CFA 36: Cost of Capital Flashcards
cost of capital
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.
component cost of capital
The rate of return required by suppliers of capital for an invdibidual source of a company’s funding, such as debt or equity.
weighted average cost of capital (WACC)
A weighted average of the marginal cost of each of the various sources of capital
target capital structure
The capital structure that a company is striving to obtain
investment opportunity schedule
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.
Net Present Value (NPV)
Present value of all the project’s cash flows
cost of debt
The cost of debt financing to a company when it issues a bond or takes out a bank loan.
yield to maturity (YTM)
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.
debt-rating apprach (matrix pricing)
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.
cost of preferred stock
The cost a company has commited to pay preferred stockholders as a preferred dividend when it issues preferred stock.
equity risk premium (ERP)
The expected return on equities minus the risk-free rate; the premium that investors demand for investing in equities.
priced risk
Risk for which investors demand compensation for bearing
historical equity risk premium approach
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.
Dividend Discount Model (DDM)
A present value model that estimates the intrinsic value of an equity share based on the present value of its expected future dividends.
survey approach
Finding equity risk premium by asking a panel of finance experts for their estimates and take the mean response.
sustainable growth rate
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.
bond yield plus risk premium approach
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.
business risk
sales risk and operating risk combined
sales risk
uncertainty of revenues
operating risk
risk attributed to the company’s operating cost structure
financial risk
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.
pure-play method
Estimating beta for a company by using a comparable publicly traded company’s beta and adjusting it for financial leverage differences.
comparable company
A company with similar business risk
asset beta
The unlevered beta of a company
sovereign yield spread
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.
debt incurrence test
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.
break point
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.
flotation cost
The fee a company pays to investment banks to raise capital
