Module 33.1 Weighted Average Cost of Capital Flashcards
What is the typical discount rate used for a firm?
the weighted average cost of capital (WACC) or the marginal cost of capital (MCC).
Why do you adjust the cost of debt for tax payments?
In many countries the interest paid on corporate debt is tax deductible, however, we are interested in after tax cost of capital.
Is the WACC accurate for evaluating all new projects?
No, because WACC reflects the average risk of projects that make up a firm, for greater than average risk projects the WACC should be adjusted.
What is the formula for WACC?
weight of after tax debt * cost of after tax debt + weight of preferred stock * cost of preferred stock + weight of equity * cost of common equity
What is the optimal capital budget?
where the marginal cost of capital crosses the investment opportunity schedule. A firm should undertake all projects with IRRs greater than the cost of funds.
For the cost of debt, should you grab the coupon rate or the market interest rate?
market interest rate
What if there is no avaiable YTM for a firms debt? how should it be calculated?
does seniority or covenants effect the YTM?
comparable analysis will determine the YTM to use
Yes strong seniority or covenants should be taken into account.
How do you calculate the cost of preferred stocK?
Dps / P
DPS = preferred dividends P = market price of preferred
What are the four steps of the capital asset pricing model approach?
1) Estimate the risk free rate
2) estimate the stock beta, risk measure
3) estimate the expected rate of return on the market
4) use the CAPM equation to estimate required rate of return:
cost of equity = risk free + beta *[expected return market - risk free]
What is the dividend discount model approach to calculating cost of equity?
kce = D1 / P0 + g
D1 = next year's dividend P0 = current value of stock g = firm's expected constant growth rate.
g = retention rate * return on equity = (1 - payout rate)*ROE
What is the bond yield plus risk premium approach to calculating cost of equity?
cost of equity = bond yield + risk premium
