Midterm 3 Part 2 Flashcards
What is the cost of capital?
It is either the interest rate for a bank (the amount they expect in exchange for providing you with money) or it is the expected rate of return if your capital came from investors/owner (the amount of money they expect in exchange for providing you with funds).
How much it costs the firm to finance either through debt or equity.
What does NPV stand for?
Net present value
What is the NPV?
It is the sum of the present values of all future cash flows minus the investment money.
How do you know if your project is valuable to the firm?
By knowing the cost of capital
Opportunity costs
The potential benefits you miss out on if you choose one alternative over another.
In finance, the goal is to figure out which project will provide the most benefits and bring the most value to the firm.
What is the cost of capital?
The cost required for bringing funds into a business, either through debt or equity.
What you’re really asking is: Are we gaining more value than we are losing?
How do we know if we are bringing value to the company?
We compare our cost of capital with ROA:
If the ROA is > Cost of capital = we have increased value to the firm.
If the ROA is < Cost of capital = we have decreased firm value
Investment Decisions
The left side of the balance sheet, all the decisions made to allocate the money your company is making.
Financing Decisions
Dealing with the right side of the balance sheet, deciding where/how to obtain funds for the business
What does WACC stand for?
Weighted average cost of capital
What is the WACC trying to do?
It calculates the average cost of capital from all debt and equity.
What are all projected returns compared to?
Cost of capital.
Because you want to see if the returns you’ll make will be higher or lower than the cost of capital.
What is the idea behind EVA?
Real value is only created when the actual returns are higher than the expected rate of return (when the company is performing better than expected)
Finance Charge
WACC x Costly Capital
Costly Capital
Capital that was invested
How does a firm earn positive EVA (and attracts investors)?
By earning returns higher than the WACC
What happens if the returns are equal to the WACC?
The investor gets 0 profits (they just break even).
What are the three basic sources of raising capital?
- Debt (borrowing)
- Equity (common stock)
- Hybrid (preferred stock)
True or False: Capital costs include coupon payments made to bond holders
True!!
True or False: Capital costs include opportunity costs of equity holders
True
What is the cost of capital for a debt?
It is the interest rate on the loan.
The rate of return required by the debt holder.
True or False: Bondholders count as debt holders when considering cost of capital
TRUE
What are the three components of calculating cost of debt?
- The borrowing cost
- The flotation cost
- Taxes
What is the borrowing cost?
The explicit interest rate you pay on debt
On a bond, it would be the YTM (include both coupons and final payments)
What are flotation costs?
They are additional fees that are determined by how you acquired your debt: transaction fees, closing fees, 3rd party fees, etc.
Interest tax shield
The savings a company gets by using debt. It basically means that the company ends up paying less taxes.
What causes an interest tax shield?
Using debt capital instead of equity capital
Why does a tax shield create a tax deduction?
Because debt-interest payments are deducted BEFORE the tax rate is applied, which means the amount the company owes taxes on is less than what it would be if they were financing through equity.
Why would the government subsidize mortgage debt (tax deductions for mortgages)?
Because they want more Americans to own homes to stabilize the national economy.
How do you calculate flotation costs into a bond equation?
They are subtracted (just once) from the PV because it is a lump sum that you lose in transaction costs.
Tax shield equation
1-tax rate
What does Kd represent in equations?
The pre-tax cost of debt
How do you calculate the before-tax debt cost?
You solve for the YTM by inputting everything in your calculator
How do you calculate the after-tax debt cost?
Kd (1-tax rate)
How do you find flotation costs?
Two ways:
1. If they give you a dollar amount, just subtract it from the PV
2. If they give you the percentage, you do (1-flotation cost percentage) then multiply that by the current PV
What are the two sources of common equity?
Internal and external
What is internal equity?
Funds that are generated within the company (Retained earnings)
What are retained earnings?
Profits made during the year that are not paid out as dividends
How are external sources of equity generated?
By issuing common stock
Are internal and external costs of equity the same?
NO, not in the real world because of flotation costs. Otherwise yes.
What are the three methods for computing the cost of common stock?
- CAPM
- Buildup
- Gordon Growth Model
True or False: You need to adjust the CAPM, Buildup method, and GGM when trying to find external costs of equity.
TRUE
True or False: The standard CAPM equation will help you solve for internal costs of equity
TRUE
How do you use the CAPM to solve for external equity costs?
You have to adjust for flotation (because that’s the only difference between internal and external equity costs).
You multiply the result of the normal CAPM by (1 + flotation cost %)
How do you adjust the Buildup method to get the external equity cost?
You adjust for flotation.
You multiply your normal buildup solution by (1 + flotation cost %)
How do you adjust the GGM to get the external equity cost?
You multiply the denominator by (1 - flotation cost %)
NOTE: This is the only method where you SUBTRACT from 1 instead of adding to it.
What if we are given a dollar amount for the flotation cost instead of a percentage?
You just subtract the dollar amount from the Net price (the denominator in GGM)
The other two methods only account for percentages, so you would need more information to solve.
True or False: When calculating equity costs for Preferred stock, you multiply the denominator by (1 - flotation cost %)
TRUE
That’s what you do any time you’re using GGM, whether it’s common or preferred stock
Do we prefer market values or book values when calculating with the WACC?
Market values, but we can use book values if we have them
Why do we prefer market values not book values?
Because book values show historical data, and market values show current numbers.
When calculating the WACC, what does the (1 - t) apply to?
Only the cost of debt, you do not multiply the tax rate (tax shield) by the equity.
True or False: If the WACC equation is calculating for two types of debt, the debt shield must be applied to both of them.
TRUE.
True or False: The weights must sum to 100% in the WACC
True
Are bonds considered short term or long term compared to notes?
Long
Notes are short
How do you find the market value of common stock, preferred stock, or bonds?
You multiply the price of the bond/stock BEFORE flotation by the number of bonds/stocks issued.
What is a company’s capital structure?
The percentages that they assign to common stock, preferred stock, and debt.
For example, the capital structure of IBM is 35% debt, 45% preferred stock, and 20% common stock
What is the limitation of WACC?
It doesn’t work for new projects. Because it can’t calculate the risks associated with a new business venture.
What is the rate of return in the DCF equation?
The WACC
Pure play
We analyze the risks that other companies have that are in the market we’re looking into.
This is what we do when the WACC wouldn’t be accurate.
True or False: According to the GGM, firms that pay dividends will have higher costs of equity than firms who do not pay dividends
FALSE
What is the goal of the cost of capital?
Maximize owner wealth
Is it cheaper to use debt capital or equity?
Debt
True or False: The best way to maximize owner wealth is to use 100% debt capital
True
Who were MnM?
Modigliani and Miller
What did MnM do?
They made the WACC
Irrelevance hypothesis, they assumed away unsystematic risk
On the WACC graph (two hyperbolas), where is the optimal capital structure?
Right where the two hyperbolas intersect.
What is the point where the two hyperbolas intersect on the WACC graph?
The point where the benefits of tax breaks are exactly cancelled out by financial distress costs
Examples of financial distress costs
Losing clients, bankruptcy, losing business, etc.
