33.1: Cost of Capital Flashcards
Component cost of capital is?
The rate of return required by suppliers of capital for an individual source of a company’s funding, such as debt or equity.
What is the Weighted average cost of capital WAAC?
A weighted average of the after-tax required rates of return on a company’s common stock, preferred stock, and long-term debt, where the weights are the fraction of each source of financing in the company’s target capital structure.
WAAC Formula is?
WACC = WdRd(1 – t) + WpRp + WeRe,
Where:
· Wd = the target proportion of debt in the capital structure when the company raises new funds;
· Rd = the before-tax marginal cost of debt
· t = the company’s marginal tax rate
· Wp = the target proportion of preferred stock in the capital structure when the company raises new funds
· Rp = the marginal cost of preferred stock we = the target proportion of common stock in the capital structure when the company raises new funds
· Re = the marginal cost of common stock
What is important to remember when calculating WAAC?
To know whether the interest rate is tax deductible.
And what is the frequency of coupon payments?
What is YTM?
An annual return that an investor earns on a bond if the investor purchases the bond today and holds it until maturity. It is the discount rate that equates the present value of the bond’s expected cash flows until maturity with the bond’s price.
How do you calculate YTM?
= [Σ^n t=1 PMTt / ( 1 + Rd/2)^t] + FV / (1 + Rd/2)^n
What is the Matrix Pricing (debt-rating) approach?
Process of estimating the market discount rate and price of a bond based on the quoted or flat prices of more frequently traded comparable bonds.
Cost of debt formula is?
Rd(1 - t) = %
Formula for the Cost of preferred stock is?
Cost of preferred stock = preferred dividend / preferred stock share price
What is CAPM?
The use of the basic relationship from the capital asset pricing model theory that the expected return on a stock, E(Ri), is the sum of the risk-free rate of interest, RF, and a premium for bearing the stock’s market risk, βi(RM − RF).
What is the Bond yield plus risk premium approach (BYPRP)?
An estimate of the cost of common equity that is produced by summing the before-tax cost of debt and a risk premium that captures the additional yield on a company’s stock relative to its bonds.
CAPM (Beta or market risk) formula is?
Cost of Equity = Rf + β(Rm - Rf)
Where:
→ Rf = risk-free rate
→ β = beta;
→ Rm = market return
→ Rm - Rf = equity risk premium ERP
The Bond yield plus risk premium approach (BYPRP) formula is?
Re = Rd + Risk premium
What is beta?
Beta is an estimate of the company’s systematic or market-related risk.
The most commonly used adjustment is?
Adjusted beta = (2/3)(Unadjusted beta) + (1/3)(1.0)
What is the asset beta?
It is the unlevered beta, which reflects the business risk of the assets; the asset’s systematic risk.
Formula for the unlevered beta is?
βU = βE [ 1 / 1+(1-t) * D/E ]
Where:
- βE be the equity beta of the peer company before removing the effects of leverage
- βD is the debt’s beta
- t is the marginal tax rate of the peer company
D and E are the market values of debt and equity, respectively, of the peer company.
Formula for the levered beta is?
βE = βU [ 1+(1-t) * D/E ]
Where:
- βE is now the equity beta of the thinly traded or nonpublic company,
- t is the marginal tax rate of the thinly traded or nonpublic company,
- D and E are the debt-to-equity values, respectively, of the thinly traded or nonpublic company.
What are the flotation costs? Investment banker fees..
For raising new capital (incl. other costs).
Flotation costs formula is? (The cost of external equity)
Re = (D1 / P0 − F) + g
Where:
- re is the cost of equity
- D1 is the dividend expected at the end of Period 1
- D0 - current dividend
- P0 is the current stock price
- F is the monetary per share flotation cost
- g is the growth rate
Flotation costs formula as a percentage applied against the price per share, the cost of external equity is?
Re = [D1 / P0(1 −f )] + g
Important points to keep in mind when calculating flotation costs:
· Pay attention whether it is D0 or D1, if D0, then D0 * (1 + g) = D1
· Also, consider whether the stock is issued or not and if it’s internal or external capital raising.
