Corporate Finance Flashcards

The weighted average cost of capital (WACC) is primarily used to:

Answer: Discount project cash flows to determine whether they create shareholder value

WACC represents the blended cost of all financing sources and serves as the discount rate (hurdle rate) for evaluating capital investment projects.

The cost of retained earnings is best estimated using:

Answer: The Capital Asset Pricing Model (CAPM) using the stock's beta

The CAPM estimates the required return on equity as the risk-free rate plus beta multiplied by the market risk premium, representing the opportunity cost of retained earnings.

Why is the cost of debt adjusted for taxes when calculating WACC?

Answer: Interest expense is tax-deductible, reducing the net cost to the firm

Because interest payments are tax-deductible, the after-tax cost of debt equals the pre-tax rate multiplied by (1 minus the tax rate).

A firm has 40% debt at a 6% pre-tax cost (tax rate 25%) and 60% equity at a 12% cost. What is the WACC?

Answer: 9.0%

WACC = (0.40 × 6% × 0.75) + (0.60 × 12%) = 1.8% + 7.2% = 9.0%.

In the CAPM, beta represents:

Answer: The stock's systematic risk relative to the overall market

Beta measures a stock's sensitivity to broad market movements, capturing only the non-diversifiable systematic risk priced by the market.

The marginal cost of capital (MCC) increases as a firm raises progressively more capital because:

Answer: Lower-cost financing sources are exhausted first, forcing the firm to use more expensive capital

A firm accesses its cheapest financing first; as total capital raised grows, it must tap progressively more expensive sources, raising the marginal cost.