week 20

Question 1

what is cost capital

Answer 1

the cost to a firm to provide capital is the return to the providers of those funds

Question 2

why is cost capital important

Answer 2

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

Question 3

what is required return

Answer 3

same as appropriate discount rate, helps firms with capital budgeting decisions

Question 4

what is cost of equity

Answer 4

return required by equity investors given the risk of the cash flows from the firm

Question 5

how do you find cost of equity

Answer 5

dividend growth model
SML or CAPM

Question 6

what is the dividend growth model formula

Answer 6

P0 = D1 / (Re - G)

Question 7

what are the advantages of the dividend growth model

Answer 7

easy to understand and use

Question 8

what are the disadvantages of the dividend growth model

Answer 8

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

Question 9

what is the formula for the SML approach

Answer 9

Re = rf + Be (E(Rm) - rf)

rf - risk free rate
E (Rm) - rf - market risk premium
Be - systematic risk of asset

Question 10

what are the advantages of SML

Answer 10

explicitly adjusts for systematic risk
applicable to all companies, as long as beta is avaliable

Question 11

what are the disadvantages of SML

Answer 11

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

Question 12

what is cost of debt

Answer 12

required return on a company’s debt
usually focus on long term debt or bonds

Question 13

what are the two methods for cost of debt

Answer 13

compute the YTM on existing debt
use estimates of current rates based on the bond ratings of comparable bonds

Question 14

how are taxes effected by cost of debt

Answer 14

concerned with after-tax cash flows
dividends are not tax deductible so there is no tax impact on cost of equity

Question 15

what is cost of preferred stock

Answer 15

preferred pays a constant dividend every period
preferred stock is a perpetuity so we take the perpetuity formula and solve for Rp = D/P0

Question 16

what is the weight average cost of capital WACC

Answer 16

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

Question 17

what are capital structure weights

Answer 17

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

Question 18

how do you calculate WACC

Answer 18

(E/V) x Re + (P/V) x Rp + (D/V) x Rd (1-Tc)

Question 19

what are divisional and project costs of capital

Answer 19

using WACC as a discount rate is only appropriate for projects that have the same risk as the firms current operations or existing assets

Question 20

what is the pure play approach