Tutorial 9 (week 8)
11.2 Why do we assume business and financial risk are unchanged when evaluating the cost of capital? Discuss the implications of these assumptions on the acceptance and financing of new projects.
Holding business risk constant assumes that the acceptance of a given project leaves the firm’s ability to meet its operating expenses unchanged. Holding financial risk constant assumes that the acceptance of a given projects leaves the firm’s ability to meet its required financing expenses unchanged. By doing this it is possible to more easily calculate the firm’s cost of capital, which a factor is taken into consideration in evaluating new projects.
11.4 You have just told, ‘Since we are going to finance this project with debt, its required rate of return must exceed the cost of debt’. Do you agree or disagree? Explain.
In order to make any such financing decision, the overall cost of capital must be considered. This results from the interrelatedness of financing activities. For example, a firm raising funds with debt today may need to use equity the next time, and the cost of equity will be related to the overall capital structure, including debt, of the firm at the time.
11.9 What premise about share value underlies the constant growth valuation (Gordon) model used to measure the cost of equity, rs?
The assumptions underlying the constant growth valuation (Gordon) model are: 1) The value of a share of stock is the present value of all dividends expected to be paid over its life. 2) The rate of growth of dividends and earnings is constant, which means that the firm has a fixed payout ratio. 3) Firms perceived by investors to be equally risky have their expected earnings discounted at the same rate.
11.10 Why is the cost of financing a project with retained earnings less than the cost of using a new issue of ordinary shares?