Stock B: 24%, 0%, 24%, Market Portfolios: 10%, 12%, 20%. Calculate the expected return
for Stock B and the market portfolio.
 Stock B 16%, Market Portfolio: 14%
2. An all-equity firm has a beta of .98. The firm is evaluating a project that will increase the
output of the firm's existing product. The market risk premium is 7.3 percent and the risk-free
rate is 3.4 percent. What discount rate should be assigned to this expansion project?
 10.55%
C. Cost of equity and CAPM
1. The historical returns data for the past three years for Stock B and the stock market portfolio
are: Stock B: 24%, 0%, 24%, Market Portfolios: 10%, 12%, 20%. Calculate the required rate
of return (cost of equity) for Stock B using CAPM. (The risk-free rate of return = 4%)
 12.6%
2. The historical returns data for the past four years for Stock C and the stock market portfolio
returns are: Stock C: 10%, 30%, 20%, 20%; Market Portfolio: 5%, 15%, 25%, 15%. If the risk-
free rate of return is 5%, calculate the required rate of return on the Stock C using CAPM.
 10%
D. Cost of capital
1. The market value of Charter Cruise Company's equity is $15 million, and the market value of
its risk-free debt is $5 million. If the required rate of return on the equity is 20% and that on
the debt is 8%, calculate the company's cost of capital. (Assume no taxes.)
 17%
2. The market value of Cable Company's equity is $60 million, and the market value of its risk-
free debt is $40 million. If the required rate of return on the equity is 15% and that on the debt
is 5%, calculate the company's cost of capital. (Assume no taxes.)
 11%
3. The market value of Charcoal Corporation's common stock is $20 million, and the market
value of its risk-free debt is $5 million. The beta of the company's common stock is 1.25, and
the market risk premium is 8%. If the Treasury bill rate is 5%, what is the company's cost of
capital? (Assume no taxes.)
 13%
4. The market value of XYZ Corporation's common stock is 40 million and the market value of
the risk-free debt is 60 million. The beta of the company's common stock is 0.8, and the
expected market risk premium is 10%. If the Treasury bill rate is 6%, what is the firm's cost of
capital? (Assume no taxes.)
 9.2%
E. WACC and COC
1. A firm has a beta of 1.3 and a debt-to-equity ratio of .4. The market rate of return is 11.6
percent, the tax rate is 32 percent, and the risk-free rate is 3.3 percent. The pretax cost of debt
is 7.2 percent. What is the firm's WACC?
 11.46%
2. Taylor's has a beta of .78 and a debt-to-equity ratio of .2. The market rate of return is 10.6
percent, the tax rate is 34 percent, and the risk-free rate is 1.4 percent. The pretax cost of debt
is 6.1 percent. What is the firm's WACC?
 7.82%
3. A company is 40% financed by risk-free debt. The interest rate is 10%, the expected market
risk premium is 8%, and the beta of the company’s common stock is .5. What is the company
cost of capital (COC)? What is the after-tax WACC, assuming that the company pays tax at a
20% rate?
F. WACC and NPV
1. A levered firm has a target capital structure of 30 percent debt and 70 percent equity. The after-
tax cost of debt is 6.5 percent, the tax rate is 34 percent, and the cost of equity is 12.3 percent.
The firm is considering a project that is equally as risky as the overall firm. The project has an
 initial cash outflow of $1.1 million and annual cash inflows of $480,000 at the end of each
year for three years. What is the NPV of the project?
 $82,018.07
2. A levered firm has a target capital structure of 40 percent debt and 60 percent equity. The after-
tax cost of debt is 7.5 percent, the tax rate is 34 percent, and the cost of equity is 15.1 percent.
The firm is considering a project that is equally as risky as the overall firm. The project has an
initial cash outflow of $1.2 million and annual cash inflows of $450,000 at the end of each
year for three years. What is the NPV of the project?
3. Alaskan Markets has a target capital structure of 45 percent debt and 55 percent equity. The
pretax cost of debt is 6.5 percent, the tax rate is 34 percent, and the cost of equity is 13.7
percent. The firm is considering a project that is equally as risky as the overall firm. The project
has an initial cash outflow of $1.8 million and annual cash inflows of $550,000 at the end of
each year for four years. What is the NPV of the project?
 -$36,209.17
4. Alaskan Markets has a target capital structure of 60 percent debt and 40 percent equity. The
pretax cost of debt is 12.5 percent, the tax rate is 20 percent, and the cost of equity is 9.7
percent. The firm is considering a project that is equally as risky as the overall firm. The project
has an initial cash outflow of $1.5 million and annual cash inflows of $350,000 at the end of
each year for five years. What is the NPV of the project?
5. Alaskan Markets is 40% financed by risk-free debt and 60 percent equity. The treasury bill rate
is 4%, the expected market rate of return is 12%, and the beta of the company’s common stock
is 1.5. Tax rate is 20%. The firm is considering a project that is equally as risky as the overall
firm. The project has an initial cash outflow of $2.8 million and annual cash inflows of
$650,000 at the end of each year for four years. What is the NPV of the project?
6. PVC has a capital structure of 35 percent debt and 65 percent equity. The pretax cost of debt
is 12.0 percent, the tax rate is 34 percent, and the cost of equity is 17.5 percent. The firm is
considering a project that is equally as risky as the overall firm. The project has an initial cash
outflow of $2.5 million and annual cash inflows of $1.150,000 at the end of each year for three
years. What is the NPV of the project?
7. Estimate WACC, tax rate is 20%
 The amount of each
Sources of fund Figures
source of fund
Long term debt from The bank charges HGM the interest rate of
$1,000,000
bank 12%.
Consider to issue 10% coupon bond with a
Bond $1,500,000 face value of $1,000, price of bond is
$1,115, and 8 years to maturity.
If the risk-free rate is 4%, the expected
Stock $2,000,000 market rate of return is 8%, and the
company’s stock beta is 1.62.

