FI 3 Cost of Capital Flashcards
Two reasons why cost of capital is determined
- Assess a new investment and discount rate required
2. Understand impact on entity’s overall cost of capital due to changes in capital structure.
Define hurdle rate
Minimum amount of return required for a project to proceed. Higher the return, riskier the project.
Define WACC
Average of after-tax financing costs for both debt and equity, weighted for proportion of each in capital structure
How is WACC used in determining project acceptance? If project is same WACC? If higher? If lower?
If same WACC then use WACC, if higher than WACC, use higher discount rate. If lower than WACC, use lower discount rate.
How is value of a firm determined using WACC?
Future cash flows discounted at cost of capital
What 4 items do you need to calculate WACC?
costs of debt
costs of equity
weighting of each in capital structure
income tax rate
WACC formula
Weighting of debt x After-tax cost of debt + Weighting of equity x Cost of equity
What is the cost of debt? Is short-term included?
Interest paid. No, only long-term debt.
How to determine current cost of debt with fixed rate of interest
Look at yield on debt if publicly traded. If not, then use yield on publicly traded debt that has a similar credit risk and term to maturity. Use FV calculator to determine the interest rate (cost of debt).
How to determine cost of debt with variable-rate
Add current base rate plus premium
How to determine after-tax cost of debt
Current debt yield (1 - tax rate)
Formula to determine cost of preferred shares
Total annual preferred dividends paid on preferred shares / total market value of all preferred shares outstanding
OR
Total annual div paid per preferred share / current market price per pref share
CAPM formula
Cost of equity = Risk-free return (Rf) + Risk premium related to risk of investment
OR
Risk-free return (Rf) + Beta x Market Risk Premium
Risk-free rate in CAPM model
Government bonds usually - the lowest-yielding bonds in current market
Define beta. What does a beta of 1 mean? of 2?
Beta is the systematic risk of an investment. If it is 1, then it is correlated perfectly with the market. When it is 2 it is twice as risky as the market.
Define market risk premium
Long-term average of difference between total return on market less return on risk-free investments.
Factors that impact cost of equity
Volatility of sales due to product or changes in selling prices
Cash outflows related to cost volatility
Amount of operating leverage - more fixed costs, higher the operating risk
More debt, higher the financial risk
WACC calculation
D/V (Rd)(1 – T) + P/V (Rp) + E/V (Re)
where
D is the market value of debt
V is the total of market value of debt, preferred shares, and equity
Rd is the current cost of debt
T is the marginal tax rate
P is the market value of preferred shares outstanding
Rp is the current cost of preferred shares
E is the market value of common shares outstanding
Re is the current cost of equity
What is marginal cost of capital
The WAC of the last dollar of capital raised.
