Unit 3: Part 1- Cost Of Capital Flashcards
What is the discount rate?
The discount rate represents the cost of raising capital to the finance manager.
What happens when we consider the company’s cost of capital?
When we consider the company cost of capital, this will capture all of the expected return on a company’s portfolio for all of the company’s outstanding debt & equity securities.
What is the company cost of capital with no debt?
For firms with no debt, the company cost of capital is calculated as expected return on equity. re=rf+Bi(rm-rf). This is ONLY applicable if the projects are EXACTLY as risky as the current business.
What does the opportunity cost of capital depend on?
The opportunity cost of capital MUST depend on the use to which the capital is put. True cost of capital depends on project risk as company cost of capital may not be suitable for individual projects
What is another option to calculate cost of equity capital when CAPM is not available?
Constant Dividend Growth Model: Pe=D1/(r-g) & r=(D1/Pe)+g
What happens if company is all equity financed?
We can use this cost of capital to discount all future cash flows at this rate
What is capital structure made up of?
Equity (shares etc) & debt (bonds, loans etc)
How do we estimate the cost of debt?
challenging to measure in reality (cost to re-finance existing debt & recall YTM on bonds), generally easy for US firms as corporate bonds are more frequently traded, & can use substitutes
What does creditworthiness mean?
corporate bonds come in a variety of forms- secured bonds (debentures/mortgage bonds), unsecured loan stock or convertible bonds (convertible to equity shares). The key difference between corporate bonds & those issued by government is in the probability of default
Why do credit rating agencies exist?
Credit rating agencies exist to provide investors with guidance on the probability as issuer will default. Generally, you would expect riskier corporate bonds to yield more than less risky bonds & this ‘yield spread’ will be higher the lower the bond’s credit rating
How do we calculate the WACC?
If we have the ability to calculate the cost of debt & the cost of equity, then we can calculate the weighted average cost of capital. We always use market values, not book values, to calculate this.
What are the assumptions for using WACC to value a project?
project has average risk to company, constant debt-equity ratio & limited leverage effects
Why is the WACC after-tax usually lower than WACC pre-tax?
The post-tax WACC is lower due to the tax deductible nature of debt interest payments. Therefore it is expected that post-tax WACC will generally be lower for firms with debt in their capital structure. Greater levels of debt will allow the firm to benefit more greatly from the interest tax shield.
