Cost Of Capital Flashcards
What is the cost of capital?
The cost of capital is the required return necessary to make a capital budgeting project worthwhile.
It includes the cost of debt and cost of equity.
What is the formula for calculating the weighted average cost of capital (WACC)?
WACC = (% of equity)(cost of equity) + (% of debt)(cost of debt)
Cost of debt is calculated on an after-tax basis.
Define the cost of debt.
The cost of debt is the effective rate that a company pays on its borrowed funds.
It is often calculated as the after-tax cost of debt.
What is the formula for the after-tax cost of debt?
After-tax cost of debt = r x (1-T)
Where r is the before-tax cost and T is the tax rate.
How do you calculate the cost of equity using the Capital Asset Pricing Model (CAPM)?
RR = Rf + Beta(Rm - Rf)
RR is the required return, Rf is the risk-free rate, and Rm is the market return.
What does the beta coefficient represent in finance?
The beta coefficient measures a stock’s volatility in relation to the market.
A beta greater than 1 indicates higher volatility than the market.
What are the three inputs for the Gordon Growth Model?
The three inputs are:
* DPS: Forecasted dividend per share
* P: Current share price
* g: Annual dividend growth rate
What is the assumption of the Gordon Growth Model?
The model assumes that the annual dividend growth rate remains constant.
This assumption may not hold true for all companies.
What is the optimal capital structure?
The optimal capital structure is the mix of long-term finance that minimizes the cost of funding for a given level of risk.
It involves a trade-off between risk and cost.
What is a tax shield in the context of debt financing?
A tax shield is the reduction in income taxes that results from taking an allowable deduction from taxable income.
Interest expense is tax-deductible, providing a tax shield.
Fill in the blank: The cost of equity can be determined using the _______ approach and the _______ approach.
[dividend-based], [risk/return-based]
What is the significance of the market risk premium in CAPM?
The market risk premium represents the additional return expected from holding a risky market portfolio instead of risk-free assets.
It is calculated as Rm - Rf.
True or False: The CAPM model assumes a linear relationship between risk and return.
True
What is the true cost of debt for a company with a 30% tax rate and a before-tax cost of debt of 10%?
The true cost of debt = 10% * (1-30%) = 7%
This reflects the tax deduction benefit.
What is the formula for the Gordon model calculation?
RR = (DPS/P) + g
Where DPS is the expected dividend per share, P is the share price, and g is the growth rate.
How do you estimate the proportions of different types of funding used in WACC?
Proportions can be estimated using:
* Book value
* Market value
* Company’s target
What does a beta of 1 indicate?
A beta of 1 indicates that the stock’s price will move with the market.
It represents average market risk.
What is the cost of equity for a company with a risk-free rate of 8%, beta of 2, and market return of 11%?
RR = 8% + (2(11% - 8%)) = 14%
This is calculated using the CAPM formula.
What is WACC used to determine?
WACC is used to reflect the expected average future cost of funds over the long run.
It represents the minimum return a company needs to achieve.
What is the Cost of Equity?
The return required by equity investors for their investment in a company
It reflects the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership.
What does Cost of Debt refer to?
The effective rate that a company pays on its borrowed funds
It is the return that lenders demand on the firm’s debt.
Define Weighted Average Cost of Capital (WACC).
The average rate of return a company is expected to pay its security holders to finance its assets
WACC is calculated by multiplying the cost of each capital component by its proportional weight and summing the results.
What are Debt/Equity Ratios?
A financial ratio indicating the relative proportion of shareholders’ equity and debt used to finance a company’s assets
It is calculated by dividing total liabilities by shareholders’ equity.
What is the market value of ENMAX’s preferred shares?
£45,000,000
This value is crucial for calculating WACC.
What is the cost of common stock for ENMAX?
12.5%
This rate is used in WACC calculations.
Fill in the blank: The cost of debt (long term bank loans) for ENMAX is estimated to be _______.
10.5%
What is the optimal capital structure of ENMAX based on target market value weights?
- Ordinary shares (common stock): 50%
- Preferred shares (preferred stock): 10%
- Long term Bank loans (Debt): 40%
This structure is determined to improve grid reliability and efficiency.
What is the current level of dividend for ENMAX’s ordinary shares?
15 pence per share
This dividend has been growing at a compound rate of 6% per annum.
What is the rate of corporation tax applicable to ENMAX?
20%
This tax rate is considered when calculating the after-tax cost of debt.
True or False: The cost of preferred shares for ENMAX is estimated to be 12%.
True
What is the total book value of ENMAX’s ordinary shares?
£60,000,000
This value contributes to the overall capital structure.
What is the purpose of constructing a new transmission line by ENMAX?
To improve grid reliability, increase capacity and improve efficiency
This project will be financed by new common stock and bank loans.
What is the book value of ENMAX’s preferred shares?
£20,000,000
This value is used in calculating the overall WACC.
What is the significance of calculating WACC for ENMAX?
It is used for future investment decisions
WACC helps in assessing the cost of financing new projects.
