Cost of Capital
What does WACC stand for and what does it represent?
Weighted Average Cost of Capital; the firm’s average required return across debt and equity financing
What is an incremental cash flow?
The difference between the firm’s future cash flows with and without the project.
What’s the main limitation of using standard deviation as a measure of risk?
It penalizes upside and downside volatility equally, even though investors only dislike losses.
What is the common claim about sustainability and cost of capital?
That sustainable firms can raise capital more cheaply because they are less risky.
Why is the after-tax cost of debt used in WACC calculations?
Because interest is tax deductible, reducing the effective cost of borrowing.
Why are sunk costs ignored in project analysis?
Because they are past costs that cannot be recovered and don’t change with the decision
What does “semideviation” measure?
The volatility of returns that fall below a benchmark (e.g., the mean or 0%)
What two value channels does Edmans identify for sustainability?
The cash-flow channel (improving future cash flows) and the cost-of-capital channel (lower required return).
If a company’s capital structure becomes more leveraged, what typically happens to its cost of equity and WACC?
Cost of equity rises (higher financial risk), while WACC may initially fall due to tax shields but eventually increases as bankruptcy risk grows
How does sensitivity analysis differ from scenario analysis?
Sensitivity changes one variable at a time; scenario changes several together to form best, base, and worst cases
How does using semideviation instead of standard deviation affect portfolio rankings?
It can reverse rankings by highlighting assets with high upside but limited downside
Why does Edmans argue that not all sustainability benefits reduce the cost of capital?
Because most sustainability effects are firm-specific (idiosyncratic) and thus don’t affect systematic risk priced by investors.
Why should a firm not use the same WACC for all projects, regardless of risk?
Because using the same rate overvalues risky projects and undervalues safe ones
What is the main advantage of Monte Carlo simulation over simple sensitivity analysis?
It tests thousands of possible outcomes using probability distributions, producing a full risk profile for NPV rather than single-variable shifts.
What does a downside beta of 2.0 imply?
When the market falls below its benchmark by 1%, the stock typically falls 2%, meaning it amplifies losses in down markets.
What is the “preference channel” and when does it lower cost of capital?
When ESG investors accept lower returns, increasing demand for sustainable firms; it matters only if non-ESG investors can’t fully offset that preference.
How should a company estimate the correct discount rate for a project whose risk is different from the firm’s average?
Use a project-specific WACC that reflects the project’s own risk, not the company’s overall WACC.
Find comparable firms (“pure plays”) in the same business.
Estimate their asset beta, adjust for your project’s capital structure to get a project beta, and use CAPM to find the project’s cost of equity.
Combine it with the project’s after-tax cost of debt to calculate the project’s WACC.
Apply this rate instead of the corporate WACC when evaluating NPV.
Explain how inflation, taxes, and opportunity costs should be treated when estimating project cash flows
Cash flows must be nominal if WACC is nominal; taxes and depreciation are included to reflect after-tax cash flows; and opportunity costs (like using an owned asset) are subtracted since they represent foregone benefits.
Explain why using downside beta or semideviation can lead to higher estimated required returns than CAPM.
Because these measures capture asymmetrical, loss-related risk, which investors demand higher compensation for
How could you empirically test whether ESG reduces cost of capital through cash-flow or discount-rate effects?
By decomposing valuation changes into cash-flow news vs discount-rate news using event studies or return decomposition models; if prices rise without earnings changes, discount rates likely fell.