G. Discount rate with WACC and CAPM

1. Buster's target debt-to-equity ratio is .6, its cost of equity is 11.8 percent, and its beta is 1.2.
The after-tax cost of debt is 6.4 percent, the tax rate is 34 percent, and the risk-free rate is 3.2
percent. What discount rate should be assigned to a new project the firm is considering if the
project's beta is estimated at .87?
 8.30%
2. A project has an internal rate of return of 11.76 percent and a beta of 1.22. The market rate of
return is 9.8 percent, the tax rate is 35 percent, and the risk-free rate is 3.4 percent. Should this
project be accepted according to the CAPM if the firm is all-equity financed? Why or why not?
 Yes; The CAPM rate is 11.21 percent
3. The Red Hen currently has a debt-to-equity ratio of .45, its cost of equity is 13.6 percent, and
its beta is 1.49. The pretax cost of debt is 7.8 percent, the tax rate is 35 percent, and the risk-
free rate is 3.1 percent. The firm's target debt-to-equity ratio is .5. What discount rate should
be assigned to a new project the firm is considering if the project is equally as risky as the
overall firm and will be financed solely with debt?
 10.76%
H. Covariance, Beta and CAPM
1. The historical returns data for the past three years for Stock B and the stock market portfolio
are: Stock B: 24%, 0%, 24%, Market Portfolios: 10%, 12%, 20%. Calculate the covariance of
returns between Stock B and the market portfolio.
  24
2. The historical returns data for the past three years for Company A's stock is -6%, 15%, 15%
and that of the market portfolio is 10%, 10% and 16%. Calculate the beta for Stock A.
 1.75
3. The historical returns data for the past three years for Company A's stock is -6.0%, 15%, 15%
and that of the market portfolio is 10%, 10% and 16%. If the risk-free rate of return is 4%,
what is the cost of equity capital (required rate of return of company A's common stock) using
CAPM?
 18%
I. Certainty equivalent cash flow
1. A project has an expected risky cash flow of $500, in year-2. The risk-free rate is 4%, the
market rate of return is 14%, and the project's beta is 1.2. Calculate the certainty equivalent
cash flow for year-2.
 $401.90
2. A project has an expected risky cash flow of $500, in year-3. The risk-free rate is 4%, the
market rate of return is 14%, and the project's beta is 1.2. Calculate the certainty equivalent
cash flow for year-3.

3. A project has an expected risky cash flow of $500, in year-3. The risk-free rate is 5%, the
market risk premium is 8% and the project's beta is 1.25. Calculate the certainty equivalent
cash flow for year-3.