Flashcards in Cost of Capital Deck (60):
The cost of capital for a company's investment projects must take into account the cost of debt and equity and generate a rate of return that would at least match a similar ____ investment.
Most companies plan for an optimal mix of debt and equity financing, which is commonly known as _____ capital structure.
This ideal mix is planned to maximize stockholders wealth.
Companies generally use a combination of debt and equity financing, so instead of examining the cost of specific fund sources, the overall cost of _______ should be looked at.
This is to ensure that a broader picture of the financing strategy is obtained and the target capital structure is attained.
The four main sources of long-term capital financing are long-term ____, preferred stock, common stock and retained earnings.
Retained earnings are earnings retained in the company to fund further company _____________ and growth.
What are the four main sources of long-term capital financing?
1) Long-term debt
2) Preferred stock
3) Common Stock
4) Retained earnings
The specific cost of each source of financing is the after-tax cost of obtaining the funds _____.
The cost of capital should be measured on an after-tax basis since it is after-tax cash flows from proposed investments that we _________ to obtain their present values.
_________ costs are the total costs associated with the issue and sale of a bond.
This is the definition of flotation costs
Flotation cost covers the cost paid to ___________ bankers, lawyers, accountants etc.
The after-tax cost today of raising long-term funds via borrowing is known as the ____ of long-term debt.
This is the net calculation of the cost of long-term debt in today's dollars.
Where the after-tax cost of debt=ki, the before tax cost of debt is kd and T=the company's tax rate; the formula for calculating ki=kd x (_-T)
__________ is the formula for calculating the after-tax cost of debt.
ki=kd x (1-T)
ki (After cost of debt)
kd (Before cost of debt)
T (Company's tax rate)
The cost of long-term debt is usually less than the cost of other types of long-term financing because interest is tax __________.
Since interest is tax deductible for long-term debt, taxes are reduced by an equal amount to the interest and therefore makes it ________ than other forms of long-term debt.
Preferred stockholders receive their fixed dividend ______ distribution of earnings to common stockholders.
Preferred stockholders get paid first because they are "preferred" and have a superior right upon _________ distribution.
Where the annual preferred stock dividend = Dp and the ____________ of the sale of preferred stock = Np, then the cost of preferred stock kp = Dp/Np
_________ the formula for calculating the cost of preferred stock and no tax adjustment is needed because preferred stock dividends are paid from after-tax cash flows.
kp = Dp/Np
kp (Cost of the Preferred stock)
Dp (Annual preferred stock dividend)
Np (Net proceeds of preferred stock)
The two types of common stock financing are new issues of common stock and ________ earnings.
Retained earnings are a form of internal common _______ that the company decided to retain to re-invest in the company, rather than paying out as dividends to the common stockholders. Hence, it is a form of common-stock financing.
The cost of common stock equity is the rate at which investors _______ expected dividends to determine the company's share value.
Investors determine the price of the stock in the marketplace through dictating the rate of _______ they require.
The cost of common stock equity capital can be calculated using the constant-growth valuation model or the _____ model.
What does CAPM stand for?
Capital asset pricing model (CAPM)
The constant-growth valuation model is also known as the _______ model.
Capital asset pricing model (CAPM) and ___________ valuation are the two techniques for calculating the cost of common stock equity capital.
The Gordon model assumes that common stock dividends will grow at a _______ rate into the future and the stock value is equal to the present value of all future dividends.
This is the calculation using the Gordon model, also known as the constant-growth valuation model.
Where P0=value of common stock, D1=per-share dividend expected after 1 year, ks=required return on common stock and g=constant rate of _______ growth, then the formula (Gordon model) for the cost of common stock equity ks = D1/P0 + g.
__________ is the formula for calculating the cost of common stock equity using the Gordon model.
ks = D1/P0 + g
P0 (Value of common stock)
D1 (per-share dividend expected after 1 year)
ks (Required return on common stock
g (Constant rate of dividend growth)
The capital asset pricing model (CAPM) is developed by taking into account the following factors: required return on common stock and the non-_________ risk of the firm measured as the beta coefficient.
Non-diversifiable risk is risk attributed to ______ factors, that cannot be removed by diversification. Of course, market factors would have a critical impact on the cost of common stock equity.
Where Rf=risk-free rate of return, km=_____________ and b=beta coefficient and ks=required return on common stock; then the CAPM formula is ks= Rf + [b x (km - Rf)]
_____________ is the formula for calculating the cost of common stock equity using the CAPM model.
ks= Rf + [b x (km - Rf)]
Rf (Rate of return)
km (Market return)
b (Beta coeffieicent)
ks (Required rate of return on common stock)
The cost of retained earnings to a company is equivalent to the cost of a fully subscribed issue of additional ____________.
The cost of retained earnings will be palatable to stockholders only if it is expected to return at least the same as the required return on ___________ funds - hence the cost of retained earnings (kr) = cost of common stock equity (ks).
The cost of a new issue of common stock (kn) is calculated with reference to the amount of _________ and the flotation costs.
This is because a stock must be underpriced ie below market price (P0) to be sold.
What does underpriced mean in relation to a stock?
Below market price (P0)
Where Nn=net proceeds from the sale of common stock, D1=per-share dividend expected after 1 year, g=constant rate of dividend growth, and kn=cost of the new _____; then the formula for kn=D1/Nn + g.
__________ is the formula for calculating the cost of a new issue of common stock.
kn=D1/Nn + g
Nn (Net proceeds from the sale of common stock)
D1 (Per share dividend expected after 1 year)
g (Constant rate of dividend growth)
kn (Cost of the new issue)
The weighed average cost of capital (WACC) is the average of the cost of debt or equity weighted by their respective ____ in the given situation.
A company's assets are financed by either _____ or equity - which constitutes the capital.
What does (WACC) stand for?
The weighed average cost of capital
The WACC can be calculated by multiplying the specific costs of each source of _________ by its proportion in the capital structure and summing the weighted values.
As we are working out the WACC, the source of cost of _____ is financing.
_______ can be calculated as book value or market value and historic or target.
Market value weights use market values to measure the ___________ of each type of capital in the financial structure.
________ weights use book or market value weights based on actual structure proportions.
Market value weights are preferable to book value weights because the former uses market values rather than __________ values and therefore more closely approximate the actual dollars to be obtained from their sale.
Book values use ___________ values and hence it is called the "book" value.
______ weights are representative of book or market value weights based on the desired capital structure proportions.
These are achieved based on what is perceived to be the optimal capital structure.
The weighted _________ cost of capital (WMCC) is a company's weighted average cost of obtaining another dollar of new capital.
This relates to the marginal cost for a company obtaining further new financing.
What does (WMCC) stand for?
The Weighted Marginal Cost of Capital
The ____ schedule and Investment Opportunities Schedule (IOS) assist a company in making decisions on investment opportunities available to it.
This WMCC (weighted marginal cost of capital) schedule allows the finance manager to examine the WMCC graphically and assess the position in relation to marginal cost of new capital - which in turn will impact on __________ decisions.
An investment project should be accepted by a company where the expected rate of return is higher than the ________ marginal cost of new financing.
The __________ is the measure of financial and business success on a project of similar risk. The project should be accepted because the rate of return is higher than the WMCC.
rate of return
Companies should accept projects up to the point where the WMCC is equal to the ________ return on its investment.
This is because beyond this point the capital cost exceeds the investment return.
The net proceeds received from the sale of a bond or security are the monies actually _________ following the sale.
The answer is net because it is monies received in the end after all associated costs have been paid for.