Cost of capital

Cost of capital

1. 1. A firm's bonds yield 6.0% YTM. Tax rate is 25%. What is the after-tax cost of debt? Answer as a percent.

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2. 2. Why should you NOT use a legacy bond's coupon rate as the firm's cost of debt today?

   Coupon rates are tax-exemptThe coupon reflects credit conditions when the bond was issued; today's market YTM reflects what new debt would actually costCoupons compound differentlyCoupons are quoted in different currency

3. 3. A consumer-staples firm (low WACC) is starting a biotech R&D division. What discount rate should it use to evaluate the biotech project?

   The firm's WACC, because that's the firm's cost of capitalA higher project-specific rate reflecting biotech's actual risk; use unlevered beta of pure-play biotech comparables, re-levered at the project's planned capital structureThe Treasury yield, because R&D is exploratoryWhatever rate makes the project look positive NPV

4. 4. Estimating beta for a PRIVATE firm without public comparables would typically follow which steps?

   Find 5-10 publicly traded comparable firmsUnlever each comparable's beta to isolate business risk from financial structureUse the firm's own stock-price history (which doesn't exist)Average the unlevered betas, then re-lever at the target's capital structure

5. 5. A firm is financed 60% equity, 40% debt. Cost of equity is 12%, pre-tax cost of debt is 8%, tax rate 25%. What is the WACC, in percent? (r_wacc = (E/V)r_E + (D/V)r_D(1−t).)

   %