cost of capital Flashcards
describe risk independence
nThe cost of capital for a project does not depend on the characteristics of the company considering the project.
The value of a project depends on what the project is, not who the investor is.
Capital markets lead to risk independence because
nbecause investors can diversify through markets; , diversification by a company does not provide any investment opportunity that is not already available to investors
estimates of current share price based on the dividend growth model are
extremely sensitive to estimates of the future growth rate in dividend per share. The same problem arises when the model is used to estimate the cost of equity.
so the CAPM may be preferred.
what are issue costs
costs that are incurred when raising new capital such as underwriters’ fees, legal and administrative fees
- it is not included in cost of capital for project evaluation
what does the cost of capital depend on?
the cost of capital is an opportunity cost that depends on the risk of the project in which the capital is invested. It does not depend on the source of the funds
nThe cost of capital should only be used as an estimate of the cost of capital for a new project if:
¡The risk of the new project is identical to the risk of existing projects.
¡
¡The new project will not cause the company’s optimal or target capital structure to change.
If a firm uses its WACC to make accept/reject decisions for all types of projects,
, it will have a tendency towards incorrectly accepting risky projects and incorrectly rejecting less risky projects.
draw a diagram of what happens if WACC is used to accept/reject decisions for all types of projects
describe this diagram
a single WACC is applied across all projects. Project proposed by retail is incorrectly rejected and he project suggested by the exploration division will be incorrectly accepted
- accept some projects with negative NPV and reject some proejcts with positive NPV
- high-systematic-risk divisions are more likely to have their projects accepted
explain why that WACC should be used only if the new project is not expected to change the company’s optimal or target capital structure.
The company’s cost of capital is also based on its existing capital structure. If the debt capacity of a new project differs from that of the existing projects, then this difference could affect the project’s cost of capital
cost of capital for diversified companies
If a company’s operations are in more than one industry, and the industries differ in risk?
discuss in terms of cost of capital
company’s cost of capital will not be appropriate for project evaluation b/c discount rate will not reflect the risk of the reject and incorrect investment decisions will be made
learning objective: Estimate the cost of capital for a division of a diversified company
pure play company?
a company that operates almost entirely in only one industry
conceptual problems with pure play approach
how to best adjust equity betas for financial leverage.
¡Appropriate leverage adjustment depends on company’s capital structure policy.
practical problems with pure-play approach
¡Pure play companies are rare.
¡Ignores valuable information from diversified co.
Possible to estimate divisions cost of capital from diversified company WACCs
cons of WACC in project evaluation
- only be estimated directly for a whole company, and a company’s cost of capital should only be used to evaluate new projects that are identical to the company’s existing operations.
- should not be used to analyse financial decisions
- it only includes cash flows directly associated with the project. It does not include strategic options that may be associated with the project
why should WACC not be used to make financial decisions
t makes debt appear to be cheaper than equity
e. g. the cost of equity was more than 11 per cent, but the cost of debt was less than 8 per cent.
1. observer might conclude debt should be increased BUT this is wrong b/c increase in debt –> risk of borrowing increases –> increase in interest rate by lender
also shareholders face increased risk –> cost of equity increases (demand for higher return for the risk)
SO WACC increases
For diversified company, use of single WACC
nFor diversified company, use of single WACC for all projects is likely to result in wrong investment decisions.
adv of WACC
flexibility and simplicity compared to estimating it using CAPM where it is difficult to estimate betas of projects
for a company’s WACC to be acceptable
a new project should generate net cash flows that are sufficient to meet the after-tax cost of debt used to finance the project,as well as provide at least the required rate of return on the equity used to finance the project.
The interest rate on the debt is not a valid measure of the new project’s cost of capital b/c
the interest rate on the debt depends on the risk of the company and its existing assets, and does not depend solely on the risk of the new project
if a company makes a share issue to raise the cash needed for a new project, why is the required rate of return of equity not a valid measure of company’s cost of capital?
he cost of equity will depend on the average risk of all the company’s assets and on its financial leverage, not just on the characteristics of the new project
when would a company’s cost of capital be a valid measure of the cost of capital of the new project?
when the risk of the proposed project is the same as the risk of the company’s existing assets (most likely b/c it is an expansion of company’s existing operations –> NO CHANGE IN RISK)
the market value of a bank overdraft will
why?
he market value of a bank overdraft will always equal its book value, b/c
Bank overdrafts carry a variable interest rate, which is adjusted in accordance with fluctuations in market rates.
what is Y in calculating the effective tax rate?
pays maximum possible franked dividends then?
proportion of the tax collected from the company that is claimed as tax credits by shareholders,
Y =1
the cost of capital is an opportunity cost that depends on
he risk of the project in which the capital is invested. It does not depend on the source of the funds.
are issue costs included?
issue costs are not included in cost of capital but it is included in in the cash flows associated with the project.
weighted average issue cost is used b/c
company’s projects are effectively financed by a ‘pool’ of funds consisting of both debt and equity
why is accounts payable excluded?
their costs are accounted for in other ways.
e.g. the cost of trade credit (the difference between the price of goods purchased with cash on delivery and the price when purchased on credit) will flow through into a company’s COGs and is therefore deducted in calculating the company’s profit and net operating cash flow
main assumptions when using the direct estimation approach
(i) The cost of capital is uniform within each industry.
(ii) The data on the proportion of assets in each industry accurately reflect the market values of the companies’ divisions.
adv of direct estimation approach over pure play approach
disadv?
(i) It is not necessary to find companies that operate in only one industry.
(ii) There is no need to employ any model to adjust equity betas or the cost of equity capital for differences in leverage.
CON: may be difficult to estimate the market value of each division of a diversified company.
importance of risk independence
allows managers to evaluate projects on a project-by-project basis.
Factors that will increase γ include the
the proportion of after-tax earnings distributed by a company as well as the proportion of investors that can claim back the tax credits that are distributed
if a diversified company uses the company’s cost of capital for all investments regardless of their divisision, what may happen?
(a) the high-risk divisions finding it much easier than the low-risk divisions to have their projects accepted
(b) some projects incorrectly accepted and rejected
