Module 11: The Cost of Capital

Question 1

From a ________ perspective, we want to think → What are the sources of capital?

Answer 1

corporate

Question 2

What are the sources of capital (how companies finance operations)? (Two main ones; one extra)

Answer 2

1. Equity
2. Debt
3. Preferred Stock (like a hybrid between debt and equity)

Question 3

When thinking about cost of capital, we want to think about what kind of returns are the _______ investors expecting to get when they give that capital to the firm, what kind of returns are the _______ expecting to get, and then we can average these together to figure out overall, what the _______ is ________ from this firm.

Answer 3

equity; debt-holders; market; demanding

Question 4

reflects the investment opportunities and alternatives in the financial market available to supplier’s of the firm’s capital.

Answer 4

cost of capital

Question 5

Does the CAPM theory and beta have to do with equity or debt?

Answer 5

equity (stockholders)

Question 6

Which does this pertain to, debt or equity?
they have promised cash flows, but they have to worry about not getting paid back. So, if a company has steadier cash flows (ex: grocery stores), the ______ may be a bit safer.

Answer 6

debt

Question 7

As debt increases, the riskiness of getting paid back or not (increases/decreases)

Answer 7

increases

Question 8

Who demands a higher rate of return: debt or equity holders?

Answer 8

debtholders

Question 9

We can look at what the market is demanding from a firm in order to allow them to hold our capital, as a gauge for how _______ the firm is overall.

Answer 9

risky

Question 10

What are the two ways of calculating the cost of equity (calculating the cost of common stock)?

Answer 10

1. Dividend Growth Model
2. The Securities Market Line (and some extensions)

Question 11

How do you calculate the cost of equity (aka the required return on equity, or the cost of equity capital)?

Answer 11

Re = (D1 / P0) + g

Aka cost of equity = (next years dividend / price today) + growth rate

Question 12

Which part of the cost of equity formula is the dividend yield? Which part is the capital gains yield?

Answer 12

Dividend Yield = D1/P0

Capital Gains Yield (how much the price goes up over time) = g

Question 13

T or F: If the dividend is growing by 4%, we expect the price to go up 4% as well to keep the equation balanced, assuming r and g stay constant.

Answer 13

True

Question 14

Recall: How do you calculate the Dividend Growth Model?

Answer 14

P0 = D1 / (r-g)

(aka price today = next years dividend / required return - growth rate)

(^With the cost of equity, we want to solve for required return, so we just move around the formula to solve for r)

Question 15

Which type of firm is likely to use the Dividend Growth Model way to solve for the Cost of Equity?
Mature or fast-growing firms? Why?

Answer 15

Mature firms; because this way would be easy to use since they have a steady dividend

(this way is much more difficult to use if you’ve got a fast-growing company which doesn’t have a constant growth rate, or maybe they’re still growing so quickly they don’t pay a dividend at all)

Question 16

What is the hard part to know, and therefore we have to estimate, in the Cost of Equity formula?

What are our 3 potential solutions to getting this?

Answer 16

The growth rate (we know the price today and we usually know what the most recent dividend was).

To get the growth rate, we can estimate using:
1. Historical Average (ex: it went up by 5% for the past four years, so it’s reasonable to estimate that growth for the next year will also go up 5%)
2. Geometric Average (takes into account compounding; is going to be lower if there’s any variation, so it will give us a slightly more conservative estimate)
3. Analysts Forecasts (we can look at what they’re estimating)
(+ any intuition we have about how it’s going to grow; ex: if we think the company’s prospects have improved, it may be they’ll grow a little faster)

Question 17

Which will give us a slightly more conservative estimate of the growth rate:
Historical Average or Geometric Average?

Answer 17

Geometric Average

(will be lower if there’s any variation between it and the historical average)

Question 18

Which way of calculating the cost of equity can always be used, regardless of if a company pays a steady dividend or none at all?

Answer 18

The CAPM Model

(so like even if a company pays a steady dividend, we can always use this, but particularly for companies that don’t pay a dividend, this is the most reasonable model we can use.)

Question 19

For calculating the cost of equity, when we use the CAPM model:
We know the average, historical risk premium and can look up the risk-free rate. We can also calculate or look up betas.
So what is the problem with this then?

Answer 19

Betas and risk premiums are based on historic information. Markets and companies evolve and change, so these things aren’t necessarily going to stay steady over time. (they may change)

Question 20

T or F: There will always be uncertainty about what the true cost of capital is.

Answer 20

True
(our models to get cost of capital use some estimates, so our models are not reality and will never be certain)

Question 21

What do we know about the dividends of preferred stock?
For a company that has preferred stock, it has a ______ ________.

Answer 21

stated dividend (that does not change over time)

So, the price of the preferred (P0) = D / Rp (which is the annual dividend divided by the cost of the preferred)

Question 22

How do you calculate the cost of preferred stock (Rp)?

Answer 22

Rp = D / P0

(Just the dividend yield for the preferred)

Question 23

We’ve talked about the cost of capital for both equity and preferred stock. Our final source of capital for a typical firm is the cost of _______.

Answer 23

debt (like bondholders)

Question 24

The cost of debt is the return that the firm’s creditors demand on _____ borrowing.

Answer 24

new

(This is like the current risk level of debt. So, for a company that has been increasing debt over time, the first debt that they issued is less risky than any new debt that they issue because they already have some debt burden now.)

Question 25

To calculate the cost of debt, we need to recall what 3 things?

Answer 25

1. Yield to Maturity
2. Coupon Rate (Annual Pmt/ Par)
3. Current Yield (Annual Pmt/Price)

Question 26

Recall: if we are trading our bond at a PREMIUM (more than par value), than we expect that our Yield to Maturity will be (higher than/lower than/equal to) our coupon rate.

Answer 26

lower than

Question 27

Recall: if we are trading our bond at a DISCOUNT (less than par value), than we expect that our Yield to Maturity will be (higher than/lower than/equal to) our coupon rate.

Answer 27

higher than

Question 28

Recall: if we are trading our bond at par (equal to par value), than we expect that our Yield to Maturity will be (higher than/lower than/equal to) our coupon rate.

Answer 28

equal to

Question 29

The Weighted Average Cost of Capital:
- Recall from the Balance Sheet that: Assets = ______ + ________.
- One thing we have to keep in mind: we are interested in _____-______ cash flows.
- One benefit of debt is that interest payments are ____ ______.

Answer 29

• Debt + Equity (So, if we know the cost of the debt, and we know the cost of the equity (which may just be common equity, or could include preferred), then we can combine these two to get the cost of the assets of the firm)
• after-tax
• tax deductible (need to take this into account when getting the WACC). When we calculate the YTM, that is the BEFORE tax cost of debt. But, our after tax cost is going to be LOWER because some of that money would have gone to the government anyways, and so when we increase debt and we have those interest payments, part of that money is basically paid by the government (they’re giving us a reduction on our taxes to pay down that debt)