Day 3- Cost of Capital Flashcards Preview

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Flashcards in Day 3- Cost of Capital Deck (9):
1

What are the steps for calculating cost of capital (WACC)?

- Determine the cost of each source of financing
- Calculate the value of each security as a proportion of the firm's market value (i.e. the weight)
- Calculate weighted average of financing costs (sum of the products of the first two steps)

2

What weighting schemes are possible with the cost of capital calculation process?

- Book values (Past) - not appropriate as it uses historical info.

- Market values (present) - appropriate if the capital structure is not expected to change - most firms would use this.

- Target values - appropriate if the capital structure is expected to change.

3

Advantages of NPV?

- consistent with wealth maximisation
- uses cash flows rather than accounting profit
- takes time value of money into account
- risk is considered through the cost of capital or required project return

4

Disadvantages of NPV?

- Requires an estimate of the company's cost of capital or required project return
- Some managers prefer a method which gives a result in percentage terms

5

Why would you use average payback period over actual?

Because the actual only uses the cash flows up until you hit the payback period - it doesn't take into consideration any future cash flows.
Actual is also difficult to automate in Excel for risk analysis

6

Why is the cost of capital an important concept?

it represents the minimum return that a firm must earn in order to satisfy not only its debt holders (i.e. the bank)
but also its shareholders.

7

What is the difference between real and nominal cash flows?

A dollar is a dollar, but the amount of goods that a dollar can buy is eroded by inflation. If prices double, the real value of a dollar halves. Financial managers and economists often find it helpful to reexpress future cash flows in terms of real dollars - i.e dollars of constant purchasing power.

8

The difference between
bond coupon rate
current yield
yield to maturity

A bond is a long-term debt of a govt or corp. When you own a bond, you receive a fixed interest payment each year until the bond matures - this payment is known as the coupon.

Bond coupon rate - the annual coupon payment expressed a a fraction of the bond's face value

Current Yield - the annual coupon payment expressed as a percentage of the bond price

Yield to Maturity - measures the rate of return to an investor who purchases the bond and holds it until maturity, accounting for coupon income as well as the difference between purchase price and face value.

9

What are the Risk Assessment Techniques?

1. Sensitivity Analysis
Uses a number of possible values for a given variable to assess its impact on return, as measured by NPV
Estimate optimistic, most likely and pessimistic cash flows and calculate NPVs

2. Scenario Analysis
Similar to sensitivity analysis but allows for simultaneous changes in a number of variables

3. Simulation
A statistically based approach using probability distributions and random numbers to estimate risky outcomes