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2nd Year - Finance 2 > Lecture 6 - Risk and The Cost Of Capital > Flashcards

Lecture 6 - Risk and The Cost Of Capital Flashcards

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1
Q

What is the opportunity cost of capital?

A

The minimum acceptable expected rate of return on a project given its risk.

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2
Q

What are the three main sources/measurements of capital?

A
  • Equity (or common stock).
  • Preferred stock.
  • Debt.
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3
Q

The cost of each source of capital to the company is equated with…

A

The return which the providers of finance (i.e. investors) are demanding on their investment.

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4
Q

To calculate the return demanded, we assume there is a…

A

Perfect market.

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5
Q

Market value of investment equals…

A

The present value of the expected returns discounted at the investor’s required return.

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6
Q

The investor’s required return is equal to…

A

The internal rate of return (IRR) achieved by investing the current price and receiving the future expected returns.

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7
Q

The cost of equity finance to the company is the…

A

Return the investors expect to achieve on their shares.

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8
Q

What are the two methods to get the cost of equity finance?

A
  • Dividend Discount Model (DDM).

- Capital Asset Pricing model (CAPM).

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9
Q

What are the assumptions in the DDM?

A
  • Future income stream is the dividends paid out by the company.
  • Dividends will be paid in perpetuity.
  • Dividends will be constant or growing at a fixed rate.
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10
Q

Therefore, share price equals…

A

Dividends paid in perpetuity discounted at the shareholder’s rate of return.

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11
Q

What are strengths of the DDM?

A
  • Simple and useful for firms that pay steady dividends (we assume dividends are growing at a constant rate).
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12
Q

What are weaknesses of the DDM?

A
  • The input data used may be inaccurate. For example, current market price and future dividend patterns. Sometimes the market may be imperfect for a short amount of time and during this time the price might be different to the intrinsic value.
  • The growth in earnings is ignored (dividends paid out of earnings/net income).
  • Not applicable to firms that pay no dividends or whose dividend growth is difficult to estimate.
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13
Q

What does the capital asset pricing model (CAPM) tell us?

A

That expected rates of return depend on risk, that is, on beta. Expected return should depend on systematic risk. If you hold a well diversified portfolio, systematic and specific risk (e.g. strikes) can be diversified away. If the portfolio holds more assets, the risk will decline. Systematic risk or market risk cannot be eliminated (e.g. macroeconomic factors such as impacts of inflation and interest rates).

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14
Q

What are the assumptions in CAPM?

A
  • Perfect capital market.
  • Well diversified investors.
  • Unrestricted borrowing and lending at rf (risk free).
  • Single period transaction period.
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15
Q

What are the advantages of CAPM?

A
  • Works well in practice.
  • Focuses on systematic risk and its effect on return.
  • Is useful for appraising specific projects.
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16
Q

What are the disadvantages of CAPM?

A
  • Less useful if investors are undiversified.
  • Ignores tax situation of investors.
  • Actual data inputs are estimates and may be hard to obtain.
17
Q

What is the cost of preferred stock?

A

The return the preferred stockholders expect to achieve.

18
Q

Why are taxes an important consideration in the company’s cost of capital?

A

Payments are deducted from income before tax is calculated.

19
Q

This cost to the company is reduced by…

A

The amount of this tax saving.

20
Q

What is the company cost of capital defined as?

A

The opportunity cost of capital for investment in the company as a whole. This is the expected return on a portfolio of all company’s outstanding securities.

21
Q

If a firm has no debt outstanding, this is called a…

A

Unlevered firm.

  • Shareholders own all of the firm’s assets and are entitled to all the cash flows.
  • The company cost of capital (re) is the same as cost of equity as the firm is completely equity financed and there is not outstanding debt.
22
Q

If a firm has both debt and equity, this is called a…

A

Levered firm. The company cost of capital is the weighted average cost of capital (WACC).

23
Q

The company cost of capital is a…

A

Weighted average of returns demanded by debt and equity investors.

24
Q

The weighted average is the…

A

Expected rate of return investors would demand on a portfolio of all the firm’s outstanding securities. It is a combination of the cost of debt and the cost of equity.

25
Q

Book values represent…

A

Historic cost of capital.

26
Q

Market values represent…

A

Current opportunity cost of capital, what investors are actually willing to pay.

27
Q

Debt can have two costs. What are these?

A
  • If a firm increases its debt ratio then the firm has a higher default risk, (higher bankruptcy risk). This will lead to increased cost on debt.
  • Shareholders will buy out a higher risk so if a firm has a higher debt ratio then the cost of equity will increase too (due to the increased demand).
28
Q

Beta may change with…

A

Capital structure. Normally it will increase if a firm has a higher debt ratio.

29
Q

What does project cost of capital depend on?

A

The use to which the capital is being put. Additionally, a project’s cost of capital depends on the risk of the project, not the risk of the company investing in the project.

30
Q

What are the determinants of risk?

A
  • Cyclicality of earnings. Variability of earnings depending on the market and economic conditions. (In an expanding economy earnings will increase more, cyclicality of earnings will be higher. These types of projects will be of higher risks.)
  • Operating leverage. (If the ratio of fixed costs to variable costs is high, then the project’s risk is higher.)
  • Financial leverage. (If the ratio of debt is high then project’s risk will be higher.)
31
Q

Typically, each project has…

A

A different cost of capital.

32
Q

In practice, most companies estimate a company cost of capital, which depends on

A

Average risk of its investments.

33
Q

The company cost of capital can be the…

A

Appropriate discount rate for the firm’s average risk projects.

34
Q

‘Average risk’ means that…

A

The project’s risk matches the risk of the firm’s existing assets and operations.

35
Q

If the new projects are more or less risky than the firm’s existing business, the company cost of capital can be…

A

Used as a benchmark and be adjusted up or down for riskier or safer projects.

36
Q

If new projects have the same risk as existing operations in the firm then the…

A

Company cost of capital is the appropriate discount rate.

37
Q

Some companies set…

A

Two or more discount rates for different types of projects (e.g. low risk and high risk).

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