Class 6 Flashcards
what is an unlevered firm
firm solely funded with equity
what is a levered firm
firm funded with both equity and debt
(levered down with debt)
what is the cost of capital
the return required to break even after being funded through equity and/or debt
what is idiosyncratic risk
firm specific
what is systematic risk
market wide
which type of risk is relevant for cost of capital?
systematic risk (undiversifiable, investors should be compensated for lowering this risk)
what is beta
Firms correlation to the market
what is the market risk premium
extra return demanded for additional risk
what is the risk free rate
capture the time value of money
Firm risk premium vs market risk prmium?
Market = (Rm - Rf)
Firm = B(Rm - Rf)
B is firms relationship to the market
what is a cyclical industry
sensitive to business cycle
high revenues in economic prosperity
low revenues in economic downturn
Imagine Tempo restructures its business operations and as a result its overall operations become more cyclical. How would this affect its cost of equity capital? Why?
The risk of the firm increases (business risk, systematic) , therefore cost of capital increases
Imagine Tempo experiences a significant increase in the share of fixed costs in its total operating costs. How would this affect its cost of equity capital? Why?
fixed costs are required payments, so it would cost more to breakeven. Cost of capital increases
what are the two types of systematic risk
business
financial
Imagine Tempo’s CFO decides to significantly increase the firm’s financial leverage. How would this affect its cost of equity capital? Why?
Business risk increases, Cost of capital increases
