Chapter 14: Cost of Capital Flashcards
Weighted average cost of capital acronym
WACC
Therefore, the cost of capital for a risk-free investment is the
Risk-free rate
The cost of capital depends primarily on the use of the funds, not the source. The use of the funds refers to risk associated with the investment.
Very important
In particular, we assume the firm has a fixed debt–equity (D/E) ratio that it maintains.
Word
A firm’s cost of capital reflects both its cost of ________ and its cost of ________
debt capital
equity capital.
cost of equity
The return that equity investors require on their investment in the firm.
Two approaches to determining the cost of equity:
1) the dividend growth model approach
2) the security market line (SML)
The easiest way to estimate the cost of equity capital is to use the ______________
dividend growth model
retention ratio or plowback ratio
Retained earnings divided by net income.
return on equity (ROE)
Net income after interest and taxes divided by average common shareholders’ equity.
g =
equation
retention ratio x ROE
Disadvantages of the dividend growth model
1) most applicable to companies that pay dividends. For companies that do not pay dividends, we can use the model and estimate g from growth in earnings
2) the estimated cost of equity is very sensitive to the estimated growth rate
3) this approach does not explicitly consider risk
The SML Approach
the required or expected return on a risky investment depends on three things:
The risk-free rate, Rf.
The market risk premium, E(RM) − Rf.
The systematic risk of the asset relative to average, which we called its beta coefficient, β.
The SML approach has two primary advantages:
1) the market risk premium
2) the beta coefficient
cost of debt
The return that lenders require on the firm’s debt.
a share of preferred stock is essentially a _____
perpetuity
The cost of preferred stock =
Rp = D / P0
One of the implications of using WACC for a project is that we are assuming that money is raised in the optimal proportions
For instance, if the optimal weight for debt is 25%, raising $100 million means that $25 million will come from new debt and $75 million from common and preferred shares
We use the symbol E to stand for the market value of the ________
firm’s equity
We calculate this by taking the number of shares outstanding and multiplying it by the price per share
We use the symbol D to stand for the market value of the ________
firm’s debt
we calculate this by multiplying the market price of a single bond by the number of bonds outstanding
We use the symbol V to stand for the combined market value of the ________
debt and equity
V =
E + D
weighted average cost of capital (WACC)
The weighted average of the costs of debt and equity.
economic value added (EVA)
also called economic value contribution (EVC
Performance measure based on WACC.
Is coupon rate the cost of debt?
No, The coupon rate is not the cost of debt
The required return for the cost of debt is calculated how?
Best estimated by computing the yield-to-maturity on the existing debt (YTM on Bonds)
For the cost of debt, focus on what?
Long-term debt or bonds
How is preferred stock different?
1) Preferred shares generally pay a constant dividend every period
2) Dividends are expected to be paid every period forever
Why is tax in the WACC formula?
Equity: Dividends are paid after tax
But debt has an interest expense and we get a tax deduction
