CFA 36: Cost of Capital

Question 1

cost of capital

Answer 1

The rate of return that the suppliers of capital - bondholders and owners - require as compensation for their contribution of capital. It is the opportunity cost of funds for the suppliers of capital.

Question 2

component cost of capital

Answer 2

The rate of return required by suppliers of capital for an invdibidual source of a company’s funding, such as debt or equity.

Question 3

weighted average cost of capital (WACC)

Answer 3

A weighted average of the marginal cost of each of the various sources of capital

Question 4

target capital structure

Answer 4

The capital structure that a company is striving to obtain

Question 5

investment opportunity schedule

Answer 5

A graphical depection of a company’s investment opportunities ordered from highest to lowest expected return. A company’s optimal capital budget is found where the investment opportunity schedule intersects with with the marginal cost of capital.

Question 6

Net Present Value (NPV)

Answer 6

Present value of all the project’s cash flows

Question 7

cost of debt

Answer 7

The cost of debt financing to a company when it issues a bond or takes out a bank loan.

Question 8

yield to maturity (YTM)

Answer 8

Annual return that an investor earns on a bond if the investor purchases the bond today and holds it until maturity. In other words, it is the yield that equates the present value of the bond’s promised payments to its market price.

Question 9

debt-rating apprach (matrix pricing)

Answer 9

When a reliable current market price for a company’s debt is not available, the debt-rating approach can be used to estimate the before-tax cost of debt by using the yield on comparably rated bonds for maturities that closely match that of the company’s existing debt.

Question 10

cost of preferred stock

Answer 10

The cost a company has commited to pay preferred stockholders as a preferred dividend when it issues preferred stock.

Question 11

equity risk premium (ERP)

Answer 11

The expected return on equities minus the risk-free rate; the premium that investors demand for investing in equities.

Question 12

priced risk

Answer 12

Risk for which investors demand compensation for bearing

Question 13

historical equity risk premium approach

Answer 13

A well-established approach based on the assumption that the realized equity risk premium observed over a long period of time is a good indicator of the expected equity risk premium.

Question 14

Dividend Discount Model (DDM)

Answer 14

A present value model that estimates the intrinsic value of an equity share based on the present value of its expected future dividends.

Question 15

survey approach

Answer 15

Finding equity risk premium by asking a panel of finance experts for their estimates and take the mean response.

Question 16

sustainable growth rate

Answer 16

The rate of dividend (and earnings) growth that can be sustained over time for a given level of return on equity, keeping the capital structure constant and without issuing additional common stock.

Question 17

bond yield plus risk premium approach

Answer 17

based on the fundamental tenet in financial theory that the cost of capital of riskier cash flows is higher than that of less risky cash flows.

Question 18

business risk

Answer 18

sales risk and operating risk combined

Question 19

sales risk

Answer 19

uncertainty of revenues

Question 20

operating risk

Answer 20

risk attributed to the company’s operating cost structure

Question 21

financial risk

Answer 21

The uncertainty of net income and net cash flows attributed to the use of financing that has a fixed cost, such as debt and leases. The greater the use of fixed-financing sources of capital, relative to variable sources, the greater the financial risk.

Question 22

pure-play method

Answer 22

Estimating beta for a company by using a comparable publicly traded company’s beta and adjusting it for financial leverage differences.

Question 23

comparable company

Answer 23

A company with similar business risk

Question 24

asset beta

Answer 24

The unlevered beta of a company

Question 25

sovereign yield spread

Answer 25

Estimating the country spread (country risk premium) by calculating the difference between the government bond yield in that country, denominated in teh currency of a developed country, and the Treasury bond yield on a similar maturity bond in the developed country.

Question 26

debt incurrence test

Answer 26

A financial covenant made in conjuction with existing debt that restricts a company’s ability to incur additional debt at the same seniority based on one or more financial tests or conditions.

Question 27

break point

Answer 27

The amount of capital at which the weighted average cost fo capital changes - which means that the cost of one of the sources of captial changes.

Question 28

flotation cost

Answer 28

The fee a company pays to investment banks to raise capital