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