{ "@context": "https://schema.org", "@type": "Organization", "name": "Brainscape", "url": "https://www.brainscape.com/", "logo": "https://www.brainscape.com/pks/images/cms/public-views/shared/Brainscape-logo-c4e172b280b4616f7fda.svg", "sameAs": [ "https://www.facebook.com/Brainscape", "https://x.com/brainscape", "https://www.linkedin.com/company/brainscape", "https://www.instagram.com/brainscape/", "https://www.tiktok.com/@brainscapeu", "https://www.pinterest.com/brainscape/", "https://www.youtube.com/@BrainscapeNY" ], "contactPoint": { "@type": "ContactPoint", "telephone": "(929) 334-4005", "contactType": "customer service", "availableLanguage": ["English"] }, "founder": { "@type": "Person", "name": "Andrew Cohen" }, "description": "Brainscape’s spaced repetition system is proven to DOUBLE learning results! Find, make, and study flashcards online or in our mobile app. Serious learners only.", "address": { "@type": "PostalAddress", "streetAddress": "159 W 25th St, Ste 517", "addressLocality": "New York", "addressRegion": "NY", "postalCode": "10001", "addressCountry": "USA" } }

Cost of Capital Flashcards

(15 cards)

1
Q

What is the Cost of Capital?

A

The cost of capital represents the minimum required return needed on a firm’s investment projects.

It reflects the riskiness of a firm’s assets as perceived by the market.

It is the return expected by investors (equity holders, debt holders, preference shareholders) in exchange for providing capital.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

What is the Weighted Average Cost of Capital (WACC)?

A

WACC =(E/V)RE +(P/V)RP + (D/V)RD(1−TC)

E/V = % financed with equity

P/V = % financed with preference shares

D/V = % financed with debt

RE = cost of equity

RP = cost of preference shares

RD = cost of debt

TC = corporate tax rate

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

How are Capital Structure Weights Calculated?

A

E = Market value of equity = shares outstanding × price per share

P = Market value of preference shares

D = Market value of debt = bonds outstanding × bond price

V = Total market value = E + P + D

Weights:
wE = E/V, wP = P/V, wD = D/V

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

What are the Methods to Estimate Cost of Equity (RE)?

A

CAPM/SML Approach:
Dividend Growth Model:

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

Estimate Cost of Equity (RE) CAPM/SML approach

A

RE = Rf + β(E(RM) – Rf)
Where:

Rf = Risk-free rate

β = Beta

E(RM) – Rf = Market risk premium

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

Estimate Cost of Equity (RE) Divdend Growth Model approach

A

RE = (DIV1 / P0) + g
Where:

DIV1 = Next year’s expected dividend

P0 = Current share price

g = Dividend growth rate

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

Example: Calculate RE using CAPM/SML
Given:
Rf = 7%, β = 1.2, MRP = 6%

A

RE = 7% + 1.2(6%) = 14.2%

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

Calculate RE using Dividend Growth Model Given:
DIV1 = $4.40, P0 = $50, g = 5.1%

A

RE = (4.40/50) + 0.051 = 13.9%

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

Cost of Debt (RD)

A

Represents the required return on the company’s debt (typically bonds).

Focus is on the Yield to Maturity (YTM) of existing debt, not coupon rates.

After-tax cost of debt = RD(1 – TC)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

Cost of Preference Shares (RP)

A

Perpetuity formula:
RP = DIV1 / P0

Example:
Dividend = $3, Price = $25
RP = 3 / 25 = 12%

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

Factors Affecting WACC

A

Market conditions: Interest rates, tax rates, risk premiums

Capital structure: Equity vs debt ratio

Investment policy: Riskiness of projects undertaken

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

Key WACC Assumptions

A

Average project risk

Constant D/E ratio

Minimal leverage effect

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

Leverage Impact

A

Leverage increases ROE but also increases financial risk.

Example: Firm L (with debt) has higher ROE and EPS than Firm U (equity only), but more variability in returns.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

Business Risk vs Financial Risk

A

Business Risk: Uncertainty in EBIT due to market factors.

Financial Risk: Extra risk for shareholders when firm uses debt.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

Financial Risk Example Summary

A

Leveraged firms (like Firm L) show higher expected returns and higher risk (variance of ROE), compared to unleveraged firms.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly