Chapter 9 Flashcards
Component Costs
the required rate of return on each capital component
weighted average cost of capital
the cost of capital used to analyze capital budgeting decisions is found as a weighted average of the carious component costs
capital is provided by
investors
accounts payable and accruals arise from _____, not from ____
operating decisions, not financing decisions
who are re and rs most relevant to
rs is more common for well established firms who obtain all new equity as retained earnings. re is rarely relevant except for very young, rapidly growing firms
New or marginal debt
used as rd
historical or embedded rate
average rate on previously issued debt
what decisions is the embedded cost important for
to determine the rate of return that a public utility should be allowed to earn
is rd equal to the company’s cost of debt
no, interest payments are deductible, which means the government in effect pays part of the total cost
project financing
a special situation in which a large project, such as an oil refinery, is financed with debt plus other securities that have a specific claim on the project’s cash flows
How is project financing different from usual debt offerings
debt does not have a claim on all of the corporation’s cash flows
Why is no tax adjustment used when calculating the cost of preferred stock?
preferred dividends are not tax deductible so the company bears their full cost
Why do firms usually have every intention of paying preferred dividends even though they aren’t mandatory?
- they cannot pay dividends on their common stock
- they will find it difficult to raise additional funds in the capital markets
- in some cases preferred stockholders can take control of the firm
companies can raise common equity in two ways
- by selling new issued shares to the public 2. by retaining and reinvesting earnings
why do few firms with moderate or slow growth issue new shares of common stock through public offerings?
- flotation costs can be high
- investors perceive new issuings as a negative signal about the value of the company
3 . even without the signaling effect, and increase in the supply of stock puts pressure on the stock price, forcing the company to sell the new stock at a lower price than before the new issue
what is the signaling effect
investors percieve issuance of common stock as a negative signal about the true value of the company’s stock. they believe that managers have superior knowledge about future prospects and are most likely to issue new stock when they believe the current stock price is greater than intrinsic value
opportunity cost
the earnings that could have been paid out as dividends or used to repurchase stock, and in either case stockholders would have received funds that they could reinvest in other securities
What is the general rule about reinvesting instead of paying dividends
the firm should earn on its reinvested earnings at least as much as its stockholders themselves could earn on alternative investments of equivalent risk, or rs
Steps to using the Capital Asset Pricing Model
- estimate the risk free rate (rRF) 2. estimate the current market risk premium RPm 3. estimate the stocks beta coefficient, bi, which measures the stock’s relative risk 4. use formula
Current market risk preium rpm
required return on the market minus the risk free rate
why is it okay to use the rate on 10 year treasury bonds as the risk free rate
- stock are long term securities so stocks will reflect long term inflation 2. short term treasury bills are more volatile than long term treasury bond rates and are more volatile than rs 3. CAPM is supposed to measure the required ror over a particular holding period
historical growth rates
if earnings and dividend growth rates have been relatively stable in the past, and if investors expect these trends to continue, then the past realized growth may be used as an estimate of the expected future growth rate
Retention growth model
the more firms retain and reinvest, the higher the earned rate of return on those retained earnings, the larger their growth rate
payout ratio
percent of net income that the firm pays out in dividends
retention ratio
the compliment of the payout ratio
Why is the cost of new common equity higher than cost of equity for companies who rely on reinvestin a large portions of earnings than issuing common stock
because of flotation costs involved in issuing new stock
Factors that affect WACC that the firm cannot control
- the state of financial markets, including stock prices and level of interest rates 2. investors aversion to risk and thus the market risk premium 3. tax rates as set by congress
stock and bond markets and WACC
if interest rates in the economy rise the costs of debt and equity will increase. firm will have to pay bondholders a higher interest rate. also increases cost of equity
Three factors that affect WACC that firms can control
- its capital structure policy 2. its dividend policy 3. its investment (capital budget) policy
stand alone risk
variability of the projects expected returns
corporate, or within firm risk
variability the project contributes to the corporations returns, giving consideration to the fact that the project represents only one asset of the firms portfolio of assets so some of its risks will be diversified awa
market, or beta risk
the risk of the project as seen by a well diversified stockholder who owns many different stocks
4 mistakes to avoid
- never base the cost of debt on the coupon rate on a firm’s existing debt 2. when estimating the market risk premium for the CAPM method, never use the historical average return on stocks with the current reurn on bonds 3. never use the current book value capial sructure to obtain the weights when estimating the wacc 4. always remember the capital components are funds that come from investors
