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Fin 301 > Final exam - Chapter 10 > Flashcards

Final exam - Chapter 10 Flashcards

1
Q

Why Cost of Capital Is Important

A

 The return to an investor is the same as the cost to the company. Thus cost of capital is the rate of return required by investors.

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2
Q

Since the required rate of return on investment depends

on the investment risk, the cost of capital provides us

A

with an indication of how the market views the risk of firm’s assets

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3
Q

Knowing the cost of capital can also help us determine

A

the required return for capital budgeting projects

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4
Q

 Firm needs to earn at least the _____ ____ to compensate our investors for the financing they have
provided

A

required return

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5
Q

What is the Financial structure (3)

A
  1. Current Liabilities
  2. Long term Debts
  3. Shareholders’ Equity
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6
Q

What is the Capital structure

A
  1. Long Term Debts

2. Shareholders’ Equity

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7
Q

What does the current asset change into after deducting the current liabilities?

A

Net working capital

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8
Q

What are the fixed assets

A
  1. Tangible assets

2. Intangible Assets

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9
Q

What is CFFA

A

Cash flow from Assets

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10
Q

What is CFFA formula

A

Cash from from assets (CFFA)

Cash flow to creditors + Cash flow to Stockholders

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11
Q

Value of the firm=

A

Market value of Equity + Market Value of Debt

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12
Q

Cash flow From Assets=

Formula

A

Operating Cash Flow - Net Capital Spending - Change in NWC

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13
Q

Divided Growth model Approach

From Stock Valuation model,

A 
P^lower 0 = 
D^lower1 
/
(R^Lower E - G )
\+
P^lower 0 = 
D^lower2
/
(R^Lower E - G )^2
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14
Q

Dividends grows at a constant rate of g

Special case

A

P^lower 0 =
D^lower 1
/
(R^Lower E - G )

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15
Q

The SML Approach

A

information to compute

our cost of equity

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16
Q

What is Risk free rate variable?

A

R^Lower F (italics)

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17
Q

Market risk premium,

Formula

A

E(R^LowerM) – Rf

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18
Q

Systematic risk of asset,

A

B (Italics)

Beta

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19
Q

What is the SML Approach Formula?

A

R^Lower Advantages and Disadvantages of SML
E = Rf + B^lowerE
(E(R^lowerM) - R^lower f)

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20
Q

Advantages of SML (2)

A

Explicitly adjusts for systematic risk
Applicable to all companies, as long as we can
compute beta

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21
Q

Disadvantages of SML (3)

A

Have to estimate the expected market risk
premium, which does vary over time
Have to estimate beta, which also varies over
time
We are relying on the past to predict the future,
which is not always reliable

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22
Q

Cost of Debt

A

 The cost of debt is the required return on our

company’s debt

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23
Q

For the Cost of Debt, what do we focus on?

A

 We usually focus on the cost of long-term debt

or bonds

24
Q

 The required return is best estimated by
computing the ______ on the existing
debt

A

yield-to-maturity

25
Q

Cost of debt

What is the best way to find out the required return (estimated)

A

yield to maturity

26
Q

We may also use estimates of ______ _____
based on the bond rating we expect when we
issue new debt

A

current rates

27
Q

True or false: The cost of debt is the coupon rate

A

False

 The cost of debt is NOT the coupon rate

28
Q

Preferred stock is a ________

A

perpetuity

29
Q

Cost of Preferred Stock Formula

A

R ^ Lower P
= D
/
P^lower0

Dividend / Price

30
Q

Cost of Preferred Stock, answers comes to what?
A. Decimal
B. %
C. fraction

A

%

31
Q

What is the Weighted Average Cost of Capital

A

We can use the individual costs of capital that we have computed to get our “average” cost of capital for the firm.

32
Q

What is the “Average”

in WAAC?

A

This “average” is the required return on
our assets, based on the market’s
perception of the risk of those assets

33
Q

How are the weights are determined?

In WAAC

A

The weights are determined by how much

of each type of financing that we use

34
Q

Capital Structure Weights
Notation
What is E=

A

market value of equity

= # outstanding shares times price per share

35
Q

Capital Structure Weights
Notation
What is D=

A

D = market value of debt = # outstanding bonds times bond price

36
Q

Capital Structure Weights
Notation
What is V=

A

V = market value of the firm = D + E

37
Q

Capital Structure Weights
Weights
What is W ^ Lower E=

A

= E/V = percent financed with equity

38
Q

Capital Structure Weights
Weights
What is W ^ Lower D=

A

= D/V = percent financed with debt

39
Q

What are we interested in for the cash-flows?

A

We are interested in after-tax cash flows, so we need to consider the effect of taxes on the various costs of capital

40
Q

What reduces our tax liability?

A

Interest

Interest expense reduces our tax liability

41
Q

What does the reduction in taxes reduce?

A

cost of debt

This reduction in taxes reduces our cost of debt

42
Q

What are not a tax deductible? What does this lead to?

A

Dividends are not tax deductible, so there

is no tax impact on the cost of equity

43
Q

WAAC Formula

A 
WACC = 
w^lowerE
R^lowerE
\+
w^LowerD 
R^lowerD
(1-T^lower C)
44
Q

R^lower A ( ROA ) =

Formula for ROA

A 
RA (ROA)= 
w^lowerE
R^lowerE
\+ w^LowerD 
R^lowerD
45
Q

Project Costs of Capital and WACC

When do we use the WAAC as our discount rate?

A

Using the WACC as our discount rate is
only appropriate for projects that are the
same risk as the firm’s current operations

46
Q

Project Costs of Capital and WACC

What should we do when it is NOT the same risk as the firm current operations

A

If we are looking at a project that is NOT
the same risk as the firm, then we need to
determine the appropriate discount rate for
that project

47
Q

Pure Play Approach

A

 Find one or more companies that specialize in
the product or service that we are considering
 Compute the beta for each company
 Take an average
 Use that beta along with the CAPM to find the
appropriate return for a project of that risk
 Often difficult to find pure play companies.

48
Q

Often can’t avoid Subjective Approach

A

 Consider the project’s risk relative to the firm

overall

49
Q

 If the project is more risky than the firm,

A

use a discount rate greater than the WACC

50
Q

 If the project is less risky than the firm,

A

use a discount rate less than the WACC

51
Q

Should you accept projects that you shouldn’t and reject projects you should accept

A

Yes
- You may still accept projects that you shouldn’t
and reject projects you should accept, but your
error rate should be lower than not considering
differential risk at all

52
Q

What is the Risk Level? Discount Rate

WAAC - 8%

A

Very Low Risk

53
Q

What is the Risk Level? Discount Rate

WAAC - 3%

A

Low Risk

54
Q

What is the Risk Level? Discount Rate

WAAC + 5%

A

High Risk

55
Q

What is the Risk Level? Discount Rate

WAAC + 10%

A

Very High Risk

56
Q

Same Risk as Firm

A

WAAC

Fin 301 (9 decks)

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