9- Financing the business and the cost of capital Flashcards
What are the 2 main categories of risk?
- Business (operating) risk
- Financial (gearing) risk
What is business risk?
Sales volatility, ability to generate sufficient revenues
What is financial risk?
Relates to financial leverage and debt financing
What is the beta of a security?
The beta of a security is the expected % change in its return given a 1% change in the return of the market portfolio
How do you find the required rate of return using CAPM?
With the formula:
E(Ri) = rf + ฮฒ[E(Rm)-rf]
What is the formula for after-tax cost of debt financing?
Pretax cost of debt(1-corporate tax rate)
rd(1-Tc)
What is the tax shield?
The cash inflow per annum resulting from the corporation tax relief of debt financing
What is the tax shield formula?
Tax shield = Debt capital (D) x interest rate (ri) x Tax rate (Tc)
What are the 2 ways of evaluating NPV?
- Weighted average cost of capital (WACC)
- Adjusted present value (APV)
What is WACC?
Discount rate which is the weighted average of the cost of the sources of capital
What is APV?
Involves calculating a base case NPV as if the firm is all-equity financed and adding on the present value of the marginal impact of financing the project
What are the 3 key assumptions of WACC?
- The project has average risk
- Debt-equity ratio is constant
- Corporate taxes are the only imperfection
What are the 3 steps of APV
- Determine the investmentโs value without leverage, ๐๐, by discounting its free cash flows at the unlevered cost of capital
- Determine the present value of the interest tax shield
- Add the unlevered value, ๐๐, to the present value of the interest tax shield to determine the value of the investment with leverage
