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Flashcards in Chapter 12: Cost of Capital Deck (20):

The equilibrium rate of return demanded by investors in the capital markets for securities with the same degree of risk

Cost of Capital


Rate in order of highest required rate of return to lowest

a. Short-Term Gov Debt (Treasuy Bills)
b. Low- quality Corporate Bond
c. Common Stock
d. Long term Government Debt
e. High Quality Corporate Debt
f. High Quality Preferred Stock

c. b. f. e. d. a.


Three types of capital

Preferred Stock


Cost of Capital also can be the _____ required by investors in the firm’s securities

required rate of return


We want the return to be _____ than the cost of capital to create value for the firm



The action of investors moving their capital away from riskier investments to the safest possible investment vehicles

Flight to Quality


Used to find the cost of capital for equity
-How much an investor will require in return for the investment
-Used by investors and firms

Capital Asset Pricing Model (CAPM)


CAPM Equation

k_e=r_f + B (r_m - f_f)

k – Amount of return equity investors should demand for taking on the amount of present risk
rf – Risk-free rate
rm – Expected market return


someone taking a risky investment should get ____ at minimum

the risk free rate


(rm - rf) is called

Market Risk Premium


Why is WACC important?

Tells you our average cost of capital given your weighted capital structure


We want WACC to be as ____ as possible

(high or low)



If risk goes up, the required rate of return goes ____

(up or down)



How could risk or events impact a firm?

If government begins to deregulate, it increases competition, which creates more risk
If government begins to regulate, cost go up (for new requirements), so many of the small companies can’t afford to keep up. They can drop out or be bought out.

-Government starts raising interest rates (means the economy is doing well). So the assumption is that there’s less risk in the market. So risk discounts go down (risk premium goes down)


What does it mean if Government starts raising interest rates?

-economy is doing well (unemployment is low)
-So the assumption is that there’s less risk in the market.
-risk discounts go down (risk premium goes down)


WACC can be impacted by


-The distribution of money between the three types
--Balancing between the three
--Can’t invest 100% in just debt (given it’s the cheapest) because leverage/risk would be too high

-How old the company is
--Example – Startups go through a lot of cash, so they don’t want to have a lot of debt. Interest on debt has to be paid, where dividends on equity do not


Why do we want to minimize WACC?

it’s easier to add value (the present value of future cash flows will be higher)
It’s the cost of investing in projects; less expensive is better


Risk that is specific to an asset or a small group of assets

Idiosyncratic Risk / Firm-Specific Risk

-Risk has little or no correlation with market risk
-Can be substantially mitigated or eliminated from a portfolio by using adequate diversification


What is the term for when you have a Diversified portfolio?

“Holding the Market” / “Investing in the Market”

It is less risky, it negate firm-specific risk


What happens when there is deregulation

competition starts to increase.
Because more competition, there is more risk. Investors will requite higher rate of return
When regulation happens, a lot of smaller firms will die or get bought out so the competition becomes more consilidated