week 20 Flashcards
what is cost capital
the cost to a firm to provide capital is the return to the providers of those funds
why is cost capital important
indicates how the market views the risk of the firms assets
a firm must earn at least the required return to compensate investors for financing they have provided
what is required return
same as appropriate discount rate, helps firms with capital budgeting decisions
what is cost of equity
return required by equity investors given the risk of the cash flows from the firm
how do you find cost of equity
dividend growth model
SML or CAPM
what is the dividend growth model formula
P0 = D1 / (Re - G)
what are the advantages of the dividend growth model
easy to understand and use
what are the disadvantages of the dividend growth model
only applicable to companies currently paying dividends
not applicable if dividends arent growing at a reasonably constant rate
extremely sensitive to estimated growth rate (increase in g of 1% increases equity by 1%)
does not explicitly consider risk
affected by dividend policy of firm
what is the formula for the SML approach
Re = rf + Be (E(Rm) - rf)
rf - risk free rate
E (Rm) - rf - market risk premium
Be - systematic risk of asset
what are the advantages of SML
explicitly adjusts for systematic risk
applicable to all companies, as long as beta is avaliable
what are the disadvantages of SML
must estimate the expected market risk premium, which does vary over time
must estimate beta, which also varies over time
relies on the past to predict the future, which is not always relaible
what is cost of debt
required return on a company’s debt
usually focus on long term debt or bonds
what are the two methods for cost of debt
compute the YTM on existing debt
use estimates of current rates based on the bond ratings of comparable bonds
how are taxes effected by cost of debt
concerned with after-tax cash flows
dividends are not tax deductible so there is no tax impact on cost of equity
what is cost of preferred stock
preferred pays a constant dividend every period
preferred stock is a perpetuity so we take the perpetuity formula and solve for Rp = D/P0
what is the weight average cost of capital WACC
cost of raising one additional £ in the same proportion of debt and equity as the existing company finance
use individual costs of capital to compute weighted average cost of capital to firm
weights are determined by how much of each type of financing is used
what are capital structure weights
E/V = percent financed with equity
D/V = percent financed with debt
E - market value of equity, number of outstanding shares x price per share
D - market value of debt, number of outstanding bonds x bond price
P - market value of preferred stock, number of outstanding preferred shares x price per share
V - market value of firm, D+E
how do you calculate WACC
(E/V) x Re + (P/V) x Rp + (D/V) x Rd (1-Tc)
what are divisional and project costs of capital
using WACC as a discount rate is only appropriate for projects that have the same risk as the firms current operations or existing assets
what is the pure play approach
