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14 Cards in this Set
- Front
- Back
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Required Return (factors)
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-same as discount rate and is based on the risk of cash flows
-need to know before compute NPV - Need to earn at least the required return to compensate investors |
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Why Cost of Capital is Important?
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-Return on assets depends on the risk of those assets
-Return to an investor is the same as the cost to the company -Knowing our cost of capital can also help determine required return for capital budgeting projects |
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Cost of Debt
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= required return on our company's debt
- focused on long-term debt or bonds -required return is best estimated by using yield to maturity on existing debt -cost of debt NOT the coupon rate |
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Cost of Preferred Stock
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-Pays a constant dividend every period
-Dividends are expected to be paid every period forever -a perpetuity Dividend/Price of Stock |
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Your company can issue preferred stock for a price of $42. The preferred stock pays a $5 dividend.
Compute preferred stock |
$5/$42
= 11.90% |
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Cost of Equity
What are two major methods for determining the cost of equity? |
-return required by equity investors given the risk of the cash flows from the firm
-Dividend Growth Model -SML or CAPM |
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Compute Cost of Common Equity
The market price of a share of common stock is $60. The dividend just paid is $3, and the expected growth rate is 10%. |
(Dividend Just Paid(1+growth)/Common Stock Price)
+ Growth |
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Disadvantages of Growth Model
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-Only applicable to companies currently paying dividends
-Not applicable if dividends aren't growing at a reasonably constant rate -Extremely sensitive -Does not consider risk |
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Weighted Average Cost of Capital
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required return on our assets, based on the market's perception of the risk of those assets
-weights are determined by how much of each type of financing that we use |
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Factors Determining Cost of Capital
1) General Economic Rates 2) Market Conditions 3) Operating and Financing Decisions 4) Amount of Financing |
1) affect interest rates
2) Affect risk premiums 3)Affect business risk, financial risk 4) Affect flotation costs and market price of security |
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Flotation Costs
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The required return depends on the risk, not how the money is raised
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To estimate a firm's equity cost of capital using the CAPM, we need to know:
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1) the stock's beta
2) the market risk premium 3) the risk-free rate |
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The WACC is the minimum return a company needs to earn to satisfy:
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1)Stockholders
2)Bondholders |
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WACC uses
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market values
book values are often similar market values for debt |
