Cost of Capital Flashcards
(15 cards)
- What is the primary determinant of the cost of capital for an investment?
The risk of the investment. Cost of capital depends on how the capital is used—not where it comes from
- What is the relationship between the required return and the cost of capital?
They are the same thing. The required return is what a firm needs to earn to satisfy investors, and that becomes the firm’s cost of capital
- What do we mean when we say a corporation’s cost of equity capital is 16%?
It means investors expect a 16% return to compensate for the risk of investing in the company’s stock. If the firm can’t provide that, investors will invest elsewhere.
- What are two approaches to estimating the cost of equity capital?
Dividend Growth Model:
RE= D1/P0 + g
Assumes dividends grow at a constant rate.
Security Market Line (SML) / CAPM:
RE=Rf+β(Rm−Rf)
Factors in market risk and the firm’s beta
- Why is the coupon rate a bad estimate of a firm’s cost of debt?
Because the coupon rate is fixed at issuance and doesn’t reflect current borrowing costs or market conditions. The cost of debt should reflect the rate the firm would pay today on new debt
- How can the cost of debt be calculated?
By observing the yield to maturity on the firm’s existing or new bonds in the market.
- How can the cost of preferred stock be calculated?
Using the perpetuity formula:
Where D is the dividend and P₀ is the price of the preferred share
- Why do we multiply the cost of debt by (1 - Tₐ) when computing the WACC?
Because interest is tax-deductible, so the true (after-tax) cost of debt is lower than the nominal rate
- Under what conditions is it correct to use the WACC to determine NPV?
Only when the project has the same risk as the firm overall. Using WACC for projects with different risk levels leads to wrong accept/reject decisions
- What are the likely consequences if a firm uses its WACC to evaluate all proposed investments?
It will over-invest in risky projects and under-invest in conservative ones, misallocating capital across divisions
- What is the pure play approach to determining the appropriate discount rate? When might it be used?
Pure Play Approach: Use the WACC of similar, publicly traded firms that operate only in a single line of business.
Useful when evaluating new projects or divisions with different risk profiles than the main company
- Why do we adjust a firm’s taxes when we do a firm valuation?
Because we want to value the operating assets only, independent of the firm’s financing structure. We use after-tax EBIT to reflect real cash flows
- Why might we prefer to use a ratio when calculating terminal value?
Using a multiple (like EBITDA or sales) helps capture market expectations without relying too heavily on uncertain long-term projections. It’s often simpler and more stable than forecasting cash flows forever.
- What are flotation costs?
Costs associated with issuing new securities (e.g., underwriting fees, legal fees). They increase the effective cost of raising capital
- How are flotation costs included in an NPV analysis?
By adjusting the initial investment or using a weighted flotation cost:
These costs reduce the project’s net cash inflows or increase its required return
