Corporate Finance: Cost Of Capital

Question 1

Asset Beta

Answer 1

The unleverer beta; reflects the business risk of the assets; the assets systematic risk

Question 2

Bond Yield plus risk premium approach

Answer 2

An estimate of the common equity that is produced the before tax cost of debt and risk premium that captures the additional yield on a companies stock relative to its bonds. The additional yield is often estimated using historical spreads between bond yields and stock yields

Question 3

Break Point

Answer 3

The amount of capital at which the the cost of one or more of the sources of capital changes, leading to a change in the WACC

Question 4

Business Risk

Answer 4

The risk associated with operating earnings. Operating earnings are uncertain because total revenues and many of the expenditures contributed to produce those revenues are uncertain

Question 5

Comparable company

Answer 5

A company that has similar business risk; usually in the same industry and preferably with a single line of business

Question 6

Component cost of capital

Answer 6

The rate of return required by suppliers of capital for an individual source of a companies funding, such as debt or equity

Question 7

Cost of capital

Answer 7

The rate of return that suppliers of capital require as compensation for the contribution of capital

Question 8

Cost of debt

Answer 8

The cost of debt financing to a company, such a me when it issued a bond or takes out a bank loan

Question 9

Cost of Preferred Stock

Answer 9

The dividend yield that a company must commit to pay preferred stockholders

Question 10

Debt incurrence test

Answer 10

A financial covenant made in conjunction with existing debt that restricts a companies ability to incur additional debt as the same seniority based on one or more financial test or conditions

Question 11

Debt-Rating approach

Answer 11

A method for estimating a companies before-tax cost of debt based upon the yield comparably rates bonds for maturities that closely match that of the companies existing debt

Question 12

Dividend discount model based approach

Answer 12

An approach for estimating a country’s equity income is premium. The market rate of return is estimated as the sum of the dividend yield and the growth rate in dividends for a market index

Question 13

Equity risk premium

Answer 13

The expected return on equities minus the risk free rate; the premium that investors demand for investing in equities

Question 14

Financial risk

Answer 14

The risk that environmental, social or governance risk factors will result in significant costs or other losses to a company and its shareholders; the risk arising from a companies obligations to meet required payments under its financing agreements

Question 15

Fixed rate perpetual preferred stock

Answer 15

Nonconvertible, non callable preferred stock that has a fixed dividend rate and no maturity date

Question 16

Flotation cost

Answer 16

Fees charged to companies by investment bankers and other costs associated with rasing new capital

Question 17

Historical equity risk premium approach

Answer 17

An estimate of a countries equity risk premium that is based upon the historical averages of the risk-free rate and the rate of return on the market portfolio

Question 18

Investment opportunity schedule

Answer 18

A graphical depiction of a companies investment opportunities ordered from highest to lowest expected return. A company’s optimal capital budget is found where the investment opportunity schedule intersects with the companies marginal cost of capital

Question 19

Matrix pricing

Answer 19

Process of estimating the market discount rate and price of a bond based on the quoted or flat prices of more frequently trade comparable bonds

Question 20

Operating risk

Answer 20

The risk attributed to the operating cost structure, in particular the use of fixed costs in operations m; the risk arising from the mix of fixed and variable costs; the risk that a company’s operations may be severely affected by environmental social, and governance risk factors

Question 21

Priced risk

Answer 21

Risk for which investors demand compensation for bearing (equity risk company specific factors, macroeconomic factors)

Question 22

Pure-play method

Answer 22

A method for estimating the beta for a company or project; it requires using a comparable company’s beta and adjusting it for financial leverage differences

Question 23

Sales risk

Answer 23

Uncertainty with respect to the quantity of goods and services that company is able to sell and the price it is able to achieve; the risk related to the uncertainty of revenues

Question 24

Sovereign yield spread

Answer 24

An estimate of the country spread (country equity premium) for a developing nation that is based on a comparison of bond yields in country being analyzed and a developed country.

Question 25

Survey approach

Answer 25

An estimate of the equity risk premium that is based upon estimates provided by a panel of finance experts

Question 26

Sustainable growth rate

Answer 26

The rate of dividend (and earnings growth that can be sustained over a given level of return on equity, keeping capital structure constants and without issuing additional common stock

Question 27

Target capital structure

Answer 27

A companies chosen proportions of debt and equity

Question 28

Weighted average cost of capital

Answer 28

A weighted average of the aftertaste required rates of return in a companies common stock, preferred stock and long term debt Where the weighs are the fraction of each source of financing in the target capital structure