Weighted Average Cost of Capital and Gearing Flashcards
How are companies ususally financed?
By both debt and equity
What does WACC represent?
A company’s average cost of long-term finance
What happens if the company’s shares are not listed on the stock market?
The book value of equity will have to be used
When can a company’s existing WACC can be used as the discount rate?
Project is financed by existing pool of funds
Proportion of debt to equity doesn’t change
Project has same business risk as existing operations
Total market value of equity limitation?
If a market price is used, is the market efficient? If the company is unquoted, how has this been estimated?
Cost of equity limitation?
How was the growth rate found? Was this calculated through DVM or CAPM
Pre-tax cost of debt limitation?
Is this likely to be constant over the project life
Corporation tax rate limitation?
Will this be constant over the life of the loan?
What is the marginal cost of capital?
The cost of raising the most recent dollar of finance
Why is WACC more appropriate than MCC?
As the WACC is an average of the cost of equity (which measures business risk) and the cost of deb
Issues with MCC? (project finance)
Project finance may be drawn from the company’s pool of funds and not from a specific source.
Issues with MCC? (cost of debt)
The cost of debt understates the risk of the project and would lead to an overstatement of the project’s NPV
What is a business risk?
The variability in the operating earnings of the company associated with the industry in which it operates
What is a financial risk?
The additional variability in returns as a result of introducing fixed-interest debt into the capital structure
What happens if a company is more highly geared?
The more fixed interest it has to pay regardless of profits, and hence the greater the risk that there will be little or nothing available to distribute as a dividend to shareholders
