ch.9 Flashcards
cost of capital used in capital budgeting is a
weighted average of the types of capital the firm uses - typically debt, preferred stock, and common equity.
component cost of debt
is the after-tax cost of new debt. To find: multply the interest rate paid on new debt by (1-T) where T=firm’s marginal tax rate
debt flotation cost adjustment
incurred when using investment bankers. Reduce the bond’s issue price by the flotation expenses, reduce the bond’s cash flows to reflect taxes, and then solve for the after-tax yield to maturity.
component cost of preferred stock
calculated as (Pref. Div)/(Net Price after flotation costs).
flotation costs on preferred stock
are usually fairly high, its necessary to include with compoenent cost of pref. stock. IF the preferred stock is convertible into common stock, then the true cost of the preferred stock will EXCEED the flotation-adjusted yield of the preferred dividend
cost of common equity
aka cost of common stock. Is the rate of return required by the firm’s stockholders, can be estimated in 3 ways
- CAPM
- dividend-yield-plus-judgemental-risk-premium approach
- over-own-bond-yield-plus-judgemental-risk-premium approach
to use CAPM approach
- estimate firm’s beta
- multiply the beta by the market risk premium, to obtain the firm’s risk premium
- add the firm’s risk premium o the risk-free rate to obtain its cost of common stock.
R(s)= R(rf)+RP(m)b(i)
best proxy for the risk free rate
is the yield on long-term T-bonds, with 10 years to maturity used most frequently. aka rf rate = % yield for t-bond 10 years
to use the dividend-yield-plus-growth-rate approach
aka discounted cash flow (DCF) approach.
add the firms expected dividend growth rate to its expected dividend yield r(s)=D(1)/P(0) + g
growth rate for use in DCF model
can be based on analysts published forecasts, historical growth rates (on earnings & dividends), or on the retention growth model g=(1-Payout)(Return on Equity)
the over-own-bond-yield-plus-judgmental-risk-premium approach
calles for adding a subjective risk premium of 3-5% points to the interest rate on the firm’s own long-term debt: r(s)= bond yield + judgemental risk premium
When calculating the cost of new common stock, the DCF approach
can be used to estimate the flotation cost. For a constant growth stock, it is r(e)=D(1)/[P(0)*[1-F]]+ g . Note that flotation costs cause r(e) to be greater than r(s).
We can find the diff btwn r(e) and r(s) and then add this differential to the CAPM estimate of r(s) to find the CAPM estimate of r(e)
each firm has target capital structure
defined as the mix of debt, preferred stock, and common equity which minimizes its weighted avg cost of capital (WACC)
WACC=w(d)r(d)[1-T]+w(ps)r(ps)+w(s)*r(s)
if you don’t now the target weights, it is better to calculated WACC using market value than book value weights
various factors affect a firm’s cost of capital
some deteremined thru financial environment, but the firm can influence others thru
- financing
- investment
- dividend policies
many firms estimate
divisional costs of capital that reflect each divisions risk and capital structure
the pure play and accounting beta methods
can be used to estimate betas for large projects or for divisions
a projects stand-alone risk
is the risk the project would have if it were the firm’s only asset, which is measured by the variability of the assets expected returns
corporate or within-firm risk
reflects the effect of a project on the firm’s risk, measured by the project’s effect on the firm’s earnings variability.
3 risk measures
- stand-alone risk
- corporate risk
- market risk aka beta
decision makers and risk
usually consider all 3 subjectively, and classify projects into risk categories. Using firms WACC as starting point, risk-adjusted costs of capital are developed for each category.
risk-adjusted cost of capital
cost of capital appropriate for a given project, given its risk. The greater the project risk, the higher its cost of capital
