Chapter 12: Cost of Capital Flashcards
Cost of Capital Basics
the cost to a firm for capital funding= the return to the providers of those funds
- the return earned on assets depends on the risk of those assets
- a firm’s cost of capital indicates how the market views the risk of the firm’s assets
- a firm must earn at least the required return to compensate investors for financing they have provided
- the required return is the same as the appropriate discount rate
Cost of Capital Basics
the cost to a firm for capital funding= the return to the providers of those funds
- the return earned on assets depends on the risk of those assets
- a firm’s cost of capital indicates how the market views the risk of the firm’s assets
- a firm must earn at least the required return to compensate investors for financing they have provided
- the required return is the same as the appropriate discount rate
The Cost of Equity
- the cost of equity is the return required by equity investors given the risk of the cash flows from the firm
- Two major approaches
- dividend growth model
- SML or CAPM
Dividend Growth Model Approach
D0(1+g)/R-g
-or= Re=D1/Po+g
Advantages and Disadvantages to DGM
advantages:
-easy to understand and use
disadvantages:
-only applicable to companies currently paying dividends
-not applicable if dividends aren’t growing at a reasonably constant rate
-extremely sensitive to the estimated growth rate
-does not explicitly consider risk
-alot of companies don’t pay dividends
-relies too much on growth rate
the SML Approach
Re=Rf + b(rm)
Advantages & Disadvantages of SML
advantages:
-explicitly adjusts for systematic risk
-applicable to all companies, as long as beta is available
disadvantages:
-must estimate the expected market risk premium, which does vary over time
-must estimate beta, which also varies over time
-relies on the past to predict the future
Cost of Debt
=required return on a company’s debt
the cost of debt is NOT the coupon rate
Component cost of Debt
- use the YTm of the firm’s debt
- interest tax is deductible, so after tax cost of debt = Rd,at= Rd,bt( 1-Tc)
Cost of preferred stock
-preferred pays a constant dividend every period
-dividends expected to be paid forever
=Rp=Preferred annual dividend/current stock price
Weighted Average Cost of Capital
- use hte individual costs of capital to compute a weighted “average” cost of capital for the firm
- this “average”= the required return on the firm’s assets, based on the market’s perception of the risk of those assets
- the weights are determined by how much each type of financing is used
Determining the Weights of the WACC
- weights=percentage of the firms that will be financed by each component
- always use the target weights (if possible)
- if not available, use the market values
Capital Structure Weights
-Notation E= market value of Equity -(outstanding shares) (price per share) D= market value of Debt -(outstanding bonds)(bond price) V= market value of firm= D+E -Weights: -E/V= % financed with equity -DV= % financed with debt
Factors that influence a company’s WACC
- market conditions, especially interest rates, tax rates and the market risk premium
- the firm’s capital structure and dividend policy
- the firm’s investment policy
- firm’s with riskier projects generally have a higher WACC
Risk-Adjusted WACC
- a firm’s WACC reflects the risk of an average project undertaken by the firms
