C4 A1 & 2 1.1. If you are trying to value a new project for your company, your f

Question

C4 A1 & 2

1.1.

If you are trying to value a new project for your company, your firm’s cost of capital could be used to figure out the present value of your cash flows.

No

Depends on the nature of the new project

Yes

1.2.

The reason we often have to choose comparables to value companies/projects is because all valuation is relative.

True

Partly true, partly false

False

1.3.

Once you have identified an appropriate set of comparables, you only need to un-lever the average cost of equity of the comparables to figure out your own company's cost of capital.

Depends on your own planned capital structure

True

False

1.4.

Even if interest on debt is not tax deductible, firms will tend to take on debt because the cost of debt is always cheaper than the cost of equity.

True

False

1.5.

There is fundamental difference between the value created by the real assets of a firm (that is, from the products and services created) and value provided by the fact that interest payments on debt are tax deductible.

True

False

2.1.

Identifying the right comparable firms is a critical step in figuring out the value of a new idea or even an existing firm?

It depends on the purpose of the valuation

True

False

2.2.

The cost of capital to be used in valuing a company in most cases is affected by the capital structures of the comparable firms.

Partly true, partly false

True

False

2.3.

Once you have identified an appropriate set of comparables, you only need to estimate the average cost of equity of the comparables to figure out the value of the firm you are analyzing.

False

True

2.4.

Given that the interest payments on debt are tax deductible, firms have an incentive to borrow.

True

False

2.5.

Taking on a lot of debt will increase the cost of debt because the debt will face higher chances of default. In leveraged buyouts (where debt can be close to 90% of the value of the firm) private equity firms (who have equity investments in such deals) insist on a quick payoff of debt because the return on equity is lower than the cost of debt.

False

Partly true, partly false

True

Explanation / Answer

1.1) For every new project, one needs to look at the risk of project which in turn will determine the cost of capital for that particular project, Higher risk projects require higher costs of capital and consequently lower risk projects require lower costs of capital. Cost of Capital for the company will be equal to that of the new project only if the risks for both is equal.

Therefore, the answer is 'Depends on the nature of the project".

1.2) The answer is partly true and partly false because relative valuation is only used when reliable free cash flow data of the firm is unavailable (making valuation techniques such as DCF, APV and CCF useless). Even if free cash flow data is present, it is extremely difficult to calculate a firm's terminal value using perpetual free cash flows and hence most Terminal Values are calculated using relative valuation. Consequently, the firm's valuation becomes a combination of DCF and relative valuation.

1.3) The answer is 'Depends on your planned capital structure' because unlevered equity beta (also known as asset beta) for the firm under consideration has to be re-levered using the Debt to Equity Ratio for which the firm's capital structure has to be known. Once, the levered firm equity beta is known it can be used to calculate the firm's WACC or Cost of Capital.

1.4) The short answer is True because the cost of debt is indeed lesser than the cost of equity. The inclusion of debt in the capital structure reduces the Cost of Capital even without the tax shields. However, too much debt might lead to increased financial risk, which in turn might increase the cost of debt and the overall cost of capital.

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