Unit 1 Flashcards
Cost of capital
Depends on the use of funds not the source
Cost of equity capital
Return that equity investors require on their investment in the firm
Methods of cost of equity
Dividend growth model
SML or CAPM
To estimate cost of equity capital
Risk-free rate
Market risk premium
Company’s Beta
Cost of debt
Return that lenders require on the firm’s debt
Cost of preference shares
Have fixed dividend paid
A perpetuity
WACC
After-tax cost of debt
Cost of equity
Proportions of each in capital structure
Calculate equity
Number of shares outstanding × share price
Calculate debt
Market price of bond × number of bonds outstanding
Using WACC for projects (SML)
Incorrectly accepting risky projects
Incorrectly rejecting less risky projects
Pure play Approach
Using beta and capital structure of another company to estimate ours for a unique project
Subjective Approach
Adjust WACC upwards (high risk) or downwards (lower risk) depending on the risk of the project
Flotation costs
Costs of issuing, or floating, new bonds and shares
Firm’s overall cost of capital
Mixture of different costs of capital from different divisions
