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Intermediate Finance > Chapter 11 > Flashcards

Chapter 11 Flashcards

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1
Q

What are the components of the cost of capital

A

debt
preferred stock
common equity

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2
Q

capital budgeting decisions

A

you compare the expected rate of return with the cost of capital

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3
Q

how compensation plans relate to cost of capital

A

you can compare the return of invested capital and cost of that capital

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4
Q

what are component costs

A

the required rate of return on each capital component

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5
Q

what is the WAAC

A

weighted average of the various components of cost

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6
Q

What is Rd

A

interest rate on long term debt (cost of new debt)

  • required return on bond, YTM for previously issued bonds
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7
Q

what is Rstd

A

interest rate on short-term debt, such as notes payable

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8
Q

what is T

A

the firms marginal tax rate

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9
Q

what is Rps

A

the required return on preferred stock

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10
Q

what is Rs

A

required return on common stock

  • cost of common equity raised internally as reinvested earnings
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11
Q

what is Re

A

component cost of external equity, or equity raised by issuing new stock

Re is rarely relevant consideration except for very young growing firms

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12
Q

what do the W’s in the WAAC formula stand for

A

the weights the firm plans to use when it raises capital in the future

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13
Q

Short term debt should be included in the capital structure only if…

A

it is a permanent source of financing

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14
Q

what do some companies use as a source of short term financing

A

commercial paper

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15
Q

what rate is the cost of new debt

A

marginal rate

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16
Q

what is the cost of previously issued debt

A

historical or embedded rate

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17
Q

what cost is relevent during the planning period

A

the cost of new debt

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18
Q

what do investment decisions hinge on

A

a projects expected future returns vs the cost of the new or marginal capital that will be used to finance the project

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19
Q

Is the required return to debt-holders equal to the companies cost of debt

A

NO

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20
Q

do debt offerings usually have a high or low flotation cost

A

low

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21
Q

what are flotation costs

A

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
22
Q

do you need to do a tax adjustment for debt

A

yes need after tax rate

23
Q

do you need a tax adjustment for preferred stock

A

no

24
Q

What is Dps

A

preferred dividend

25
Q

what is Pps

A

preferred stock price

26
Q

which is riskier to investor preferred stock or debt

A

preferred stock

27
Q

what are the two ways companies can raise common equity

A
  1. selling newly issued shares to the public (external)
  2. retaining and reinvesting earnings (internal)
28
Q

what do few firms with moderate or slow growth issues new shares of common stock

A
  • high flotation cost
  • investors perceive issuance as a negative signal
  • an increase in supply of stock will put pressure on stock prices
29
Q

does reinvesting earnings come at a cost to the firm>

A

yes opportunity costs

30
Q

what are the two methods to figure out cost of common stock

A
  1. the capital asset pricing model (CAPM)
  2. discounted cash flow method (DCF)
31
Q

what is the rate that is typically used for the risk free rate

A

rate on 10-year treasury bonds

32
Q

what is the market risk premium

A

required return on the stock market minus the risk-free rate

“how much return do investors require to induce them to invest in stock”

33
Q

what are the three approaches to estimating Market Risk Premium Rate

A
  1. use historical premiums
  2. survey experts
  3. use current market value
34
Q

what are the issues with estimating Market Risk Premium by using historical premiums

A
  • stock returns are quite volatile
  • the historical average is extremely sensitive
  • changes in the risk premium can occur if investors tolerance for risk changes
35
Q

what is the required return on the market

A

the markets expected dividend yield + expected constant growth rate in dividends

36
Q

how can beta be estimated

A

historical betas or industry beta

37
Q

When should a company use the Discounted Cash Flows approach to estimate price of common stock (Rs)

A

if an investor expects dividends to grow at a constant rate

If the company makes all payout in the form of dividends

38
Q

in an equilibrium market the expected return and intrinsic value is equal to what

A

the market price

39
Q

What three inputs are needed for the DCF approach

A
  1. current stock price
  2. the current dividend
  3. marginal investors expected dividend growth rate
40
Q

how can you estimate the growth rate

A
  • use historical growth rate
  • use earnings retention model
  • obtain analyst estimates
41
Q

What is the retention model

A

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
42
Q

for companies that issue new stock is the cost of external or internal equity more expensive

A

external

43
Q

what is the Re equation on the equation sheet

A

cost of new common stock for a constant growth firm

44
Q

are flotation costs higher for equity or for debt

A

for equity

45
Q

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

A

the cost the company would incure to raise each new or marginal dollor of capital

46
Q

Divisional Cost of Capital

A

estimating the cost of capital that a division would have if it were a standalone firm

47
Q

What are the two ways to find a divisons BETA

A

-pure play method
- Accounting Beta Method

48
Q

what is pure play method

A

method for estimating divisions beta

  • find publicly traded companies exclusively in projects business and use averages of their betas
49
Q

what is the accounting beta method

A

estimates divisions beta

  • found by regressing the return of a particular companies stock against the return on a stock market index
50
Q

What are the three types of project risk

A
  1. standalone risk
  2. Corporate risk
    3: Market Risk (beta risk)
51
Q

What are factors that affect WAAC that a firm cannot control

A
  1. Interest Rates
  2. Credit Crisis
  3. Market Risk Premium
  4. Tax Rates
52
Q

What are factors that affect the WAAC that a firm can control

A
  1. Capital structure policy
  2. Dividend policy
  3. Investment (capital budgeting) polciy

Intermediate Finance (15 decks)

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