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Corporate issuer > Cost of capital fundation > Flashcards

Cost of capital fundation Flashcards

1
Q

What is the cost of capital?

A

It is the rate of return that the suppliers or providers of capital are required to contribute their capital to the firm.

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2
Q

What is the component and the component cost of capital?

A
  • Component: it is an instrument used to obtain financing.
  • The component cost of capital: it is the different required rate of return for each component.
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3
Q

What is the weighted average cost of capital (WACC)?

A

It is the expected rate of return that investors demand to finance an average-risk investment of the company.

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4
Q

What is another name for the WACC?

A

The marginal cost of capital (MCC)

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5
Q

What is the target capital structure?

A

It is the capital structure that the company aims to maintain.

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6
Q

What is the cost of fixed-rate capital?

A

It is the cost of debt financing when a company issues a bond or takes a bank loan.

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7
Q

What are the 2 methods to calculate the cost of fixed-rate capital?

A
  • Yield-to-maturity approach
  • Debt-rating approach
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8
Q

When and why should we use a debt-rating approach?

A

It is when a reliable current market price for the company’s debt is not available. We then use the BT cost of debt that is estimated using the yield on similarly rated bonds that also have similar terms to maturity as the company’s existing debt.

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9
Q

What factors can affect the rating and yield of the cost of debts?

A

The relative seniority and security of different issues.

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10
Q

What are the issues in estimating the cost of debt?

A
  • Fixed-rate versus floating-rate debt: cost of floating-rate debt varies a lot, so it’s hard to estimate the fixed rate.
  • Debt with option-like features: We can only use the yield to maturity on these bonds to estimate the cost of debt if we expect similar bonds to be issued going forward.
  • Nonrated debt: if the debt doesn’t have any outstanding debt (to be rated) or yields on existing debt that is not available, an analyst may not be able to use the YTM of the debt-rating approach to estimate the company’s cost of debt.
  • Leases: the cost of leases should be included in its cost of capital.
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11
Q

How can we use the perpetuity formula for the preferred stock?

A

When preferred stock is noncallable and nonconvertible, when there is no maturity date, and pays dividends at a fixed rate.

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12
Q

What is the cost of equity?

A

It is the rate of return required by the holders of a company’s common stock.

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13
Q

What are the 2 common approaches to determining the cost of common equity?

A
  • Capital pricing model (CAPM)
  • Bond yield plus risk premium approach
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14
Q

What is the CAPM?

A

It states that the expected rate of return from a stock equals the risk-free interest rate plus a premium for bearing risk.

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15
Q

How can you estimate the market risk premium?

A

With a survey approach where the average of the forecasts of financial experts s adjusted for the specific stock’s systematic risk.

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16
Q

What is the systematic risk?

A

It is the nondiversiable risk.

17
Q

What is the bond yield plus risk premium approach?

A

It is based on the assumption that the cost of capital for riskier CF is higher than that of less risky CF.

18
Q

How do we get the beta of a company?

A

By regressing the company’s stock’s returns against market returns over a given period.

19
Q

What issues should be considered when determining beta?

A
  • They are based on historical returns and are therefore sensitive to the length of the estimation period.
  • Smaller standard errors are found when betas are estimated using small return intervals.
  • Betas are sensitive to the choice of the market index against which stock returns are regressed.
  • Betas are relieved to revert toward 1 over time, which implies that the risk of an individual project or firm equals market risk over the long run.
  • Small-cap stocks generally have greater risks and returns compared to large-cap stocks.
20
Q

What is the smoothing technique used to adjust beta for small-cap companies?

A

Adj. Beta = 2/3 *unadjusted beta + 1/3

21
Q

What method do analysts use to estimate the beta of a particular project or of a company that is not publicly traded? Describe it.

A

They use Pure-play. It required adjusting a comparable publicly-listed company’s beta for differences in financial leverage.

22
Q

How do we use the pure-play?

A
  • We find a comparable company that faces similar business risks as the company or project under study and estimate the equity beta of the company.
  • We “unlever” the beta to remove all elements of financial risk from the comparable’s beta to only show the business risk.
  • ## We adjust the unleverd beta of the comparable for the level of financial risk in the project or company under study.
23
Q

What does the asset beta represent?

A

It only reflects the business risk of the comparable company.

24
Q

What does the equity beta represent?

A

It reflects the business and financial risk of the comparable company.

25
Q

What does the project beta represent?

A

It only represents the business and financial risk of the project.

26
Q

What are flotation costs?

A

It is the fee charged by investment bankers to assist a company in raising new capital.

27
Q

What are the 2 approaches to account for flotation costs?

A
  • Incorporate the flotation cost into the cost of capital using its formula. But this adjustment will not necessarily equal the PV of flotation costs.
  • The correct approach is to adjust the CF used in the valuation. We add the estimated dollar amount of the flotation cost to the project’s initial cost.
28
Q

What is the WACC formula?

A
29
Q

What is the formula to transform Debt-to-Equity Ratio into a component’s weight?

A
30
Q

What is the CAPM formula?

A
31
Q

What is the dividend discount model formula?

A
32
Q

What is the formula for unlevered beta for comparable assets?

A
33
Q

What is the formula for a beta for a project using a comparable asset re-levered for the target company?

A

Corporate issuer (8 decks)

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