Cost of Capital Flashcards
what two things make up the cost of capital
cost of debt
cost of equity
what tells us the cost of new detb
the yield on outstanding bonds
how can we calculte the cost of equity
dividend discount model
capital asset pricing model
average of these two
why does the firm need to know the cost of their capital
to compensate investors for the financing they have provided, they need to be able to earn at least their cost of capital
what does WACC stand for
weighted cost of capital
what is the link between the required rate of return and the dicsount rate
cash flows should be discounted using the appropriate disocunt rate
the appropraite discount rate reflects the riskinedd of the cash flows
if all the firms earnings are paid out in dividends then what does dividend per share =
earnings per share
what is the payout ratio
fraction of earnings paid out as diivdends
what is the plowback ratio
the fraction of earnings retained by the firm
if its more risky will the discount rate be higher or lower
higher
how can the estimated growth rtae be calcuated
plowback ratio * return on equity
if the return on equity is high, should you reinvest earnigns
yes
how high should the return on equity be to reinvest
higher than the rate of return expected by investors
what does it mean to sit on profits
hold onto profits without reinvesting
advantage of the dividend discount model
easy to understand
disadvantages of the dividend disount model
hard to estimate for compnaies not currently paying dividends
extremely sensitive
does not consider risk
advantages of CAPM
adjusts for risk
applicable for all companies so long as we can calculate bet
disadvantages of CAPM
have to estimate expected market risk premium whihcvaries over time
have to estimate beta which varies over time
how can cost of debt be estimated
yield on exisiting bonds
how can cost of debt be calcultaed if the compnay has no yields
using yields of bonds with a similar credit rating
what is capital
long term sources of finace, debts, or equity
how to get return on preferred stock
Rp = Div1 / P0
where do the weights come from in WACC
the proportions of debt and equity in the firms capital structure
what is the WACC formula
WeRe + WdRd(1-Tc)
