Question

1. Which components are cheapest, and which is most expensive and where the cost of capital would fit into the mix?
   • How to compute a portfolio’s beta?
   • What is the difference between independent and mutually exclusive projects?

Answer 1

a.  Various types of cost of capital are described below:

i. Explicit Cost of Capital

ii. Implicit Cost of Capital

iii. Specific Cost of Capital

iv. Weighted Average Cost of Capital

v. Marginal Cost of Capital

As the cost of debt is finite and the company will not have any further obligations to the lender once the loan is fully repaid, generally debt is cheaper than equity for companies that are profitable and expected to perform well

b. What Is Beta? A stock that swings more than the market over time has a beta greater than 1.0. If a stock moves less than the market, the stock's beta is less than 1.0. High-beta stocks tend to be riskier but provide the potential for higher returns; low-beta stocks pose less risk but typically yield lower returns.

How to Calculate Beta

To calculate the beta of a security, the covariance between the return of the security and the return of the market must be known, as well as the variance of the market returns.

Beta =covariance/variance

Covariance=Measure of a stock’s return relative to that of the market

Variance=Measure of how the market moves relative to its mean ​

Beta Examples

Beta could be calculated by first dividing the security's standard deviation of returns by the benchmark's standard deviation of returns. The resulting value is multiplied by the correlation of the security's returns and the benchmark's returns.

c.  What is mutually exclusive Projects? A set of projects from which at most one will be accepted is termed as Mutually Exclusive Projects. In mutually exclusive projects, cash flows of one project can be adversely affected by the acceptance of the other project. In mutually exclusive projects, all projects are to accomplish the same task. Therefore, such projects cannot be undertaken simultaneously. Hence, while choosing among Mutually Exclusive Projects, more than one project may satisfy the Capital Budgeting criterion. However, only one project can be accepted.

independent v/s mutually exclusive projects

An example of mutually exclusive projects would be the option of a manufacturer to (a) expand its existing plant or (b) build a new one on a separate site in order to increase production capacity. The project that offers the higher NPV and IRR would be picked. Since a firm usually has limited financial resources with substantial opportunity cost, it is not feasible to do both. Hence, these projects are considered mutually exclusive. Independent projects are ones being evaluated that could potentially all be selected as long as their projected CFs will produce a positive NPV or generate an IRR greater than the firm's hurdle rate. (e.g. a real estate investment co. looking to buy income producing properties)

With Independent projects, they are evaluated as if you can invest in both projects. Therefore, a project with a positive NPV will also have an IRR higher than the cost of capital. The decision rule for independent projects is the same regardless of the method used to evaluate profitability. For Mutually exclusive projects, you can't take on both projects, you have to chose. When deciding to pick between the projects, the NPV and IRR decision rules (assuming all are profitable) can be in conflict because of time horizon and cash flow differences between the two projects. For example, a short project might have IRR=7% and NPV=10,000 and a long project might have IRR=6% and NPV=20,000. The decision between these projects may be complicated based on the circumstances in which the firm finds itself, but as a general rule, you should pick the project with the higher NPV thereby maximizing firm value.