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19 Cards in this Set
- Front
- Back
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What is the Cost of Capital?
Ch. 9 |
It is the marginal cost of the funds that a company uses to finance its assets.
It is an opportunity cost that depends on where the money goes, not where it comes from. It depends on the capital structure of the company. |
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Why do we care about the Cost of Capital?
Ch. 9 |
To maximize value, we need to minimize costs.
Capital budgeting decisions (NPV, IRR) require an estimate of the opportunity cost of funds. |
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What does the WACC depend on?
Ch. 9 |
The target capital structure of the company.
The required return for each source of funding - the component cost. |
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What are the weights of the WACC based on?
Ch. 9 |
Target capital structure or market values, not book values.
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What is meant by the Opportunity Cost of Retained Earnings?
Ch. 9 |
Firms should earn at least as much as shareholders could earn on alternative investments of equivalent risk if the earning were paid out as dividends.
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Why do you use the CAPM?
Ch. 9 |
You use the CAPM to estimate the firm's required return on equity.
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What are the four "Cost of Common Equity" models?
Ch. 9 |
1. The Opportunity Cost of Retained Earnings.
2. CAPM Approach 3. DCF Approach 4. Bond-Yield plus Risk-Premium Approach |
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What does the Bond-Yield plus Rick-Premium Approach do?
Ch. 9 |
It adds an equity risk premium of 3-5% to the firm's cost of debt.
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Of the CAPM Approach, the DCF Approach, and the Bond-Yield plus Risk-Premium Approach, which is the most widely used?
Ch. 9 |
The CAPM approach is the most widely used (more than 70% of firms surveyed).
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Which companies use the Bond-Yield plus Risk-Premium approach?
Ch. 9 |
It is usually used by private companies.
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What factors influence a company's WACC?
Ch. 9 |
1. Market conditions, especially interest rates and taxes.
2. The firm's capital structure and dividend policy. 3. The firm's investment projects. |
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When is the WACC the appropriate discount rate?
Ch. 9 |
When the risk of the proposed project is similar to the risk of the firm as a whole.
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When should the WACC be adjusted?
Ch. 9 |
1. If a firm's divisions are unique, they should use different beta estimates and different costs of capital.
2. Firms may also need to adjust capital costs across national boundaries. |
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What are the two approaches of WACC adjustment?
Ch. 9 |
1. Pure play approach
2. Subjective approach |
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What is the pure play approach of WACC adjustment?
Ch. 9 |
Using a WACC that is unique to a project based on companies in similar lines of business.
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What is the subjective approach of WACC adjustment?
Ch. 9 |
Projects under consideration with higher or lower than average risk should be discounted with rates above or below the WACC.
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Why is internal equity less expensive than external equity?
Ch. 9 |
1. Flotation costs
2. Indirect issue costs |
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What are flotation costs?
Ch. 9 |
Costs associated with issuing (floating) new stocks or bonds that increase the costs associated with undertaking a project. These costs depend on the risk of the firm and the type of capital being raised. It is highest for common equity and often ignored when computing the WACC.
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How do you compute flotation costs?
Ch. 9 |
Amount needed = (1-f)*Amount Raised
f = flotation % |
