Ch 14- Cost of Capital Flashcards
What things form the CAPM return?
Market via Beta
Cost of Money
Market again via MRP (market risk premium)
required return = cost of capital = discount rate = CAPITALIZATINO RATE
and this leads into NPV
wHAT ARE THE Methods to determine the cost of equity
1) P0 = D1/re-g
isolate for r
2) SML/CAPM
What are two ways to predict the grwoth rate of dividends
1) look at historical data and tak e asimple average of grwoth rates, use this as next years growth rate
2) g= Retention ratio * ROE (if there is a stable ROE)
disadvantages of CAPM
have to estimate beta and have to estimate market risk premium
Capm cost of equity
Cost of Equity = Risk-Free Rate of Return + Beta * (Market Rate of Return - Risk-Free Rate of Return)
what is the cost of debt
- required return on debt
- we use YTM
- estimates of YTM on new debt if we needed to issue some
how to calculate the average cost of capital for the firm?
use individual costs of capital that you have computed
The goal is to get your cost of capital as low as you can!!!
Equity doesnt involve the interest payments so why doesnt everyone always take equity?
BECAUSE equity paymetns (dividends) are often higher
Capital Structure Weights, notation
E=?
D=?
V=?
E= market value of equity = # outstnading shares ties price per share
D= market value of debt = # outstanding bonds times bond price
V= D+E
Weighted Equity?
We= E/V
Weighted Debt?
Wd= D/V
Debt to equity
D/E= D/E
If you have D/E =0.5, what is We and Wd?
D/E= 0.5/1
V= 1+ 0.5 (D+E)
We= 1/1.5 = 66.67% (E/V)
Wd = 0.5/1.5 = 33.33% (D/V)
The after tax cost of ddebt is
Rd(1-Tc)
because interest is tax deductible
the cost of capital is higher for higher irsk project
the IRR should be greater than our WACC, the required return should be lower than the IRR
Pure Play approach
Subjective approach
if hte project is more risky than the firm, use a disc rate that is greater than WACC
IF THE PROJECT IS LESS RISKY THAN THE FIRM, USE A DISC RATE LESS THAN THE WACC
What does the current disc rate depend on?
riskiness of the market
what is the cost of capital
the minimuum required return or the return u need
or the min return that an investor will aceept taking into account the risk!
What is WACC
the cost of capital for the firm as a whole, andn the reqired return on the overall firm