2: Cost of Capital

Return earned on assets depends on ______ of the assets

risk

Return to investors = __________ to the company

cost

_______________________ gives an indication of how the market views the risk of a firm's assets

Cost of Capital

Required Return = ____________________

Appropriate discount rate

Required return is based off on...

the risk of the cash flows

We must earn at least the ___________________ to compensate investors for financing they have provided

required return

Forecasting future cash flows and discounting them by the cost of capital determines the...

value of a firm

If a firm takes on riskier projects, cost of capital (increases/decreases)

increases

A riskier firms stock will have (higher/lower) expected return

higher

A riskier firm must pay a (higher/lower) interest rate on debt

higher

A firm's assets are financed by ____________ and ______________

debt; equity

A firm's cost of capital should reflect its cost of debt and cost of equity and its _______________________ of debt and equity

relative weights

The return required by investors given risk of the firm's cash flows

cost of equity

2 Types of Risk:

1. Business Risk
2. Financial Risk

Methods to determine cost of equity (2):

1. Divided Growth Model
2. SML / CAPM

PV of FCF @ rWACC =

EV

T/F: one advantage to the dividend growth model is that it is easy to understand and use

True

Disadvantages to the dividend growth model are that it only applies if companies are planning on paying dividends, is extremely sensitive to the ________________________ and does not explicitly consider __________.

estimated growth rate; risk

SML stands for...

Security Market Line

SML is also called...

CAPM

CAPM stands for...

Capital Asset Pricing Model

E(Rm)-Rf is the...

market risk premium

What represents the systematic risk of an asset?

Beta

The difference between the average return on common stocks and the average return on Treasury bills is the average compensation for investing in the riskiest class of assets rather than in the safest one. This difference is called the...

market risk premium

Advantages to CAPM are that it explicitly _________________________ and is applicable to all companies

adjusts for systematic risk

Disadvantages to the CAPM model include having to estimate ______________ and _______________________ which varies over time.

Beta; expected market risk premium

T/F: The CAPM model uses the past to predict the future which is not always reliable

True

When calculating the cost of debt, focus on cost of _____________ debt or ____________.

long term debt; bonds

The required return is best estimated by computing the ______________________ on the existing debt

yield to maturity

Does the cost of debt = the coupon rate?

No

T/F: Most treasurers use book value debt because it has been recently priced by the market

True

____________________ generally pays a constant dividend each period

Preferred stock

T/F: Dividends are expected to be paid every period forever

True

Preferred stock is a _____________________

perpetuity

We can use the individual costs of capital that we have computed to get our ________________ cost of capital for the firm.

average

The average cost of capital for the firm is the ____________________ on the firms assets, based on the market's perception of the risk of those assets.

required return

Market Value of Equity=

# of shares outstanding x price per share

Market Value of Debt =

# of bonds outstanding x bond price

Market Value of the firm =

D+E

Do we want pre tax or after tax cash flows?

After tax cash flows

Interest expense (increases/reduces) our tax liability

reduces

Reduction in taxes (increases/reduces) cost of debt

reduces

Are dividends tax deductible?

no

T/F: Because dividends are not tax deductible, there is no impact on the cost of equity

True

The weights in the WACC equation should be based on _________________

market value

Using WACC as a discount rate is only appropriate for projects with the _______________ as the firm's overall

same risk

T/F: Appropriate discount rates need to be determined for projects that do not have the same risk as the firm

True

When required return > WACC, the risk portfolio of the project is (less than/ greater than) the risk of the firm

greater than

when required return = WACC, the risk of the project is _____________ the risk of the firm

equal to

If IRR > required return, should you accept the project?

Yes

If IRR< WACC, should you accept the project?

No

Approaches to determining a discount rate for projects that do not have the same risk as the company (2):

1. Pure Play Approach
2. Subjective Approach

For the pure play approach, we must find one or more companies that ...

specialize in the product or service that we are considering

For the subjective approach, we must consider a projects...

risk relative to firm overall

If the project has more risk than the firm, we should use a discount rate (less than/greater than) WACC

greater than