lec 5 Flashcards
What are the long-term sources of funds?
Long-term sources include debt (e.g., bonds, debentures, bank loans) and equity (e.g., common shares, preferred shares, retained earnings). These funds are considered “permanent” financing.
How are medium- and short-term sources classified?
Medium-term sources include leasing and term debt (e.g., notes payable), whereas short-term sources include accounts payable and bank margin accounts.
What is meant by cost of capital?
The cost of capital is the weighted-average cost of a firm’s long-term sources of funds. Therefore, it is the minimum return on investment that a firm must earn to satisfy its obligations towards its suppliers of permanent capital, i.e. its long-term creditors and shareholders
For a project: The cost of capital represents the return the company requires to make an investment worthwhile
How is the cost of debt for new bonds calculated?
For new bond issues, net proceeds (NP) are determined as: NP = Face Value – (issuing expenses + any Discount). If the yield-to-maturity (YTM) is given, the after-tax cost of debt is: k_d = YTM × (1 – t) where t is the tax rate.
What do NP and IE represent?
NP (Net Proceeds): The amount the company actually receives from issuing a security after subtracting flotation costs (issuance expenses) and any discount.
IE (Issuance Expenses): The flotation costs incurred when issuing new securities, which reduce the net proceeds.
How is the cost of preferred equity determined?
For preferred shares, the cost is typically calculated as: k_p = (Annual Dividend) / (Net Proceeds) where Net Proceeds = Par Value – Flotation Costs. If dividends are not tax deductible, no tax adjustment is applied.
What is the formula for the cost of common equity for existing shares?
For existing common shares (with no new issuance costs): K_e = (D₁ / P₀) + g where D₁ is the dividend expected next period, P₀ is the current market price, and g is the constant dividend growth rate.
How is the cost of new common equity (or new shares) calculated?
When issuing new common shares, flotation costs reduce the net proceeds. Thus, the cost becomes: K_e = (D₁ / NP) + g where NP = Par – Flotation Costs. This ‘new’ cost is higher than for existing shares because of the issuance expense.
How is the cost of retained earnings determined?
Retained earnings have an implicit cost equal to the cost of existing common equity: K_re = (D₁ / P₀) + g. This reflects the opportunity cost of not paying dividends and instead reinvesting profits.
How does dividend growth affect the cost of equity?
In the dividend growth model, the expected growth rate (g) adds to the required yield: K_e = (D₁ / Price) + g. A higher growth rate implies that investors demand a higher return, thereby increasing the cost of equity.
Bond’s current yield
new: PMT/NP
existing: PMT/MKT P
Dividend yield
D_1/PMKT (exist) or D_1/NP (new)
what is the relation between retention ratio and ROE
growth (div) = RR * ROE
Required rate of return
Cost of equity -> Expected Rate of return that shareholders demand
If the question asks for the firm’s overall required rate of return, it usually refers to WACC.
If the question asks for the required rate of return for investors (shareholders), it refers to
𝐾e, which excludes debt.
If the question asks for the cost of debt (𝐾𝑑), it refers to the interest rate the firm pays on borrowed funds.
what does it mean when we say the preferred shares are priced to yield 8%
The cost of preffered shares K_ps = 8% (no growth so were good)
Leverage
Leverage refers to the ability of a business to increase its return on equity by including long-term debt in its capital structure.
+ profit, + risk
NP for existing vs ipo vs dilution
Existing: NP = MKT price
IPO: NP = Par - IE(1-t)
Dilution: NP = MKT - IE(1-t)
Relationship between debt to equity ratio and financial leverage
Higher D/E, higher leverage
DPP > PP ?
True for IRR > 0
If kept to maturity, what return will the bond yield to bondholder vs issuer
issuer will have to include issuing expenses, bondholder not
