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
if someone says “Required return on project is 10%” what does this mean
the investment has NPV as positive only if return is > 10%
BASICALLY, the firm MUST earn 10% on investment so investors can get their cut, and then after wards they will be earning money
THIS IS WHY 10% IS THE COST OF CAPITAL
wHAT IS THE cost of capital fo ra risk free investment?
the risk free rate
WHERE does the cost of capital come from **
FROM THE USE OF THE FUNDS, NOT THE SOURCE!!!!
the use of the funds refers to risk associated w investment (this is why the cost of capital is tied to the risk of the project!!)
PEOPLE THINK IT DEPENDS ON IF THE CAPITAL IS DEBT OR EQUITY -> NOT THE CASE
WHERE does the cost of capital come from **
FROM THE USE OF THE FUNDS, NOT THE SOURCE!!!!
the use of the funds refers to risk associated w investment (this is why the cost of capital is tied to the risk of the project!!)
PEOPLE THINK IT DEPENDS ON IF THE CAPITAL IS DEBT OR EQUITY -> NOT THE CASE
WHERE does the cost of capital come from **
FROM THE USE OF THE FUNDS, NOT THE SOURCE!!!!
the use of the funds refers to risk associated w investment (this is why the cost of capital is tied to the risk of the project!!)
PEOPLE THINK IT DEPENDS ON IF THE CAPITAL IS DEBT OR EQUITY -> NOT THE CASE
WHERE does the cost of capital come from **
FROM THE USE OF THE FUNDS, NOT THE SOURCE!!!!
the use of the funds refers to risk associated w investment (this is why the cost of capital is tied to the risk of the project!!)
PEOPLE THINK IT DEPENDS ON IF THE CAPITAL IS DEBT OR EQUITY -> NOT THE CASE
Does the cost of capital reflect the mixture of debt and equity?
YES! both costs are taking into account
Why is it hard to determine the cost of equity?
can really observe what the required return is for investors holding equity! must estimate
Two methods to determingin the cost of equity
- dgm
- sml
How to use the DGM to get the cost of capital
isolte and solve for Re (Return on equity)
In DGM if you are missing g, how do u solve for it?
- volatile market
-non volatile market
-alt: earning retention
volatile: get year over year growth rates then average them
non volatile: get the compound growthr ate
Begin val (1+g)^n = end val
rearning retention -
g = (Retained earnings this year/ Earnings this year) * Return on Retained Earnings
or
g= Retenetion Ratio * ROE
PROS AND CONS OF DGM APPROACH
- applies mostly to companies that have dividends
- con: very senstive to the change in growth rate
- con: does not adjust for risk or uncertainty in growth rate of divs (Cant say that est return is proporitonal to level of risk)
SML approach pros and cons
adjusts explictyly for irsk,
- applys to the companies with steady div growth
-con: it needs the MRP to be estimated and beta to be estimated
-con: ur using the past to predict the future, and things change
How to calc the firms cost of debt
the cpst os the interest rate the firm must pay on new borrowing
!!! THE COUPON RATE ON THE COST OF DEBT IS IRRELEVANT!!!! it tells us the cost of debt back when bonds were issued, thats why you look at YIELD!!!!
TWO Types of debt firms can have
debt or preferred stock
Cost of preferred stock
Rp = D/Po because dividend is fixed forevr
What does E mean in terms of WACC
the market val of a firms equity
(# shares otustanding x price per share)
How do you calc the val of long term debt
- How do you calculate the debt from mulitple bond issues
multiply the market price of a single bond by the number of bonds outstanding
- multiply the market price of all bonds by the number of bonds outstanding!
V = E+ D
100% = E/V + D/V
This is the market val of debt and equity
THis is the percents of the total cap represnted by the debt and equity
the interest paid by a
corporation is deductible for tax purposes. Payments to shareholders, such as dividends, are no
BASICALLY govt helps pay some of the interest! provided firm has net income not net loss
WACC
avg cost of capital, takes into accoaunt costo f equity , debt, weights of debt and equity (E/V) AND (D/V) and tax rate (1-T)
important notes baout the WACC
The firms WACC is the appropraite disc rate only if the propose invesment has the same risk as the firm deoes!!!! IF A PROJECT IS INTEGRAL TO AFIRM THEN USE WACC,
How can you use WACC to determine the NPV?
NPV = -Inv + PVIFA (where c= yearly cash flow, r= WACC, n= years)
perofmrance evaluation- another use of WACC
(EVA) (also called economic value contribution (EVC)) method
EVA as a means of evaluating corporate performance. I
Although the details differ, the basic idea behind EVA and similar strategies is straightforward. Suppose we
have $100 million in capital (debt and equity) tied up in our firm and our overall WACC is 12%. If we
multiply these together, we get $12 million. Referring back to Chapter 2, if our cash flow from assets is
less than this, we are, on an overall basis, destroying value. If cash flow from assets exceeds $12 million, we
are creating value. In practice, strategies such as these suffer to a certain extent from problems with
implementation. For example, it appears that the Corporate Renaissance Group makes extensive use of
book values for debt and equity in computing cost of capital. Evidence is mixed on the track record of EVA
in identifying undervalued securities. Even so, by focusing on value creation, WACC-based evaluation
procedures force employees and management to pay attention to the real bottom line: increasing share
prices.
WHAT IS WACC ESSENTIALLY
A discount rate
When can using WACC lead to poor decisions?
WHen you are evaluating investments with risk SIGNIFICANTLY different from the overall firm
What is the divisonal cost of capital
if a corp has more than two divisions, cost of capital can be diffeernt for for both lines
RISKIER DIVISON HAS MORE RETURNS (ignore the greater risk)
The pure play approach
the subjective appracoh
how do you account for risk in wacc
the divisonal cost of capital, pure play approach, subjective approach
Can you vlaue a company with WACC?
- Adjust Taxes to EBIT*Tc
- Calc Cash flow from assets:
CFA=EBIT(1-Tc) + Dep - Change in NWC- Cap spend - if the firm is growing you can value it with this (V0 is val of firm today)
V0 = CFA/(WACC -g)
valuing a firm is like valuing a project, but adjust taxes to remove the effect of debt finanicng
Can you consider the impact of non constant growth for a firm to value the firm with vWACC?
YES do steps 1 & 2, then
Vt= CFAt+1/(WACC-g)
notice Vt is value at time in future or “tERMINAL VALUE”
WWHAT DOES THE WEIGHTED AVG float cost tell us
for every dollar in outside financing needed for new project the firm must actually raide (1/(1-float cost)
