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32 Cards in this Set
- Front
- Back
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Cost of Capital
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The minimum required return/expected rate of return an investment must offer to be attractive
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What is Cost of Capital the same as?
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Required return
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The required return to a supplier of capital is what to a company?
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The cost of capital expected to be met by the company
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The cost of capital is what?
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The rate the firm must earn on the investment just to compensate its investors for the use of the capital needed to finance the project
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What does the required return on an asset depend on?
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The risk of the cash flows generated by the asset
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What is financial capital?
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- Money raised by a firm for investment
- Permanent source of funding for a company - Equity and long-term debt - Money invested in company by shareholders and lenders |
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What are the three components of Capital Budgeting Project Evaluation?
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1. Decision Rules (NPV, IRR, Payback)
2. Cash Flow Estimation (OCF, Change in NWC, CAPEX, Tax effects) 3. Required Rate of Return (Cost of Capital - WACC) |
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What is the first component of WACC?
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Cost of Equity (Re)
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What is the second component of WACC?
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Cost of Debt (Rd)
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Cost of Equity
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- The return that equity investors require on their investment in the firm
- The return required by equity investors given the risk of the cash flows that flow to holders of equity |
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What are the three approaches CFO's could use to calculate cost of equity?
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- CAPM
- Historical average stock returns - Dividend Growth Model |
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What is the rearranged equation of the Dividend Growth Model, used to calculate cost of Equity?
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Re = D1
---- + g Po |
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What is the D1 component?
---- Po |
Dividend yield
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What is the g component of DGM?
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Capital gains yield
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What must we do if we are given Do instead of D1?
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Calculate D1 using D1 = Do (1+g)
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What are the advantages of Dividend Growth Model? (x3)
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- Easy to understand and use
- Dividends fairly easy to estimate - Adjusts for risk via market determine Po |
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What are the disadvantages of the Dividend Growth Model? (x3)
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- Only works for firms that are paying dividends (Half of NZX stocks DO NOT pay dividends)
- Assumes/needs that dividends are growing at a reasonably constant rate - Very sensitive to the estimated growth rate (g) |
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What is the CAPM equation to calculate cost of equity?
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E(Re) = Rf + Be[E(Rm) - Rf]
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What are the advantages of using the CAPM/SML approach? (x3)
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- Adjusts for systematic risk (using beta)
- Applicable to all companies that can compute beta, not just companies that pay dividends like the DGM - Can be applied to BOTH companies and individual projects |
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What are the disadvantages of using the CAPM/SML approach? (x3)
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- Need to estimate both the Expected Market Risk Premium and Beta, which vary over time
- Relying on the past to predict the future - CAPM has strong assumptions |
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Cost of Debt (Rd)
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- The return that lenders require on the firm's new debt
- The return required by debt investors given the risk of the cash flows that flow to holders of debt |
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What is the most common element given to us, which we use for cost of debt?
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YTM
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What other figure could we use for cost of debt?
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Estimates of yields based on bond ratings
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Weighted Average Cost of Capital (WACC)
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- Average of the component costs of capital for project
- Overall return the firm must earn on its existing assets to maintain the value of the shares - Firm's after-tax cost of the supply of capital for the project given the markets perception of the risk of the cash flows generated by the assets of the project |
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What is the first step of WACC?
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Calculate the weights of debt and equity
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How do we calculate the weight of debt or equity?
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The amount of debt or equity divided by the combined total of debt and equity
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Does the unleveraged free cash flows to capital include the tax benefit of debt?
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NO
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What is the second step of WACC?
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Calculate cost of equity and cost of debt (if applicable - usually given)
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What is the third step of WACC?
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Calculate WACC
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What is the equation used to calculate WACC?
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We x Re + Wd x Rd x (1 - Tc)
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What do small firms use when calculating cost of equity/debt?
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Book value
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What do large firms use when calculating cost of equity/debt?
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Market Value
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