Final exam - Chapter 10 Flashcards
Why Cost of Capital Is Important
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.
Since the required rate of return on investment depends
on the investment risk, the cost of capital provides us
with an indication of how the market views the risk of firm’s assets
Knowing the cost of capital can also help us determine
the required return for capital budgeting projects
Firm needs to earn at least the _____ ____ to compensate our investors for the financing they have
provided
required return
What is the Financial structure (3)
- Current Liabilities
- Long term Debts
- Shareholders’ Equity
What is the Capital structure
- Long Term Debts
2. Shareholders’ Equity
What does the current asset change into after deducting the current liabilities?
Net working capital
What are the fixed assets
- Tangible assets
2. Intangible Assets
What is CFFA
Cash flow from Assets
What is CFFA formula
Cash from from assets (CFFA)
Cash flow to creditors + Cash flow to Stockholders
Value of the firm=
Market value of Equity + Market Value of Debt
Cash flow From Assets=
Formula
Operating Cash Flow - Net Capital Spending - Change in NWC
Divided Growth model Approach
From Stock Valuation model,
P^lower 0 = D^lower1 / (R^Lower E - G ) \+ P^lower 0 = D^lower2 / (R^Lower E - G )^2
Dividends grows at a constant rate of g
Special case
P^lower 0 =
D^lower 1
/
(R^Lower E - G )
The SML Approach
information to compute
our cost of equity
What is Risk free rate variable?
R^Lower F (italics)
Market risk premium,
Formula
E(R^LowerM) – Rf
Systematic risk of asset,
B (Italics)
Beta
What is the SML Approach Formula?
R^Lower Advantages and Disadvantages of SML
E = Rf + B^lowerE
(E(R^lowerM) - R^lower f)
Advantages of SML (2)
Explicitly adjusts for systematic risk
Applicable to all companies, as long as we can
compute beta
Disadvantages of SML (3)
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
Cost of Debt
The cost of debt is the required return on our
company’s debt
For the Cost of Debt, what do we focus on?
We usually focus on the cost of long-term debt
or bonds
The required return is best estimated by
computing the ______ on the existing
debt
yield-to-maturity
Cost of debt
What is the best way to find out the required return (estimated)
yield to maturity
We may also use estimates of ______ _____
based on the bond rating we expect when we
issue new debt
current rates
True or false: The cost of debt is the coupon rate
False
The cost of debt is NOT the coupon rate
Preferred stock is a ________
perpetuity
Cost of Preferred Stock Formula
R ^ Lower P
= D
/
P^lower0
Dividend / Price
Cost of Preferred Stock, answers comes to what?
A. Decimal
B. %
C. fraction
%
What is the Weighted Average Cost of Capital
We can use the individual costs of capital that we have computed to get our “average” cost of capital for the firm.
What is the “Average”
in WAAC?
This “average” is the required return on
our assets, based on the market’s
perception of the risk of those assets
How are the weights are determined?
In WAAC
The weights are determined by how much
of each type of financing that we use
Capital Structure Weights
Notation
What is E=
market value of equity
= # outstanding shares times price per share
Capital Structure Weights
Notation
What is D=
D = market value of debt = # outstanding bonds times bond price
Capital Structure Weights
Notation
What is V=
V = market value of the firm = D + E
Capital Structure Weights
Weights
What is W ^ Lower E=
= E/V = percent financed with equity
Capital Structure Weights
Weights
What is W ^ Lower D=
= D/V = percent financed with debt
What are we interested in for the cash-flows?
We are interested in after-tax cash flows, so we need to consider the effect of taxes on the various costs of capital
What reduces our tax liability?
Interest
Interest expense reduces our tax liability
What does the reduction in taxes reduce?
cost of debt
This reduction in taxes reduces our cost of debt
What are not a tax deductible? What does this lead to?
Dividends are not tax deductible, so there
is no tax impact on the cost of equity
WAAC Formula
WACC = w^lowerE R^lowerE \+ w^LowerD R^lowerD (1-T^lower C)
R^lower A ( ROA ) =
Formula for ROA
RA (ROA)= w^lowerE R^lowerE \+ w^LowerD R^lowerD
Project Costs of Capital and WACC
When do we use the WAAC as our discount rate?
Using the WACC as our discount rate is
only appropriate for projects that are the
same risk as the firm’s current operations
Project Costs of Capital and WACC
What should we do when it is NOT the same risk as the firm current operations
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
Pure Play Approach
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.
Often can’t avoid Subjective Approach
Consider the project’s risk relative to the firm
overall
If the project is more risky than the firm,
use a discount rate greater than the WACC
If the project is less risky than the firm,
use a discount rate less than the WACC
Should you accept projects that you shouldn’t and reject projects you should accept
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
What is the Risk Level? Discount Rate
WAAC - 8%
Very Low Risk
What is the Risk Level? Discount Rate
WAAC - 3%
Low Risk
What is the Risk Level? Discount Rate
WAAC + 5%
High Risk
What is the Risk Level? Discount Rate
WAAC + 10%
Very High Risk
Same Risk as Firm
WAAC
