Chapter 12: Cost of Capital Flashcards
The equilibrium rate of return demanded by investors in the capital markets for securities with the same degree of risk
Cost of Capital
Rate in order of highest required rate of return to lowest
a. Short-Term Gov Debt (Treasuy Bills)
b. Low- quality Corporate Bond
c. Common Stock
d. Long term Government Debt
e. High Quality Corporate Debt
f. High Quality Preferred Stock
c. b. f. e. d. a.
Three types of capital
Debt
Equity
Preferred Stock
Cost of Capital also can be the _____ required by investors in the firm’s securities
required rate of return
We want the return to be _____ than the cost of capital to create value for the firm
higher
The action of investors moving their capital away from riskier investments to the safest possible investment vehicles
Flight to Quality
Used to find the cost of capital for equity
- How much an investor will require in return for the investment
- Used by investors and firms
Capital Asset Pricing Model (CAPM)
CAPM Equation
k_e=r_f + B (r_m - f_f)
k – Amount of return equity investors should demand for taking on the amount of present risk
rf – Risk-free rate
rm – Expected market return
someone taking a risky investment should get ____ at minimum
the risk free rate
(rm - rf) is called
Market Risk Premium
Why is WACC important?
Tells you our average cost of capital given your weighted capital structure
We want WACC to be as ____ as possible
high or low
low
If risk goes up, the required rate of return goes ____
up or down
up
How could risk or events impact a firm?
If government begins to deregulate, it increases competition, which creates more risk
If government begins to regulate, cost go up (for new requirements), so many of the small companies can’t afford to keep up. They can drop out or be bought out.
-Government starts raising interest rates (means the economy is doing well). So the assumption is that there’s less risk in the market. So risk discounts go down (risk premium goes down)
What does it mean if Government starts raising interest rates?
- economy is doing well (unemployment is low)
- So the assumption is that there’s less risk in the market.
- risk discounts go down (risk premium goes down)
WACC can be impacted by
-Regulation
- The distribution of money between the three types
- -Balancing between the three
- -Can’t invest 100% in just debt (given it’s the cheapest) because leverage/risk would be too high
- How old the company is
- -Example – Startups go through a lot of cash, so they don’t want to have a lot of debt. Interest on debt has to be paid, where dividends on equity do not
Why do we want to minimize WACC?
it’s easier to add value (the present value of future cash flows will be higher)
It’s the cost of investing in projects; less expensive is better
Risk that is specific to an asset or a small group of assets
Idiosyncratic Risk / Firm-Specific Risk
- Risk has little or no correlation with market risk
- Can be substantially mitigated or eliminated from a portfolio by using adequate diversification
What is the term for when you have a Diversified portfolio?
“Holding the Market” / “Investing in the Market”
It is less risky, it negate firm-specific risk
What happens when there is deregulation
competition starts to increase.
Because more competition, there is more risk. Investors will requite higher rate of return
When regulation happens, a lot of smaller firms will die or get bought out so the competition becomes more consilidated
