Chapter 11 Flashcards
What are the components of the cost of capital
debt
preferred stock
common equity
capital budgeting decisions
you compare the expected rate of return with the cost of capital
how compensation plans relate to cost of capital
you can compare the return of invested capital and cost of that capital
what are component costs
the required rate of return on each capital component
what is the WAAC
weighted average of the various components of cost
What is Rd
interest rate on long term debt (cost of new debt)
- required return on bond, YTM for previously issued bonds
what is Rstd
interest rate on short-term debt, such as notes payable
what is T
the firms marginal tax rate
what is Rps
the required return on preferred stock
what is Rs
required return on common stock
- cost of common equity raised internally as reinvested earnings
what is Re
component cost of external equity, or equity raised by issuing new stock
Re is rarely relevant consideration except for very young growing firms
what do the W’s in the WAAC formula stand for
the weights the firm plans to use when it raises capital in the future
Short term debt should be included in the capital structure only if…
it is a permanent source of financing
what do some companies use as a source of short term financing
commercial paper
what rate is the cost of new debt
marginal rate
what is the cost of previously issued debt
historical or embedded rate
what cost is relevent during the planning period
the cost of new debt
what do investment decisions hinge on
a projects expected future returns vs the cost of the new or marginal capital that will be used to finance the project
Is the required return to debt-holders equal to the companies cost of debt
NO
do debt offerings usually have a high or low flotation cost
low
what are flotation costs
the percentage of proceeds paid to the investment bankers
- commissions, legal expenses, fees and any other costs that a company incurs when it issues new securities
do you need to do a tax adjustment for debt
yes need after tax rate
do you need a tax adjustment for preferred stock
no
What is Dps
preferred dividend
what is Pps
preferred stock price
which is riskier to investor preferred stock or debt
preferred stock
what are the two ways companies can raise common equity
- selling newly issued shares to the public (external)
- retaining and reinvesting earnings (internal)
what do few firms with moderate or slow growth issues new shares of common stock
- high flotation cost
- investors perceive issuance as a negative signal
- an increase in supply of stock will put pressure on stock prices
does reinvesting earnings come at a cost to the firm>
yes opportunity costs
what are the two methods to figure out cost of common stock
- the capital asset pricing model (CAPM)
- discounted cash flow method (DCF)
what is the rate that is typically used for the risk free rate
rate on 10-year treasury bonds
what is the market risk premium
required return on the stock market minus the risk-free rate
“how much return do investors require to induce them to invest in stock”
what are the three approaches to estimating Market Risk Premium Rate
- use historical premiums
- survey experts
- use current market value
what are the issues with estimating Market Risk Premium by using historical premiums
- stock returns are quite volatile
- the historical average is extremely sensitive
- changes in the risk premium can occur if investors tolerance for risk changes
what is the required return on the market
the markets expected dividend yield + expected constant growth rate in dividends
how can beta be estimated
historical betas or industry beta
When should a company use the Discounted Cash Flows approach to estimate price of common stock (Rs)
if an investor expects dividends to grow at a constant rate
If the company makes all payout in the form of dividends
in an equilibrium market the expected return and intrinsic value is equal to what
the market price
What three inputs are needed for the DCF approach
- current stock price
- the current dividend
- marginal investors expected dividend growth rate
how can you estimate the growth rate
- use historical growth rate
- use earnings retention model
- obtain analyst estimates
What is the retention model
way of estimating growth rate
- the more companies retain, the higher the earned rate of return on those R.E, the higher the growth rate
for companies that issue new stock is the cost of external or internal equity more expensive
external
what is the Re equation on the equation sheet
cost of new common stock for a constant growth firm
are flotation costs higher for equity or for debt
for equity
Is WAAC…
the cost the company would incure to raise each new or marginal dollor of capital
OR
the average cost of dollars raised in the past
the cost the company would incure to raise each new or marginal dollor of capital
Divisional Cost of Capital
estimating the cost of capital that a division would have if it were a standalone firm
What are the two ways to find a divisons BETA
-pure play method
- Accounting Beta Method
what is pure play method
method for estimating divisions beta
- find publicly traded companies exclusively in projects business and use averages of their betas
what is the accounting beta method
estimates divisions beta
- found by regressing the return of a particular companies stock against the return on a stock market index
What are the three types of project risk
- standalone risk
- Corporate risk
3: Market Risk (beta risk)
What are factors that affect WAAC that a firm cannot control
- Interest Rates
- Credit Crisis
- Market Risk Premium
- Tax Rates
What are factors that affect the WAAC that a firm can control
- Capital structure policy
- Dividend policy
- Investment (capital budgeting) polciy
