FIN 3403 Exam 4 (Chapter 14) – Flashcards
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Define Required Return.
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% interest rate from investor's POV Minimum required % earning on a potential investment to satisfy risk =Discount Rate
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Define Cost of Capital.
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% interest rate from firm's POV Cost paid to investor in order to attract investment in their asset =Discount Rate
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Define Cost of Equity. -Be able to calculate using the Dividend Growth Model Approach. What are advantages and disadvantages of this approach? -Be able to calculate using the CAPM Approach. What are the advantages and disadvantages of this approach?
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How much a firm must pay to equity investors (comm) to compensate for risk Growth Model: Re=(D1/P0)+g or (depending on info given) CAPM: Re=Rf+Be(Erm-Rf)
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Define Cost of Debt. How is it calculated?
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How much a firm must pay to debt investors to compensate for risk Rd=YTM (TVM)
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Define Cost of Preferred Stock. How is it calculated?
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How much a firm must pay to equity investors (pref) to compensate for risk Rp=D/P0
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What are Capital Structure Weights? How are they calculated?
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Market values of firms Common Equity (E), Debt (D), and Preferred Stock (P) E = #shares outstanding x price per share D = #bonds outstanding x price per bond P = #shares of pref stock outstanding x price per share Combined market value of firm's equity and debt (V)=E+D+P (E/V)+(P/V)+(D/V)=1
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How do taxes affect the WACC?
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As taxes increase, WACC decreases (and vice versa) Because interest expense (only comes from debt) is tax deductible, Higher tax rate = larger tax shield = Lower WACC
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What is the Weighted Average Cost of Capital? How is it calculated? What is it used for?
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Cost of capital deployed by the business Average of the required returns for all of the firm's divisions/projects WACC = (E/V)Re + (P/V)Rp + (D/V)Rd(1-Tc) Shouldn't be used to decide which projects to take
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What is the Pure Play Approach? Why is it used in practice?
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Used when deciding whether or not to take on a new project with different level of risk than your current company's risk Use an imaginary company that is identical to the potential project you are considering in real life (pure play company is only in line of business that the project is in) Substitute pure play company's Beta for your company's Beta and recalculate WACC (this adjusts WACC up or down to match risk of project you're evaluating). This new WACC should be used as discount rate when evaluating Flaw: Hard to find a company that matches a project to use a pure play company (unrealistic)
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What is the Subjective Approach? Why is it used in practice?
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Used if pure play approach doesn't work (more common than pure play) Look at current company risk Subjectively look at projects' risks and decide if they are more or less risky than your current company Add or subtract from WACC to match subjective risk of project Flaw: subjective so different people can come up with different results (professionals would be better at it)
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What are Flotation Costs? Why and when must they be taken into account? How should they be taken into account in calculations (2 ways)?
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Additional costs of issuing new capital for a company (new securities are being 'floated' out into the marketplace and sold) Means that required return needs to be higher (higher than if you were to use retained cash flows only to finance a new project) to cover additional costs 2 adjustments: 1. Need to raise enough money to cover cost of project PLUS payment to investment bankers, legal fees, etc. ('gross capital') (this means that outflow at beginning of project will be larger than cost of project) 2. Because returns on debt, equity, and preferred stock are based on #shares outstanding (already in market place), cost of debt and equity will be higher than in past now that more funds are needed to cover flotation costs (makes discount rate needed to accept project higher)
