Chapter 14 Flashcards
(26 cards)
What does the cost of capital indicate?
It provides an indication of how the market views the risk of our assets.
What is the required return in capital budgeting?
It is the same as the appropriate discount rate and is based on the risk of the cash flows.
What is the cost of equity?
The return required by equity investors given the risk of the cash flows from the firm.
What are the two major methods for determining the cost of equity?
- Dividend growth model
- SML or CAPM
What is the formula for the Dividend Growth Model?
RE = D1 / P0 + g
What is the growth rate (g) in the Dividend Growth Model?
g = Retention ratio x ROE
What is an advantage of the Dividend Growth Model?
Easy to understand and use.
What is a disadvantage of the Dividend Growth Model?
- Valid only for firms that pay dividends
- Not valid for firms that grow unsteadily
- Not explicitly considering risk
- Extremely sensitive to g
What is the formula for the SML approach to compute the cost of equity?
RE = Rf + βE(E(RM) - Rf)
What is the cost of debt?
The required return on our company’s debt.
What is the formula for the cost of preferred stock?
RP = D / P0
What does WACC stand for?
Weighted Average Cost of Capital.
What is the formula for WACC?
WACC = wERE + wDRD(1-TC)
What are the capital structure weights denoted as?
- wE = E/V (percent financed with equity)
- wD = D/V (percent financed with debt)
What does the after-tax cost of debt formula represent?
RD(1-TC)
What is the implication of using WACC as a discount rate?
It is only appropriate for projects that have the same risk as the firm’s current operations.
What is a pure play approach?
Use a WACC that is unique to a particular project.
What is the subjective approach in determining discount rates?
Adjust the firm’s WACC based on the riskiness of the project relative to the riskiness of the firm.
If a project is less risky than the firm, what discount rate should be used?
Use a discount rate less than the WACC.
What is the process to apply the pure play approach?
- Find companies specializing in the product/service
- Compute the beta for each company
- Take an average
- Use that beta with CAPM to find the appropriate return
What is the relationship between dividends and tax in WACC?
Dividends are not tax deductible, so there is no tax impact on the cost of equity.
True or False: The cost of debt focuses on short-term debt.
False
Fill in the blank: The return required by shareholders is known as _______.
WACC
What must be determined before computing NPV?
The required return for an investment.
