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Chapter: Chapter 13: Estimating the Cost of Capital

Multiple Choice

1. A firm has a target debt-to-equity ratio of 1. Its cost of equity equals 12 percent, the cost of
debt is 8 percent, and the tax rate is 30 percent. What is the weighted average cost of capital
(WACC)?
a) 10.0 percent.
b) 10.8 percent.
c) 9.8 percent.
d) 8.8 percent.

Ans: [d]
Response: [D/E = 1.0 => D/(D + E) = E/(D + E) = 0.50
WACC = {0.5 * 8% * (1 – 0.3)} + (0.5 * 12%) = 8.8%]

2. A firm has a target debt-to-equity ratio of 3. Its cost of equity equals 12 percent, its cost of
debt is 9 percent, and the tax rate is 34 percent. What is the WACC?
a) 7.46 percent.
b) 8.97 percent.
d) 10.00 percent.
d) 10.49 percent.

Ans: [a]
Response: [Wd = 3/(3 + 1) = 0.75, We = 1 – 0.75 = 0.25, and WACC = 0.75 × 0.09 × (1 – 0.34) +
0.25 × 0.12 = 0.0746 or 7.46%]

3. A firm has 1,200,000 shares of stock outstanding with a price per share equal to $14. There
are 10,000 bonds outstanding, priced at $1,125 each. The cost of equity is 14 percent, the cost
of debt is 8 percent, and the corporate tax rate is 40 percent. What is the WACC?
a) 10.3 percent.
b) 10.8 percent.
c) 9.8 percent.
d) 8.8 percent.

Ans: [a]

McKinsey/Valuation 85
Response: [V = (1,200,000 * $14) + (10,000 * $1,125) = $28,050,000
The weights are:
E/V = 16,800,000/28,050,000 = 0.60
D/V = 11,250,000/28,050,000 = 0.40
WACC = {0.40 * 8% * (1 – 0.40)} + (0.60 * 14%) = 10.31%]

4. A firm has 4,000,000 shares of stock outstanding with a price per share equal to $22. There
are 200,000 bonds outstanding each priced at $995 each. The cost of equity is 14 percent, the
cost of debt is 8 percent, and the corporate tax rate is 34 percent. What is the WACC?
a) 10.3 percent.
b) 9.8 percent.
c) 8.0 percent.
d) 8.8 percent.

Ans: [c]
Response: [

]
True/False

5. An analyst should use the pretax cost of equity and the pretax cost of debt to estimate the
cost of capital.

Ans: [False]
Response: [Since free cash flows are measured without interest tax shields, the after-tax cost of
debt is used to incorporate the tax shield into the WACC.]

6. The cost of capital must include the cost of capital for all investors—debt, preferred stock,
and common stock.

Ans: [True]

McKinsey/Valuation 86
Response: [Since free cash flow is available to all investors, it must include the cost of capital for
all investors.]

Short Answer

7. Briefly explain the two methods of estimating market returns.

Ans: [The first method looks backward using historical market returns. But given that past
market returns are heavily influenced by the rate of inflation prevalent at the time, a simple
average of past returns isn’t helpful. Instead, add a historical market risk premium to today’s
interest rate, which incorporates today’s expected inflation.
A second method calculates the cost of equity implied by the relationship between current
share prices and aggregate fundamental performance (earnings, return on invested capital
[ROIC], and growth expectations). By valuing a large sample of companies like the Standard &
Poor’s (S&P) 500 index using discounted cash flow, one can reverse engineer the embedded
cost of equity. Although the method requires a forecast of future performance, it is quite
powerful, since it incorporates up-to-date market prices.]

True/False

8. One should create a synthetic risk-free rate by adding the expected inflation rate to the long-
term historical average real risk-free rate for the period following the financial crisis.

Ans: [True]
Response: [In the aftermath of the financial crisis of 2008, the U.S. Federal Reserve and several
other central banks throughout the world lowered interest rates to historically low levels and
simultaneously bought trillions of dollars of government bonds. Together, these actions pushed
yields on government bonds to near zero. This poses a challenge in estimating the firm's cost of
equity, as these yields are typically used as an estimate of the (nominal) risk-free rate. One can
create a synthetic risk-free rate to address this by adding the expected inflation rate to the
long-term historical average real risk-free rate.]

Short Answer

McKinsey/Valuation 87
9. What challenges did the financial crisis of 2008 and its aftermath pose for estimating a firm’s
cost of capital? How should one handle these challenges?

Ans: [An important component of the cost of equity, and, thus, the cost of capital is the risk-
free rate. In the aftermath of the financial crisis of 2008, the U.S. Federal Reserve and several
other central banks throughout the world lowered interest rates to historically low levels and
simultaneously bought trillions of dollars of government bonds. Together, these actions pushed
yields on government bonds to near zero. This poses a challenge in estimating the firm's cost of
equity, as these yields are typically used as an estimate of the (nominal) risk-free rate. One can
create a synthetic risk-free rate to address this by adding the expected inflation rate to the
long-term historical average real risk-free rate. This synthetic risk-free rate will create more
plausible estimates for the cost of equity and cost of capital.]

