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27 Cards in this Set
- Front
- Back
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Define: Weighted Average Cost of Capital (WACC) |
The minimum return an entire firm must earn on its existing assets in order to maintain its share value and satisfy its investors, including stock and bondholders. |
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What is the purpose of the WACC? |
To know the required rate of return. |
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When can projects have positive net present values? What is this concept? |
When their returns are higher than what investments of similar risk in the financial markets can offer. Cost of Capital. |
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From the viewpoint of the firm, how is the required rate of return interpreted? |
It is the minimum rate of return that must be earned in order to compensate for the use of capital needed to finance the project. |
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What is the key difference between required rate of return and the cost of capital? |
The viewpoints:
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What does the cost of capital depend on? |
The use of money, not the source. It depends on the risk of the project, not from the viewpoint. |
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What is the primary determinant of the cost of capital for an investment? |
Its risk because the calculation of the NPV depends on the minimum required rate of return, which is directly proportional to its risk. |
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What will be the cost of overall capital be comprised of? Why? |
The cost of equity and cost of debt capitals because the overall cost of capital depends on the return of all of its existing assets, which is owned by both creditors and stockholders. |
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Define: cost of equity. How is this estimated? |
The return that investors require on their investments on the firm. 1. Stock Valuation (Dividend Growth Model) 2. CAPM |
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What are two ways in order to estimate the growth rate of dividends? |
Arithmetic or Geometric averages of the %D in dividends. |
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What is the interpretation for the statement: "the corporation's cost of equity capital is x%?" |
X% is the minimum required rate of return for the investment of stockholders. It is to compensate for the cost of capital from the investor's perspective. |
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Define: cost of debt capital |
The required rate of return for lenders on the firm's debt. |
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What are two examples of methods to calculate the cost of debt capital? |
Directly: if a firm already has bonds outstanding, then the yield to maturity of those bonds are the cost of capital. Indirectly: if the firm's bonds had a certain rating (e.g. AA), then its cost of capital is the interest rates of similar ratings in the markets. |
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Cost of capital: why is the coupon rate irrelevant? |
The coupon rate illustrates the cost of debt at the time of issuance (YTM = Coupon rate), not the current one. |
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How is the cost of debt for preferred stocks calculated? |
Since it issues fixed dividends, it is a perpetuity. Rd = D/P0 I.e. the dividend yield on the preferred stock. Another is to look for similarly rated rates on preferred stocks. |
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Why is the discount rate (cost of debt) needed to be expressed in terms of aftertax? |
Because interest expense is deductible |
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How is the after tax rate calculated? |
The pretax rate * (1 - corporate tax rate). |
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In words, how is WACC calculated? |
The sum of the capital structure weights multiplied by their respective costs (equity, debt, aftertax rate, preferred stock, etc.). |
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How is WACC useful for estimating the discount rate for projects? |
It serves as the appropriate discount rate for investments of the firm, given that the project is in the same risk class as the firm itself, or when it is similar to the firm's existing activities. |
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WACC: given the structure weight of equity, how is the cost of debt calculated, assuming that the cost structure only uses equity and debt? |
1 - weight(equity) |
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What are some problems when using the WACC to evaluate all investments in the firm? |
It may lead to incorrect evaluations of projects (i.e. reject profitable ones or accept risky ones). |
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If the interest rate for loans is 6%, will this imply that the cost of capital is also 6%? |
No, because this only satisfies the current debt; not including the stockholders. |
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Why are aftertax figures used for cost of debt, but not equity? |
Because interest expense is tax deductible. This does not apply to dividends. |
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Define: capital structure |
The mixture of financing of the firm's assets. I.e. Equity to Debt |
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WACC: why is book value applicable to finding cost of debt? |
Book and market values are similar for debt (short term) because it is paid first. I.e. debt is legally guaranteed. |
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What is the proper theoretical method for calculating capital weights? |
The target debt:equity ratios. |
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Theoretically, how much will the share price increase as a result of projects with a given NPV nature? |
NPV/shares outstanding |
