Cost of Capital Flashcards
(18 cards)
WACC
- Weighted average cost of capital
- Calculated by adding the weights of equity and debt, multiplied by their costs, and 1 - the corporate tax rate
- If WACC is positive, then invest
Cost of Equity - CAPM
- Risk based model, calculated using the RADR - riskiness of investment relative to the rest of the market
CAPM - Assumptions (8)
1) Investors are rational, and have free access to information
2) Investors expect greater return for greater risk
3) You can eliminate unsystematic risk
4) Borrowing & lending rates are equal
5) 0 transaction cost
6) Perfect market - no taxation, or information asymmetry
7) RFR is the same as on government bonds (0)
8) No inflation
CAPM - Drawbacks (5)
1) Beta line is not always linear
2) CAPM only measures changes in beta
3) CAPM assumes that markets are perfect
4) Divisions of different companies with different levels of risk are not accounted for
5) The CAPM can account for 1 year only
Dividend Growth Model
Used to estimate shareholder return and appraise investments with dividend-paying stocks.
Cost of Debt
Kd = I (1–t)
Sd
Debt can be preferable to equity because:
Dividends paid after tax
Interest tax shield effect
Systematic Risk
1) Relates to markets and the economy macro factors
2) Unavoidable, and cannot be diversified
3) All shares will be affected
Unsystematic Risk
1) Specific factors to an industry/ company
2) Not impacted by wider political/economic factors
3) Can mitigate unsystematic risks as an investor by diversifying portfolio
Risks of Types of Capital Finance
Equity is riskier than debt for investors (residual claim, no guarantee of return).
Debt holders have legal protection and priority in repayment.
Debt Disadvantages
Increased gearing (more debt relative to equity):
1) Raises financial risk
2) Increases cost of equity and debt
3) May lead to loss of flexibility
Debt Advantages
Easier to issue (no shareholder approval needed)
Interest is tax-deductible (interest tax shield)
Can be repaid when convenient
Often used in project finance
Traditional View of Capital Structure
Key Idea: There is an optimal gearing level where WACC (Weighted Average Cost of Capital) is minimized.
Shape of WACC curve: Falls with moderate gearing (due to cheaper debt), then rises again (due to rising financial risk).
Management should aim for this optimum point to maximize firm value.
Assumptions of the Traditional View
1) Rational investors
2) Only debt and equity financing
3) All profits are distributed
Oversights of the Traditional view
1) Taxes
2) Bankruptcy risk
3) Market imperfections
4) Investor preferences
Modigliani & Miller v 1
In a perfect capital market, capital structure is irrelevant to firm value.
Financing mix (debt vs equity) does not change total firm value.
“Slicing pizza doesn’t give more pizza” – financing mix doesn’t affect value.
Modigliani & Miller v 2
Recognizes tax shield of debt → more debt = more value (theoretically).
Most debt is the optimal capital structure.
Modigliani & Miller v2 Oversights
1) Bankruptcy risk
2) Loan covenants (restrictive terms)
3) Tax exhaustion (no taxes left to offset interest)
4) Asset limits (difficulty in securing new loans)
5) Behavioural issues (directors may be risk-averse)
Real World Capital Structure Approach
Firms prefer funding sources in the following order:
1) Retained earnings (no issuance costs or dilution)
2) Straight debt
3) Convertible debt
4) Preference shares
5) New equity (last resort – costly & dilutive)
Reflects a preference to avoid external scrutiny and issuance costs, and to minimize control dilution.