Multiple Choice

10. To estimate the risk-free rate in developed economies, the analyst should use:
a) Short-term commercial paper.
b) Short-term government discount instruments.
c) Long-term coupon-paying government bonds.
d) Long-term government zero-coupon bonds.

Ans: [d]
Response: [Long-term government zero-coupon bonds best match the horizon of cash flow
estimates used in valuing firms.]

True/False

11. Theoretically, one should discount each year’s cash flow at a cost of equity that matches the
maturity of the cash flow. However, for practical purposes, analysts typically choose a single
yield to maturity that best matches the cash flow stream being valued.

Ans: [True]
Response: [In choosing the bond’s duration, the most theoretically sound approach is to
discount each year’s cash flow at a cost of equity that matches the maturity of the cash flow. In
other words, year 1 cash flows would be discounted at a cost of equity based on a one-year

McKinsey/Valuation 88
risk-free rate, while year 10 cash flows would be discounted at a cost of equity based on a 10-
year discount rate. To do this, one should use zero-coupon bonds (known as STRIPS) rather
than Treasury bonds that make interim payments. The interim payments cause their effective
maturity to be much shorter than their stated maturity.
However, using multiple discount rates is quite cumbersome. Therefore, few practitioners
discount each cash flow using its matched bond maturity. Instead, most choose a single yield to
maturity that best matches the cash flow stream being valued.]

Multiple Choice

12. Which of the following is/are FALSE regarding risk-free rates?

I) The 30-year Treasury bonds match the cash flow streams of a company better, and therefore
should be used over 10-year bonds in estimating the risk-free rate.
II) One should use government bond yields denominated in the same currency as the
company’s cash flow to estimate the risk-free rate.
III) One should ensure that the inflation rate embedded in the cash flows is consistent with the
inflation rate embedded in the government bond rate being used.
a) I only.
b) II only.
c) III only.
d) I and III only.

Ans: [a]
Response: []

13. Suppose that the median price‐to‐earnings ratio for the S&P 500 is 20. If the long‐run return
on equity is 11.5 percent and the long‐run growth in gross domestic product (GDP) is expected
to be 6 percent (3.5 percent real growth and 2.5 percent inflation), what is the cost of equity
implied by the equity-denominated key value driver formula?
a) 7.9 percent.
b) 8.4 percent.
c) 8.9 percent.
d) 9.4 percent.

Ans: [b]
𝒈
Earnings ∗ (1− ) Earnings 𝒈 𝟏 0.𝟎𝟔
ROE
Response: [𝑘𝒆 = +𝑔= ∗ (1 − ) + 𝑔 = (20) ∗ (1 − )+
Price Price ROE .115
0.06 = 8.4%]

McKinsey/Valuation 89
True/False

14. Researchers have concluded that an appropriate range of the equity risk premium for use in
valuation models should be 10 to 12 percent.

Ans: [False]
Response: [Different forms of measurement converge on an appropriate range of market risk
premium of 4.5 to 5.5 percent, which has held even during the financial crisis of 2008.]

Multiple Choice

15. Which of the following is NOT an input into the Fama-French three-factor model?
a) The difference between low book-to-market returns and high book-to-market returns.
b) The difference between growth stock returns and value stock returns.
c) The market portfolio returns.
d) The difference between small-cap returns and large-cap returns.

Answer: [b]
Response: []

True/False

16. Since the factors and their measurement for use in the arbitrage pricing theory (APT) model
have become fairly standardized, the APT model is becoming a more popular alternative to the
CAPM in estimating the market risk premium.

Answer: [False]
Response: [In practice, implementation of the model has been tricky, as there is little
agreement about how many factors there are, what the factors represent, or how to measure
the factors. For this reason, use of the APT resides primarily in the classroom.]

McKinsey/Valuation 90
Multiple Choice

17. In computing the cost of equity for a firm, which of the following are recommended steps in
estimating the CAPM beta using regression analysis?
I. Use a sample size equal to or greater than 60.
II. Use daily returns.
III. Use a diversified value-weighted index.
IV. Watch for possible distortions from market bubbles.
a) I, II, and III only.
b) I, III, and IV only.
c) II and IV only.
d) II, III, and IV only.

Ans: [b]
Response: []

18. Which of the following are true concerning the index recommended for use in the CAPM?
I. It should include both traded and untraded investments.
II. The S&P 500 is the most common proxy for U.S. stocks.
III. The S&P 500 and the MSCI World index will produce very different results for U.S. stocks.
IV. For less developed countries, a local market index is recommended.
a) I and II.
b) I and IV.
c) II and III.
d) III and IV.

Ans: [a]
Response: []

19. Which of the following is NOT true concerning the index recommended for use in the
CAPM?
a) It should include both traded and untraded investments.
b) The S&P 500 is the most common proxy for U.S. stocks.
c) The S&P 500 and the MSCI World index will produce fairly similar results for U.S. stocks.
d) For less developed countries, a local market index is recommended.

