Chapter 9 Flashcards
Represents the firms cost of financing and is the minimum rate of return that a project must earn to increase firm value.
Cost of capital
Investments with a rate of return _____ cost of capital will increase the value of the firm. In contrast, projects with a rate of return _____ cost of capital decrease the firm value.
Increase, decrease
Acts as a major link between the firms long term investment decisions and the wealth of the firms owners as determined by the market value of their shares.
Cost of capital
By weighting the cost of each source of financing by its relative proportion in the firms target capital structure, the firm can obtain a
Weighted average cost of capital.
Process of evaluating and selecting long term investments.
Capital budgeting.
Four basic sources of long term capital for firms:
Long term debt, preferred stock, common stock and retained earnings.
Financing cost associated with new funds raised through long term borrowing.
Cost of long term debt
Funds actually received by the firm from the sale of a security.
Net proceeds
Total costs of issuing and selling a security.
Flotation costs
Flotation costs include two components
Underwriting costs and administrative costs
Compensation earned by investment bankers for selling the security
Underwriting costs
Issuer expenses such as legal and accounting costs.
Administrative costs
Rate of return the firm must pay on new borrowing.
Before tax cost of debt
Must account for the tax savings created by debt and solve for cost of long term debt on an after tax basis. Can be found by multiplying the before tax cost by (1-tax rate)
After tax cost of debt
When dividends are stated as __________ the stock is often referred to as x dollar preferred stocks.
Preferred stock dividend.
Sometimes preferred stock dividends are stated as _____________. This rate represents the percentage of the stocks par, or face value that equals the annual dividend.
Annual percentage rate.
Ratio of preferred stock dividend to the firms net proceeds from the sale of preferred stock.
Cost of preferred stock
Return required on the stock by investors in the marketplace.
Cost of common stock
2 types of common stock financing:
Retained earnings and new issues of common stock.
Rate of which investors discount the expected dividends of the firm to determine its share value.
Cost of common stock equity
Assumed that the value of a share of stock equals the present value of all future dividends (assumed to grow at a constant growth) that it is expected to provide over an infinite time horizon.
Constant growth valuation (Gordon growth) model
Describes the relationship between the required return and the nondiversifiable risk of the firm as measured by the beta coefficient
Capital asset pricing model (CAPM)
The CAPM technique differs from the constant growth valuation model in that it directly considers the firms ____ as reflected by beta, in determining the required return or cost of common stock equity.
Risk
When the constant growth valuation model is used to find the cost of common stock equity, it can easily be adjusted for _______ to find the cost of new common stock.
Flotation costs.
The same as cost of an equivalent fully subscribed issue of additional common stock, which is equal to the cost of common stock equity
Cost of retained earnings
Cost of common stock, net underpricing and associated flotation costs.
Cost of a new issue of common stock
Stock sold at a price below its current market price
Underpriced
The cost of new issues will always be greater than the cost of ____ issues, which is equal to the cost of retained earnings.
Existing
The cost of new common stock is normally greater than
Any other long term financing cost
Reflects the expected average future cost of capital over the long run; found by weighting the cost of each specific type of capital by its proportion in the firms capital structure.
Weighted average cost of capital (WACC)
Weights that use accounting values to measure the proportion of each type of capital in the firms financial structure.
Book value weights
Weights that use market values to measure the proportion of each type of capital in the firms financial structure.
Market value weights
Either book or market value weights based on actual capital structure proportions.
Historical weights
Either book or market value weights based on desired capital structure proportions
Target weights
