Cost of Capital Flashcards
The cost of ______ for a company’s investment projects must take into account the cost of debt and equity and generate a rate of return that would at least match a similar risk investment.
capital.
Most companies plan for an optimal mix of debt and equity financing, which is commonly known as ______ ________ structure.
target capital.
This ideal mix is planned to maximise stockholders wealth.
Companies generally utilize a combination of debt and equity financing, so instead of examining the cost of specific fund sources, the _______ cost of capital should be looked at.
overall.
This is to ensure that a broader picture of the financing strategy is obtained and the target capital structure is attained.
The four main sources of long-term capital financing are long-term debt, preferred stock, common stock and _____ _____.
retained earnings.
Retained earnings are earnings retained in the company to fund further company investments and growth.
The specific cost of each source of financing is the ___-__ cost of obtaining the funds today.
After-tax.
The cost of capital should be measured on an after-tax basis since it is after-tax cash flows from proposed investments that we discount to obtain their present values.
Flotation costs are the total costs associated with the issue and sale of a ________.
Security or bond.
This is the definition of flotation costs and covers the cost paid to investment bankers, lawyers, accountants etc.
The after-tax cost today of raising long-term funds via borrowing is known as the _____ of long-term debt.
cost.
This is the net calculation of the cost of long-term debt in today’s dollars.
Where the after-tax cost of debt=ki,
the before tax cost of debt is kd and
T=the company’s tax rate;
the formula for calculating ki=kd x (_____-T)
1.
ki=kd x (1-T) is the formula for calculating the after-tax cost of debt.
The cost of long-term debt is usually less than the cost of other types of long-term financing because interest is ______ _________.
tax deductable.
Since interest is tax deductible, taxes are reduced by an equal amount to the interest and therefore makes it cheaper than other forms of long-term debt.
Preferred stockholders receive their fixed dividend ______ distribution of earnings to common stockholders.
before.
Preferred stockholders get paid first because they are “preferred” and have a superior right upon dividend distribution.
Where the annual preferred stock dividend = Dp
and the net proceeds of the sale of preferred stock = Np,
then the cost of preferred stock kp = ______
Dp/Np.
This is the formula for calculating the cost of preferred stock and no tax adjustment is needed because preferred stock dividends are paid from after-tax cash flows.
The two types of common stock financing are new issues of common stock and _____________ ___________.
retained earnings.
Retained earnings are a form of internal common equity that the company decided to retain to re-invest in the company, rather than paying out as dividends to the common stockholders. Hence, it is a form of common-stock financing.
The cost of common stock equity is the rate at which _______ discount expected dividends to determine the company’s share value.
investors.
In other words, investors determine the price of the stock in the marketplace through dictating the rate of return they require.
The cost of common stock equity capital can be calculated using the constant-growth valuation model or the _______ model.
CAPM.
Capital asset pricing model (CAPM) and constant-growth valuation These are the two techniques for calculating the cost of common stock equity capital. Please note that the constant-growth valuation model is also known as the Gordon model.
The Gordon model assumes that common stock dividends will grow at a constant rate into the future and the stock value is equal to the present value of all future __________.
dividends.
This is the calculation using the Gordon model.
Where P0=value of common stock,
D1=per-share dividend expected after 1 year,
ks=required return on common stock and
g=constant rate of dividend growth,
then the formula (Gordon model) for the cost of common stock equity ks = D1/P0 + ___.
g.
ks = D1/P0 + g is the formula for calculating the cost of common stock equity using the Gordon model.
The capital asset pricing model (CAPM) is developed by taking into account the following factors: required return on common stock and the non-______ risk of the firm measured as the beta coefficient.
diversifiable.
Non-diversifiable risk is risk attributed to market factors, that cannot be removed by diversification. Of course, market factors would have a critical impact on the cost of common stock equity.
Where Rf=risk-free rate of return,
km=market return and,
b=beta coefficient and,
ks=required return on common stock;
then the CAPM formula is ks= ____+ [b x (km - Rf)]
Rf.
This is the formula for calculating the cost of common stock equity using the CAPM model.
The cost of retained earnings to a company is equivalent to the cost of a fully subscribed issue of additional _______ stock.
Common.
The cost of retained earnings will be palatable to stockholders only if it is expected to return at least the same as the required return on reinvested funds
- hence the cost of retained earnings (kr) = cost of common stock equity (ks).
The cost of a new issue of common stock (kn) is calculated with reference to the amount of _______ and the flotation costs.
underpricing.
This is because a stock must be underpriced ie below market price (P0) to be sold.
Where Nn=net proceeds from the sale of common stock,
D1=per-share dividend expected after 1 year,
g=constant rate of dividend growth,
and kn=cost of the new issue;
then the formula for kn=____/Nn + g.
D1.
This is the formula for calculating the cost of a new issue of common stock.
The weighed average cost of capital (WACC) is the average of the cost of debt or ______ weighted by their respective usage in the given situation.
equity.
A company’s assets are financed by either debt or equity - which constitutes the capital.
The WACC can be calculated by multiplying the specific costs of each source of _______ by its proportion in the capital structure and summing the weighted values.
financing.
As we are working out the WACC, the source of cost of capital is financing.
Weights can be calculated as book value or market value and ______ or target.
historic.
Market value weights use market values to measure the proportion of each type of capital in the financial structure. Historic weights use book or market value weights based on actual structure proportions.