McKinsey/Valuation 91
Ans: [d]
Response: []

20. Bloomberg’s recommended adjustment to a firm’s beta will:

a) Lower beta in all cases.
b) Increase beta in all cases.
c) Move the beta toward 1.
d) Either increase or decrease beta, but it depends on the size of the standard error of the
estimated beta.

Ans: [c]
Response: []

True/False

21. To estimate a company’s beta, using an industry-derived unlevered beta relevered to the
company’s target capital structure is preferred to directly estimating a company-specific beta.

Ans: [True]
Response: []

Multiple Choice

22. An analyst gathers the following information for Firm A and Firm B. Using the information to
compute the industry unlevered beta, what is the appropriate beta for each company for use in
the WACC? (Assume that the debt beta for each firm equals zero.)
Firm A: CAPM beta = 0.9; debt-to-equity ratio = 0.4
Firm B: CAPM beta = 1.2; debt-to-equity ratio = 2
a) 0.73; 1.56
b) 0.90; 1.20
c) 0.52; 0.52
d) 1.12; 1.65

Ans: [a]

McKinsey/Valuation 92
Response: [Unlevered beta for Firm A = 0.9/1.4 = 0.64
Unlevered beta for Firm B = 1.2/3.0 = 0.40
Industry beta = 0.52 = (0.64 + 0.40)/2
Equity beta for Firm A = 0.52 * 1.4 = 0.73
Equity beta for Firm B = 0.52 * 3 = 1.56]

23. An analyst gathers the following information for Firm A and Firm B. Use the information to
compute the industry unlevered beta and the appropriate beta for Firm B to use in the WACC.
Firm A: CAPM beta = 1.6; debt-to-equity ratio = 1.2
Firm B: CAPM beta = 1.0; debt-to-equity ratio = 0.8
The appropriate beta for Firm B is closest to:
a) 1.026
b) 1.154
c) 1.170
d) 1.163

Ans: [b]

Response: [

24. Which of the following practices are appropriate in estimating a firm’s cost of debt?
I. Use the coupon rate on outstanding debt that is investment grade.
II. Use the yield to maturity on outstanding debt that is investment grade.
III. Use the yield to maturity on outstanding debt that is below investment grade.
IV. Use the adjusted present value (APV) method to value firms that have debt that is below
investment grade.
a) I and IV only.
b) III and IV only.
c) II and III only.
d) II and IV only.

McKinsey/Valuation 93
Ans: [d]
Response: []

25. Which of the following most accurately describes the types of companies where the yield to
maturity on outstanding bonds is an appropriate proxy for the cost of debt?
a) All companies with outstanding bonds.
b) Only companies whose bonds are rated investment grade.
c) All companies whose bonds are rated investment grade or below investment grade but not in
default.
d) The yield to maturity is not an appropriate proxy for the cost of debt for any company
because of the reinvestment rate assumption.

Ans: [b]
Response: []

True/False

26. Yield to maturity should be calculated on liquid, option-free, short-term debt.

Ans: [False]
Response: [Yield to maturity should be calculated on liquid, option-free, long-term debt.]

27. While estimating the cost of debt for a firm, one should always use market prices for
publicly traded debt.

Ans: [False]
Response: [For companies with only short-term bonds or bonds that rarely trade, market prices
should not be used. Instead, credit ratings should be used to determine yield to maturity.]

28. You are analyzing a distressed bond with one year to maturity. If the probability of default
rises for this bond, the yield to maturity will likely increase, while the cost of debt will likely
decrease.

McKinsey/Valuation 94
Ans: [False]
Response: [Both the yield to maturity and the cost of debt will likely increase.]

Multiple Choice

29. The weights to use in the WACC should reflect the:

a) Current book values.
b) Current market values.
c) Target-market-based values.
d) Book values in the case of bonds and market values in the case of equity.

Ans: [c]
Response: []

True/False

30. If an observable market value is not readily available, book value of debt can be used to
calculate capital structure.

Ans: [True]
Response: [If an observable market value is not readily available, debt securities can be valued
at book value (referred to as carrying value), or discounted cash flow can be used.]

31. If interest rates have changed since the company’s last valuation or if the company has
entered into financial distress, book value is a reasonable approximation of market value.

Ans: [False]
Response: [In these two situations, the current price will differ from carrying value because
either expected cash flows have changed or the discount rate has changed from its last
valuation. In these situations, each bond should be valued separately by discounting promised
cash flows at the appropriate yield to maturity.]

McKinsey/Valuation 95
Multiple Choice

32. Which of the following is NOT a property necessary for a consistent estimate of the WACC?
a) It uses book-value-based weights.
b) It includes the opportunity cost of all investors.
c) It includes related costs/benefits such as the interest tax shield.
d) The duration of the securities used in estimating the WACC equals the duration of the free
cash flows.

Ans: [a]
Response: []

McKinsey/Valuation 96