The Cost of Capital Flashcards
(39 cards)
When talking about the “Cost of Capital”, we set ourselves in “Perfect Capital Markets”, what is meant by this?
- All shareholders share the same information
- All securities are fairly priced
- No taxes of transaction costs
What is the formula for unlevered FCF?
EBIT*(1-T) + Non-cash expenses - ΔWCR - CAPEX
What is the formula for levered FCF?
NI + Non-cash expenses - ΔWCR - CAPEX
Why is risk of debt lower than the risk of equity?
Answer:
1) Riskier to invest in stocks –> Can lose all of our money –> they, therefore, require a higher interest –> Higher cost of equity than debt
2) Stock vs bond - No guarantee of dividend with stocks, but that’s the case with bonds.
3) The higher the risk, the higher the return and the higher the cost of equity is.
In a world with no taxes, does an increase in debt impact the value of the company?
NO
In a world with no taxes, does an increase in debt impact the cost of capital (WACC)?
NO
In a world with no taxes, why doesn’t an increase of debt impact the value of the company?
Mentions M&M - pizza as a size of the firm - capital structure is the size of the firm - can divide it in different parts - doesn’t impact the value - not dependent on how we cut the pizza.
It’s all about restructuring.
What is the formula for WACC?
r_A = r_U = WACC = {r_E(E/V) + r_D(D/V)}
- where V = E + D, which functions as the weighted
market values of the firm.
What are the 2 propositions of Modigliani & Miller?
Proposition I:
- The market value of any firm is independent of its capital structure:V_L = E+D = Assets = V_U
Proposition II:
- The weighted average cost of capital is independent of its capital structure: r_wacc = r_A = r_U
- rA is the cost of capital of an all-equity firm (unlevered)
- NB: Whatever the capital structure, the total assets of the firm remain constant here.
Why do we assume that EBIT is equal to FCF_u?
Since; FCF_u=Non−Cash Expenses−ΔWCR−CAPEX
—> If there are no changes in depreciation, Fixed assets or the liquidity balance, then we assume that EBIT is equal to FCF.
What is the relationship between MM I and MM II?
1) EBIT = Int + DIV
2) E = DIV / r_e
3) D = Int / r_D
Describe the relationship between the WACC and the value of a company?
1) From the definition of the WACC:
r_wacc * V_L = r_equity * E + r_debt * D
2) As, r_equity * E = Div and r_debt * D = Int
- - -> r_wacc * V_L = EBIT
3) V_L = EBIT/r_wacc
This holds since,
i) EBIT = Int + DIV
ii) E = DIV / r_e
iii) D = Int / r_D
(See slide 14 & 15)
What is the link between equity and debt?
The link between the equity and the debt is that the higher (lower) the D/E-ratio is the higher (lower) the cost of equity will be.
Why does the cost of equity increase due to higher leverage?
Higher debt ratio –> higher risk of bankruptcy –> higher cost of equity for shareholders
What is the formula for the Beta of the portfolio and what does it measure?
Beta of portfolio: Beta_portfolio = Beta_equity * X_equity + Beta_debt * X_debt
𝛽portfolio = 𝛽𝐴𝑠𝑠𝑒𝑡
What is the formula for the 𝛽𝐸𝑞𝑢𝑖𝑡𝑦 and what does it measure?
𝛽𝐸𝑞𝑢𝑖𝑡𝑦 = 𝛽𝐴𝑠𝑠𝑒𝑡 + (𝛽𝐴𝑠𝑠𝑒𝑡 − 𝛽𝐷𝑒𝑏𝑡) ×𝐷/E
here we use CAPM
What is the formula for the 𝛽𝐴𝑠𝑠𝑒𝑡 and what does it measure?
𝛽𝐴𝑠𝑠𝑒𝑡 = 𝛽𝐸𝑞𝑢𝑖𝑡𝑦 ×{𝐸 / (𝐸 + 𝐷)} + 𝛽𝐷𝑒𝑏𝑡 ×{D / (𝐸 + 𝐷)}
In a world with taxes, does an increase in debt impact the company value?
Yes, the company value will increase
1) Why? More money –> more interest –> more cost –> less NI due to taxes –> higher value of the company
2) Also, there will be less to pay out in dividends, therefore saving more.
In a world with taxes, does an increase in debt impact the cost of capital (WACC)?
Yes, the WACC will decrease.
- The tax will work as a tax shield. If the company borrows money then they will pay less in tax.
How is the tax shield calculated?
Tax shield = Interest payment × Corporate Tax Rate
moreover,
(r_D * D) * T_c
How is the PV of the tax shield calculated?
PV(Tax-shield) = { ((r_D * D) * T_c) / r_D }
In a perfect world, with taxes AND Perpetual debt, how will the Value of the company be affected by an increase in debt?
It will increase the value of the company.
Higher debt –> higher tax shield –> Higher Present Value
What is meant by NOPAT and how is it calculated?
Net Operating Profit After Taxes = Unlevered Free Cash Flow
NOPAT = (EBIT -r_DD)(1-T_c)+r_DD-T_cr_D*D=EBIT(1-T-c)
see slide 25
How do you calculate the value of a company with the help of WACC and NOPAT
Value of company = NOPAT / WACC
