Capital Budgeting and Risk Flashcards
(14 cards)
What is the NPV decision rule?
Accept any project with a positive Net Present Value (NPV); reject those with negative NPV.
What is the cost of capital?
The required return investors expect for providing capital to a company. It’s used as a discount rate in NPV calculations.
What is WACC?
Weighted Average Cost of Capital: the firm’s overall cost of capital from all sources, weighted by proportion of each source (debt and eq
How is cost of equity estimated?
Using the Capital Asset Pricing Model (CAPM):
Cost of Equity = Risk-free rate + Beta × (Market Return - Risk-free rate)
What is beta in the CAPM model?
Beta measures how much a stock’s return moves relative to the market. It reflects the stock’s systematic risk.
How is cost of debt estimated?
Typically using the yield to maturity (YTM) on the firm’s debt. If bonds are not available, estimate using interest rate on similar loans.
Why might firm-wide WACC be inappropriate for some projects?
Because not all projects have the same risk profile as the overall firm. Using firm WACC can lead to wrong investment decisions for riskier or safer projects.
What is unlevered cost of capital?
It is the cost of capital of a firm or project without debt — i.e., financed entirely with equity. It reflects business risk without the effects of leverage.
How do you calculate division-specific WACC?
Find comparable firms in the same industry, estimate their unlevered cost of capital, re-lever it based on the target division’s capital structure, and calculate WACC.
What is the impact of taxes on WACC?
Interest on debt is tax-deductible, so the cost of debt is reduced by (1 - tax rate), which lowers the WACC due to the tax shield.
What is the WACC formula?
WACC = (E/V)re + (D/V)rd*(1-Tc)
E = Market value of equity
D - Market value of Debt
V = E + D = Total market value of the firm
re = cost of equity which is estimated using capm
rd = cost of debt which is typically YTM on long-term debt
Tc - Corporate tax rate
What is project WACC?
What is Firm WACC?
What is unlevered cost of capital?
