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22 Cards in this Set

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  • Back
What is weighted average cost of capital?
is the rate of return that the firm must earn on all of its investments (aka projects/assets) as a whole in order to maintain its stock price (that is to maintain the firm’s value).
What causes IRR to change?
- Cash Flows
Why do you choose not to use flotation costs?
They are insignificant
These reduce the amount of capital raised from the sale and increase the WACC
What are are three guidelines for cost of debt?
1. Assume long term debt comes from the sales of bonds
2. Tax cost depends on firms debt rating/ Has outstanding debt – determine YTM and use for new debt
3. Can use bond rating and look at the cost that is similar to bonds in the market place
What is internal equity?
retained earnings
What is external equity?
newly issued stock
What type of mix do firms typically use?
a mix of debt and equity
What value do you use for debt and equity?
use market value
What is the order of riskiness of the component costs of capital?
1. Debt 2. Preferred Stock 3. Internal 4. External
Why is issuing new CS the most expensive way to raise capital?
Floatation Costs
Why is debt the least expensive way to raise new capital?
Debt least risky
What are marginal cost of funds?
the relevant costs of capital
What are the firms component costs of capital equal to?
Equal to its investors required rates of return
What is the appropriate discount rate?
The investor’s required rate of return on any investment is an opportunity cost. It is the rate of return that the firm must pay to compensate investors for the use of their money
How does flotation cost impact the firm’s cost of capital?
-the floatation costs take money away from the firm that it can invest with
-it therefore has to take into account the loss of money to calculate the required rate of return
What exactly are we averaging and what do the weights mean?
- we are averaging of all the costs of capital used in the firm
-the weights is the rate of return that a strives to achieve
What is the WACC and Cost of Capital and what does a lower or higher WACC mean?
Cost of Capital is basically the amount money that costs the firm to return the money to its shareholders or the interest it has to pay to its debt holders / is also a opportunity cost
WACC- is the weighted average of the cost of capitals for a firm expressed as a percentage
Higher the WACC the more risk is involved in the project and the more it costs the firm and lower is vice versa. Lower WACC is better than higher
What happens if you use the WACC method for all the projects in a firm?
only use WACC to evaluate prjoects when projects are similar in riskiness to the firm's investments as a whole
1. accept higher return/risk projects incorrectly
2. reject lower risk/return projects incorrectly
Is the WACC required return rate the same as the rr of a individual project?
No, it is not
What are the length time used for sources used in WACC?
Long Term
What is the downfall of using cheap debt for financing?
It creates more risk
How should firms use WACC when thery are in multiple industries with different risk characteristics?
- find the cost of capital for each division and use that for each division