# Chapter 10 - The Cost of Capital

## 10 terms

### Investment Policy

When we estimate the cost of capital, we use as the starting point the required rates of return on the firm's outstanding stock and bonds. Those rates reflect the risk of the firm's existing assets. Therefore, we have implicitly been assuming that new capital will be invested in the assets with the same degree of risk as existing assets.

### Capital Structure

Beta is a function of financial leverage, so capital structure affects the cost of equity. Therefore, if the firm decides to use more debt and less common equity, this change in the weights in the WACC equation will tend to lower the WACC. However, an increase in the use of debt will increase the risk of both the debt and equity, and increases in component costs will tend to offset the effects of the change in the weights.

### Dividend policy

If a firm's payout ratio is so high that it must issue new stock to fund to fund its capital budget, this will force it to incur flotation costs, and this too will affects its cost of capital

### Beta of a portfolio

A weighted average of the betas of its individual assets.

### Pure play method

The company tries to find several single-product companies in the same line of business as the division being evaluated, and it then averages those companies' betas to determine the cost of capital for its own division.

### Accounting beta method

Betas normally are found by regressing the returns of a particular company's stock against returns on a stock market index.

### Accounting betas

Run a regression of the division's accounting return on assets against the average return on assets for a large sample of companies, such as those included in the S&P 500.

### Stand-alone risk

The variability of the project's expected return

### Corporate, or within-firm, risk

The variability the project contributes to the corporation's returns, giving consideration to the fact that the project represents only one asset of the firm's portfolio of assets, hence that some of its risk effects will be diversified away.

### Market, or beta, risk

The risk of the project as seen by a well-diversified stockholder. Is measured by the project's effect on the firm's beta coefficient.