cost of capital Flashcards
what is the weighted average cost of capital
the overall opportunity cost of the firms capital is the WACC for debt and equity
when should a project be undertaken in terms of return on invested capital and opportunity cost of capital
ONLY if the ROIC is greater then the opportunity cost of capital
what does these comments of WACC mean
rD rPD rE
rD = required return on debt
rPS = required return on preference share capital
rE = required return on equity capital
what is the calculation for WACC
r* = WACC = (D/V).[rD(1-TC)] + (E/V).(rE)
what is yield to maturity
the internal rate of return (IRR) and is the pre tax costs of debt
how can we use linear interpolation
to work out rD
what three methods can be used to estimate the cost of equity
- CAPM where rE = rf + β(rm – rf)
- Dividend discount model where:
rE = D1 + g
P0 - Bond yield plus risk premium
what are the CAPM assumptions
Investors are rational and risk-averse
Investors have a common single-period planning horizon
Investors have homogenous expectations
All assets are publicly held and traded
Investors can sell short
There are no transaction costs
Personal income taxation is zero
Investors can all lend and borrow at the risk-free rate
what are the two ways to determine the growth rate in dividends
- Historic annual dividend growth (taking nth root where n is the number of years of growth)
- We assume that growth is a function of the historic return on equity (r) generated by the firm and the proportion of profits retained (b)
g = r x b
how can we calculate rE
rE = bond market yield + risk premium
4 steps to work out cost of capital for a project
- Identify the equity beta of a comparable company (or companies) that is a pure play in the industry
- “Unlever” the equity beta to adjust for differences in debt/equity ratio—this is the asset beta
- “Relever” the asset beta to reflect the debt/equity ratio of the subject company—this is the project (equity) beta
- Use the project beta as the cost of equity for the project when calculating project WACC
what is the formula to convert an equity beta to an asset beta
B asset = B pure play [1/1+((1-t)D/E)]
where D/E is the pure play company’s debt to equity ratio and t is its marginal tax rate
how do you calculate the company or project beta
B project = B asset [1+((1-t)D/E)]
use the subject’s firms tax rate and debt to equity ratio to re lever the asset beta
what is beta instability
company systematic risk may change from period to period leading to instability
how do we modify the CAPM formula when the risk is not diversifiable
add CRP to the formula (country risk premium)
rE = rf + B(rM - rF) + CRP
