Reading 33: Cost of Capital Flashcards
Describe the optimal capital budget.
It occurs at the point where the marginal cost of capital intersects the investment opportunity schedule.
Define flotation costs.
These costs refer to the fee charged by investment bankers to assist a company in raising new capital. In the case of debt and preferred stock, these do not usually incorporate flotation costs in the estimated cost of capital because the amount of these costs is quite small, often less than 1%. However, for equity issues, flotation costs are usually quite significant.
Identify the adjustments made to the WAAC if the risk of the project under consideration is above or below the average risk of the company’s current portfolio of projects.
If a project has greater risk than the firm’s existing projects, the WACC is adjusted upward.
If the project has less risk than the firm’s exiting projects, the WACC is adjusted downward.
Give the formula used to calculate perpetuity.
Vp=Dp/rp
Why does a company’s marginal cost of capital (MCC) increase as additional capital is raised?
The company may have existing debt covenants that restrict it from issuing debt with similar seniority. Subsequent rounds of debt will be subordinated to the senior issue, so they will obviously carry more risk, and therefore entail a higher cost.
Due to economies of scale in raising a significant amount of a component (debt or equity) of capital in one issuance, firms may deviate from their target (optimal) capital structure over the short term. These deviations may cause the marginal cost of capital to rise.
Describe the bond yield plus risk premium approach.
It is based on the assumption that the cost of capital for riskier cash flows is higher than that of less risky cash flows. Therefore, we calculate the return on equity by adding a risk premium to the before-tax cost of debt.
Identify and explain the various systematic risks.
Business risk is comprised of sales risk and operating risk.
Sales risk refers to the unpredictability of revenues, and operating risk refers to the company’s operating cost structure.
Financial risk refers to the uncertainty of profits and cash flows because of the use of fixed-cost financing sources such as debt and leases. The greater the use of debt financing, the greater the financial risk of the firm.
Define the dividend discount model approach.
It asserts that the value of a stock equals the present value of its expected future dividends.
List the issues that should be considered when determining beta.
Sensitive to the length of the estimation period.
Smaller standard errors are found when estimated using small return intervals.
Sensitive to the choice of the market index against which stock returns are regressed.
Revert toward 1 over time, which implies that the risk of an individual project or firm equals market risk over the long run.
Small-cap stocks generally have greater risks and returns compared to large-cap stocks. Betas of small companies should be adjusted upward to reflect greater risk.
Define the bond’s yield to maturity (YTM).
A measure of the return on the bond assuming that it is purchased at the current market price and held till maturity. It is the yield that equates the present value of bond’s expected future cash flows to its current market price.
Describe the capital asset pricing model (CAPM).
It states that the expected rate of return from a stock equals the risk-free interest rate plus a premium for bearing risk.
Give the formula used to calculate a company’s WACC.
WACC = (wd)(rd)(1 − t) + (wp)(rp) + (we)(re)
