Term
| Cost of capital provides us an indication of |
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Definition
how the market views the risk of our assets
determine required return for capital budgeting projects |
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Term
| Weighted average cost of capital reflects |
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Definition
the weighted average cost of funds for a firm--the rate that a firm is actually paying for its capital.
also the after tax cost of debt
weights are determined by how much of each type of financing are used
it is the required return to compensate investors for the financing they have provided to the firm given its current level of risk (on any investments by the firm that have essentially the same risks as existing operations) |
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Term
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Definition
the firm's equity, debt and preferred stock
this depends on the assets (uses of funds) not the financing (the source of funds) |
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Term
| Use WACC as the "r" in the DCF formula when |
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Definition
| the project has risks similar to the firm in general |
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Term
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Definition
| the return required by equity investors given the risk of the cash flows of the firm |
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Term
| Two ways to estimate the cost of equity |
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Definition
1. Dividend Growth Model Approach
P0 = D1/ Re-g or D1/P + g
where Re=risk of equity
2. The Security Market Line or CAPM Approach
E(R)= Rf + BETA x (E(Rm)-Rf)
(risk free rate, market risk premium, beta to find cost of equity) |
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Term
| Dividend Growth Model Strengths and Weaknesses |
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Definition
Strength: simple
Weakness: constant g is not reasonable
sensitive to assumptions
only for firms with dividends
no explicit risk adjustment
historically based |
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Term
| CAPM strengths and weaknesses |
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Definition
Strengths: adjusts explicitly for risk
applicable to all companies
Weaknesses: requires estimate of E(Rm)
Requires estimate of beta
Historically based |
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Term
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Definition
the return that lenders require on the firm's debt
focus on the cost of long-term debt or bonds
for existing debt, use yield to maturity
if new debt, use current rates based on expected bond rating
cost of debt is NOT THE COUPON RATE, it's the YTM |
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Term
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Definition
= E/V(Re) + D/V(Rd) (1-Tc)
E=market value of equity
D= market value of Debt
V= total value of the firm (E+D)
Re=cost of equity
Rd=cost of debt
Tc=corporate tax rate |
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Term
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Definition
| gives the ratio of total debt to total equity for a firm |
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Term
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Definition
preferred stock pays a constant dividend each period
dividends are expected to be paid every period forever
therefore, it's a perpetuity
rearrange the perpetuity formula: P = CF/r = D/r
so, Rp = D/P0 |
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Term
| WACC including preferred stock |
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Definition
E/V (Re) + P/V (Rp) + D/V (Rd) (1-Tc)
P=value of preferred stock
Rp=cost of preferred stock |
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Term
| Using WACC as our discount rate is only appropriate for these kinds of projects |
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Definition
| those that have the same risk was the firm's current operations |
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Term
| The project that does NOT have the same risk of the firm needs |
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Definition
| the appropriate discount rate to be found |
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Term
| Consequences of applying the WACC to all projects regardless of risk |
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Definition
| you may reject positive NPV projects and accept negative ones |
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Term
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Definition
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Term
| Alternatives for Project Cost of Capital |
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Definition
1 the pure play approach
2. Subjective approach
3. Flotation costs |
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Term
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Definition
-fine one or more companies that specialize in the product or service that we are considering
-compute the beta for each company and take an average
-use that beta along with the CAPM to find the appropriate return for a project of that risk
-often difficult to find pure play companies |
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Term
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Definition
-consider the project's risk relative to the firm overall
-if the project has more risk than the firm, use a discount rate greater than the WACC
-if the project has less risk than the firm, use a discount rate less than the WACC
you may still accept projects that you shouldn't and reject projects you should accept, but your error rate should be lower than not considering differential risk at all |
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Term
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Definition
-the required return depends on the risk, not how the money is raised
-however, the cost of issuing new securities should not just be ignored either
-Basic Approach:
computed the weighted average flotation cost
use the target weights because the firm will issue securities in these percentages over the long term |
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