Cost Of Capital Flashcards
Equity and debt as costs of capital are labeled as
Components cost of capital
Increasing tax rate will encourage or discourage investment in relation with the NPV method
Encourage
Which department is responsible for the financing costs of capital and should capital be raised in small or large sums
Financing , large sums
What are the weights used in calculating the WACC
The firms long term target capital Weights, determined by the market prices of capital and not the book value
Do we adjust the WACC for different risk carrying projects
Yes upwards with riskier projects and downwards for less riskier projects compared to the average risk of a firms current projects
How to solve Dividend discount model and CAPM without calculation errors
Practice more questions
What can an analyst use to calculate a companys capital weights
It’s target capital weights if available (often not publicly announced), take the current weights and adjust it to trends as the target weights or take an industry average capital structure weights
When does the WACC become the appropriate discount rate for projects
When evaluating projects with risks close to the risk of the average firms projects
Alternative method of calculating the after tax cost of debt
Interest rate - tax savings
When to consider and when to ignore the tax shield in our after tax cost of debt
When the tax rate is higher than the interest rate we consider it and when the tax rate is lower than the interest rate we ignore it
What adjustments should be made when calculating cost of debt using the debt rating approach
We should make adjustments according to the convents and other factors, since the debt rating approach provides the YTM of another companies debt with different characteristics
Explain the optimal capital budget
Y-axis has the IRR and the cost of capital
X-axis has the new capital invested/ more projects
The marginal cost of capital line is upward sloping
The opportunity schedule line is downward sloping
(Represents all profitable projects)
The intersection between both is the optimal capital budget
The payout rate formula
Dividends divided by earnings per share
What is the most used model in calculating the cost of equity/return on equity
CAPM model
When is the pureplay method used
When calculating the equity beta for a project for a company that is privately trading, we use a similar company with similar field and use its beta, through unlevering it and then levering it with the projects D/E ratio
To calculate the weight of debt give the D/E ratio
We use D/D+E
Problems when using the pureplay method
Beta is estimated using historical data
The estimate is affected by which index is chosen to represent the market return
Betas are believed to revert towards 1 over time
Estimated of beta for small cap firms need and upward adjustment
Country risk premium formula
Sovereign yield spread* (annualized S.D of equity index of developing countries/ annualized S.D of sovereign bond market in terms of the developed market currency)
Sovereign yield spread= difference between the yield s of the government bonds in the developing country and treasury bonds of Similar maturities
Factors that could raise the marginal cost of capital
Raising more capital and deviating from the firms target capital structure
Both are done to undertake short term project opportunities
Incorrect calculation of flotation costs
We add (1-flotation cost) in the denominator while calculating the dividend discount model
What tax rate is used in calculating the cost of capital
Marginal and not the effective
What is levered beta
Levered beta or equity beta can be levered using the comparable companies D/E ratio or the projects D/E ratio
Will different equity cost model produce different results
Yes
When does a break point occur
When one of the component costs of capital increase
What is the marginal cost of capital
Is the last dollar cost raised by the firm
Perpetual preferred stock formula
D/R
The cost of proffered stock is also called
The dividend yield on the firms newly issued preferred stock
