The capital cost of projects Flashcards
Definition cost of capital:
The cost of capital for a project is the minimum risk adjusted return required by shareholders of the firm for undertaking that project
This rate must take account of both the time value of money,measured by risk free rate of return and the riskiness of the project’s cash flows
Discount Rate = Cost of capital = Expected return, required return of hurdle rate. What is the CC unter uncertain conditions?
CC = risk free rate + risk premium.
Which discount rate method to use when regarding FCF to equity?
Use levered equity method (LE)
The LE method discounts the FCFE at the levered cost of equity.
Which discount rate method to use when regarding FCF to firm?
WACC method the Weighted Average Cost of Capital .
Definition of WACC
The WACC method discount FCFF at the the Weighted
Average Cost of Capital (WACC) after tax
What is the Arditti Levy formulation WACCal?
This method advocates the incorporation of debt tax benefits in the definition of cash flows, which leads to the use of the WACC before taxes, as the discount rate
What is the definition of Adjusted present value (APV) and its objective?
APV = base case NPV + sum of PVs of financing side effects
The APV aims to seperate the various sources that create value
How to estimate the cost of equity for listed companies 1/2?
Capital asset pricing model (CAPM)
Risk of equity = Riskfree rate + asset beta*Market risk premium
How to estimate the cost of equity for listed companies 2/2?
Use the gordon model: Estimated cost of equity capital (r )=Dividend yield + Expected dividend growth rate
How to estimate the cost of equity for NONlisted companies (three answes)?
- ROE = Net Profit / Equity (bad proxy; to
- Use CC of a similar listed company similar risk characteristicsand similar financing structure)
- “Pure play beta ””_ using CAPM+ HAMADA equations
What does the “pure play” beta mean?
Find a portfolio of firms that share similar risk characteristics and use the firm’s beta to proxy for the project beta
Financial risks will differ if they use different amounts of debt financing
Cost of debt is a function of
- Current level of interest
- Default risk for the company
- Taxation (tax savings)
- Inflation
What is YTM?
the rate of return the investor gets if he buys the bond at price P (and keeps it until maturity)
How to estimate the cost of debt from the company’s default risk?
The interest rate on debt equals the nominal risk free rate plus risk premiums sufficient to compensate debt holders for the possibility of default
What rating does an interest coverage ratio of 8,5 get?
AAA Rating with typical default spread 1,25 %
