Cost of Capital Flashcards
What is the Company Cost of Capital?
The expected return on a portfolio of all the company’s existing securities.
The opportunity cost of capital for investment in the firm’s assets.
The discount rate for the firm’s average-risk project.
(Since most projects can be treated as average risk, it is mainly used as an “all-purpose discount rate for every project proposal”)
What is the Cost of Debt?
The opportunity cost of capital for the investors who hold the firm’s shares (bondholders) and are entitled to receive a promised payment each year (interest).
Bond default risk:
Measured by bond rating agencies estimating the probability that companies will be unable to make the required payments on debt obligation. The higher the rating (AAA) the lower the cost of debt.
In the case of investment grade debts it is assumed that the cost of debt equals the risk-free interest rate.
What is the Cost of Equity?
The opportunity cost of capital for the investors who invested in the firm’s assets and therefore hold the firm’s shares (shareholders) and are entitled to receive residual claims (what is left after claimants have been paid off).
It is calculated with the CAPM.
But only a small portion of each stock’s total risk comes from movements in the market (beta); the majority is diversifiable risk.
What is the Asset Beta and what are its determinants?
The blend of the seperate betas of debt and equity which is an estimate of the average risk.
Determinants?
1) Cyclicality: firms whose revenues and earnings strongly depend on the state of the business cycle (peformance of the economy) tend to have a high beta (e.g. airlines, luxury products)
2) Operating leverage: projects with a high operating leverage, meaning high FC relative to VC, have a high asset beta
3) Time horizon of the project: Projects with long-term CF are more sensitive to changes in the risk-free interest rate or the market premium
Valuation of Projects - Pure Plays
Alternative valuation specifically for projects which have a non-average risk which takes a pure play (focused firms) and its cost of capital to best reflect the industry-specific cost of captial of the project the firm is considering.
Characteristics of such firms are that they are publicly traded, in the same line of business as the project considered, and not involved in any other type of business.
