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Component Costs

the required rate of return on each capital component


weighted average cost of capital

the cost of capital used to analyze capital budgeting decisions is found as a weighted average of the carious component costs


capital is provided by



accounts payable and accruals arise from _____, not from ____

operating decisions, not financing decisions


who are re and rs most relevant to

rs is more common for well established firms who obtain all new equity as retained earnings. re is rarely relevant except for very young, rapidly growing firms


New or marginal debt

used as rd


historical or embedded rate

average rate on previously issued debt


what decisions is the embedded cost important for

to determine the rate of return that a public utility should be allowed to earn


is rd equal to the company's cost of debt

no, interest payments are deductible, which means the government in effect pays part of the total cost


project financing

a special situation in which a large project, such as an oil refinery, is financed with debt plus other securities that have a specific claim on the project's cash flows


How is project financing different from usual debt offerings

debt does not have a claim on all of the corporation's cash flows


Why is no tax adjustment used when calculating the cost of preferred stock?

preferred dividends are not tax deductible so the company bears their full cost


Why do firms usually have every intention of paying preferred dividends even though they aren't mandatory?

1. they cannot pay dividends on their common stock
2. they will find it difficult to raise additional funds in the capital markets
3. in some cases preferred stockholders can take control of the firm


companies can raise common equity in two ways

1. by selling new issued shares to the public 2. by retaining and reinvesting earnings


why do few firms with moderate or slow growth issue new shares of common stock through public offerings?

1. flotation costs can be high
2. investors perceive new issuings as a negative signal about the value of the company
3 . even without the signaling effect, and increase in the supply of stock puts pressure on the stock price, forcing the company to sell the new stock at a lower price than before the new issue


what is the signaling effect

investors percieve issuance of common stock as a negative signal about the true value of the company's stock. they believe that managers have superior knowledge about future prospects and are most likely to issue new stock when they believe the current stock price is greater than intrinsic value


opportunity cost

the earnings that could have been paid out as dividends or used to repurchase stock, and in either case stockholders would have received funds that they could reinvest in other securities


What is the general rule about reinvesting instead of paying dividends

the firm should earn on its reinvested earnings at least as much as its stockholders themselves could earn on alternative investments of equivalent risk, or rs


Steps to using the Capital Asset Pricing Model

1. estimate the risk free rate (rRF) 2. estimate the current market risk premium RPm 3. estimate the stocks beta coefficient, bi, which measures the stock's relative risk 4. use formula


Current market risk preium rpm

required return on the market minus the risk free rate


why is it okay to use the rate on 10 year treasury bonds as the risk free rate

1. stock are long term securities so stocks will reflect long term inflation 2. short term treasury bills are more volatile than long term treasury bond rates and are more volatile than rs 3. CAPM is supposed to measure the required ror over a particular holding period


historical growth rates

if earnings and dividend growth rates have been relatively stable in the past, and if investors expect these trends to continue, then the past realized growth may be used as an estimate of the expected future growth rate


Retention growth model

the more firms retain and reinvest, the higher the earned rate of return on those retained earnings, the larger their growth rate


payout ratio

percent of net income that the firm pays out in dividends


retention ratio

the compliment of the payout ratio


Why is the cost of new common equity higher than cost of equity for companies who rely on reinvestin a large portions of earnings than issuing common stock

because of flotation costs involved in issuing new stock


Factors that affect WACC that the firm cannot control

1. the state of financial markets, including stock prices and level of interest rates 2. investors aversion to risk and thus the market risk premium 3. tax rates as set by congress


stock and bond markets and WACC

if interest rates in the economy rise the costs of debt and equity will increase. firm will have to pay bondholders a higher interest rate. also increases cost of equity


Three factors that affect WACC that firms can control

1. its capital structure policy 2. its dividend policy 3. its investment (capital budget) policy


stand alone risk

variability of the projects expected returns


corporate, or within firm risk

variability the project contributes to the corporations returns, giving consideration to the fact that the project represents only one asset of the firms portfolio of assets so some of its risks will be diversified awa


market, or beta risk

the risk of the project as seen by a well diversified stockholder who owns many different stocks


4 mistakes to avoid

1. never base the cost of debt on the coupon rate on a firm's existing debt 2. when estimating the market risk premium for the CAPM method, never use the historical average return on stocks with the current reurn on bonds 3. never use the current book value capial sructure to obtain the weights when estimating the wacc 4. always remember the capital components are funds that come from investors