Chp 11 - Cost of Capital Flashcards
define cost of capital
The cost, expressed as a percentage rate, that a firm must pay investors for the use of debt and equity financing
how to calculate growth in dividends
(current / past)^(1/n) - 1
put in order from smallest to largest, cost of debt, cost of equity, cost of preferred
cost of debt < cost of preferred < cost of equity
how to get market value weight of debt
add up market values of all different bond issues and divide by value of capital to get weight of debt
2 things that makes cost of capital higher
1) high risk
2) low liquidity
explain why low liquidity makes cost of capital higher
illiquidity increases cost of equity and therefore increases WACC
explain what liquidity means
cost of buying/selling stock
define weighted average cost of capital
the average cost of debt and equity financing where the average is computed as a weighted average using the long term target weights of debt and equity
what is WACC also called?
average cost of funds
true or false? If you can borrow money to finance the expansion of your online custom nail polish distribution company at 8%, and you expect to earn 12% as a result, you should borrow the funds
false. base the decision on the average cost of money, not on the cost associated with a particular piece of capital. If the next time you borrow it will cost 20%, your current decision may change
how is WACC used in capital budgeting decisions - 4 points
1) it is the hurdle rate
2) Return on project must exceed return required by providers of capital
3) It is the opportunity cost or return that investors could earn in another investment of similar risk
4) Firm must earn at least WACC on its investments or the value of the firm will fall
how to calculate simple average
sum of grades / number of items
how to calculate weighted average
sum of grade*weight
define cost of debt
return firm’s lenders demand on new borrowing/interest rate on new borrowing (yield to maturity of existing bonds)
how can cost of debt be calculated
interest rate * (1-t)
why don’t we use coupon rate for cost of debt?
because that reflects the cost of debt when the bonds were issued
explain why we use after-tax cost of debt
1) We need to use the after-tax cost of debt because interest on debt is tax deductible (interest tax shield)
2) Tax shield lowers the cost of debt financing because the government is paying a portion of the expense by reducing the taxes due from the company
how much approximately is firm’s avg capital raised from issuing preferred stock?
5%
why are dividends not tax deductible?
Dividends are not tax deductible because they are paid from after-tax income (net income)
2 things that results from dividends being not tax deductible
1) This makes cost of equity and cost of preferred shares higher than cost of debt
2) Because cost of debt is lower, firms are reluctant to issue stock than bonds
price of preferred
dividend/cost of preferred
define cost of equity
return on investment required by investors in the stock of a company
why is computing cost of equity more uncertain?
there is no promised dividend/cash flow
define capital asset pricing model (CAPM)
describes the relationship between the required return, or cost of common stock equity capital, and the non diversifiable/systematic risk of the firm as measured by the beta coefficient
what does CAPM compute?
CAPM computes the return investors require to feel compensated for the risk they incur for holding equity
3 methods of calculating cost of equity
1) CAPM
2) constant growth model
3) bond yield plus premium
define constant growth valuation model
a model for computing the value of stock that assumes dividends grow at a constant rate forever and the price is the PV of these dividends
price of equity formula
Dividend1 / (cost of equity - growth) OR price = Dividend0 (1+g) / cost of equity - growth
define risk premium
additional return investors require due to the increased risk one investment has over another
what is risk premium generally?
between 3-5%
what is an additional reason why equity is riskier than debt?
has a residual claim on firm’s assets
bond yield plus premium: cost of equity formula
pre-tax cost of debt + risk premium
bond yield plus premium: when calculating cost of equity why do we use pre-tax cost of debt?
because cost of equity is not tax deductible
interpreting WACC: define target mix
proportions of debt, equity and preferred stock a firm wants in its capital structure
interpreting WACC: why do we use target weights?
because WACC is a rate to use in evaluating long term projects
interpreting WACC: do we use market value or book values?
market values for all debt, equity, preferred
divisional WACC: define divisional cost of capital
cost of capital for specific unit or division within a company that reflects that area’s weighted average cost of funds
divisional WACC: how does IRR, WACC affect NPV
If IRR < WACC then NPV < 0
divisional WACC: true or false?If the WACC for the health care division is 8% and the WACC for the paper products division is 4%, assuming each division is the same size, would you use 6% (computed as average of 8% and 4%) to evaluate the purchase of a new line of paper towels?
This is false, you should use divisional cost of capital
divisional WACC: When evaluating an investment for a firm with multiple divisions that each have different risk…
use the rate associated with the division most closely related to the new investment.
what to do if cost of equity < cost of debt
say none of the above for WACC
how to find price of bonds when not given the amount outstanding?
face value * 0.(price)
