week 2: Flashcards
Define the cost of capital.
The cost of capital is the minimum rate of return on a company’s investments that can satisfy the providers of capital (both shareholders and bondholders). It can also be considered the total cost of financing, the required rate of return, and the hurdle rate.
What is the weighted average cost of capital (WACC)?
The WACC is a calculation of a firm’s cost of capital in which each category of capital (debt and equity) is proportionately weighted.
Provide the formula for WACC
(E/(E+D)) * re + (D/(E+D)) * rd * (1-t)
List three methods for calculating the cost of equity
Dividend Discount Model (DDM)
Earnings Capitalization Model (ECM)
Capital Asset Pricing Model (CAPM)
What is the Dividend Discount Model
This model assumes that a company’s dividend payments will grow at a constant rate in perpetuity. It calculates the cost of equity by dividing the expected dividend payment for the next year by the current stock price and adding the dividend growth rate.
What is the Earnings Capitalization Model?
This model is appropriate for companies that do not pay dividends or have a stable, non-growing earnings per share (EPS). It calculates the cost of equity by dividing the projected earnings per share for the following year by the current price per share.
What is the Capital Asset Pricing Model (CAPM)?
The Capital Asset Pricing Model (CAPM) is a formula used to calculate the expected return on an investment, based on its risk compared to the overall market. It helps investors understand how much return they should expect to earn, given the risk they are taking by investing in a particular stock or asset.
It calculates the cost of equity based on the risk-free rate of return, the expected market risk premium, and the beta of the security.
Provide the formula for CAPM.
re = Rf + βi (Rm – Rf)
What is the risk-free rate of return (Rf)?
The risk-free rate is the theoretical rate of return of an investment with zero risk. In practice, it is approximated by the yield on a government bond with a maturity matching the investment’s time horizon.
Define the equity risk premium (Rm-Rf)
The equity risk premium is the additional return that investors expect to receive for investing in the stock market compared to a risk-free investment. It compensates investors for the higher risk associated with equity investments.
Define beta (β).
Beta measures the systematic risk of a security, which is its sensitivity to market movements. A beta of 1 indicates that the security’s price will move in the same direction and magnitude as the market. A beta greater than 1 indicates that the security’s price is more volatile than the market, and a beta less than 1 indicates that the security’s price is less volatile than the market.
Explain the difference between asset beta (unlevered beta) and equity beta (levered beta)
Asset beta reflects only the business risk of the company, assuming it is financed entirely with equity. Equity beta incorporates the company’s financial leverage, which increases the risk for equity holders due to the fixed interest payments on debt.
How can you estimate a company’s beta?
Regression analysis: Regress the historical returns of the company’s stock against the returns of the market index (e.g. S&P 500).
Comparable company analysis: Identify publicly traded companies with similar business risks and use their betas as proxies, adjusting for differences in financial leverage.
Provide Hamada’s equation.
βL = βU[1 + (1 - t)(D/E)]
What is the cost of debt (rd)
The cost of debt is the effective rate that a company pays on its debt, considering factors like interest rates and default risk.
