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Chapter 12 Final exam
Terms in this set (62)
cost of capital
what a firm has to pay for the capital- the debt, preferred stock, retained earnings and common stock- it uses to finance new investments
the greater the risk of a firm, the greater the return...
and the greater the cost of capital
investment earnings> cost of capital
value of firm increases
cost of capital (easy definition)
the rate of return required by investors in the firms securities
what are the different ways to use cost of capital?
1. as a discount rate used when computing the NPV of a project of average risk
2. the hurdle rate used in conjunction with the IRR(internal rate of return)
How is the cost of capital calculated?
obtained from the weighted costs of individual components
using equity, beta, preferred stock in a after tax basis
cost of capital equation
ka= (equity fraction of capital structure)
(marginal cost of equity) + (Debt fraction of capital structure)
(Marginal cost of debt)+(preferred fraction of capital structure)*(Marginal cost of preferred stock)
which should be used in the weighted cost of capital?
market value because it is consistent with the goal of maximizing shareholder wealth
market value of equity and book value of equity usually.....
why are book values still used in cost of capital?
1. bc market pricing changes daily and it is annoying calculate the cost of capital everyday
2. gathering market prices of various cost of capital can be hard to calculate into one private firm
what is the problem with lumpy capital?
it is incorrect to associate any particular source of financing with a particular project -the investment and financing decision should be done separately. (this is even though firms only raise one capital payment at a time)
what is the relative costs of capital?
the cost of capital to the firm is equal to the equilibrium rate of return demanded by investors in the capital markets for securities with that degree of risk
what is the capital market line?
comparing different debt and stocks and their overall risk ( higher up the ladder the higher the risk)
-low quality corporate debt
-high quality preferred stock
-long term governments debt
-high quality corporate debt
-short term govt debts
marginal costs dealing with the cost of capital
cost of latest increment of money obtained
what is the cost of debt dealing with the cost of capital?
the rate of return required by the firms creditors
what is the pretax cost of debt based on?
net proceeds of issuing new bonds
what is the after tax debt based on?
the relevant costs
(1-T) what is T?
marginal tax rate
what can be used to estimate the cost of debt?
-yield to maturity of outstanding bonds
-the pretax cost of debt recently sold by other firms with similar risk
yield to maturity
The investors rate of return on a security investment
what is the cost of preferred stock?
the rate of return required by investors on preferred stock issued by the company
what is the equation of preferred stock? only if it does not mature and is not callable
kp=Dp/Pnet ( need to calculate issuance costs)
the internal equity of capital is found in two ways....
internally through retained earnings
externally through the sale of new common stock
why is the cost of internal equity less than the new common stock?
issuance costs -no need to go through selling the items
when does one use the dividend evaluation model approach (gordon growth model)
when earnings or dividends are:
-expected to grow at a constant rate to infinity
-not expected to grow at all (g=0)
what is the dividend valuation model approach equation?
what are the issues of implementation?
investors and analysts -it can be really time consuming
capital asset pricing model approach
describes the the risk required return trade off for securities
what is Security Market Line expected values used for?
risk free rate
expected market return
what is the CAPM equation?
what is the SML and how does it differ in equation?
is based on the investors expectations regarding the a security's risk and return characteristics **change the kj to ke (cost of equity)
higher rate on return always equals....
what are the components of cost of capital
1. marginal costs
2. cost of debt
3. cost of preferred stock
4. cost of internal equity capital
5. non constant divided growth and the cost of common equity
6. cost of external equity capital
what is the risk premium over debt approach
a shortcut method of estimating the cost of equity capital based on actual historic returns
equity risks premium over a company's debt yields tend to be higher when interest rates are.....
when do you use risk premium over debt approach?
for stocks that do not pay dividends
what is the equation for risk premium over debt approach?
solve for ke
why is external equity is greater than the internal equity?
-issuance costs of new shares are usually high
-the selling price of the new shares to the public is normally set less than the market price
what is the equation for the cost of external common equity?
divisional costs of capital
-some divisions of company may have higher or lower systematic risk
-each division could have its own beta and discount rate
what happens when some divisions of a company may have higher or lower systematic risk?
discount rates for divisions should be higher or lower than the discount rate for the firm as a whole
should each division have its own beta?
YES and should reflect both the differential risks and the differential normal debt ratios for each division
what are the steps in determining the Marginal Cost of Capital Schedule
1. calculate the cost of capital for each individual component
2. compute the marginal cost of capital for each increment of captital raised
amount of low cost debt available /debt fraction of capital structure
what are break points?
they delineate the levels of financing where the weighted cost of capital increases die to an increase in the cost of one component source of capital
break point equation
dollars of common equity financing /we
what is the marginal cost of capital
cost of the additional securities - the latest once beings sold
what is the problem of Lumpy capital?
brings in money from one source at a time have to use weighted average of all the sources
how is the after tax cost of preferred stock found?
not using the tax benefit
why is the cost of internal equity not zero?
retained earnings is still owned of owners of common stock and you must give them a portion or they will leave owning the company
what is the "net price" for the new equity capital?
issuance cost must be subtracted from the price per share (public cost)
determining the Marginal cost of capital
1) Calculate the cost of capital for each individual component
2) Compute the marginal cost of capital for each increment of capital raised
How can break points be determined?
by dividing the amount of funds available from each financing source of funds available from each financing source at a fixed cost of by the target capital structure proportion for that financing source
on the chart the break points are....
every time the weighted marginal cost of capital increases
equation used in break point in problems
Break point= dollars of common equity financing/ we
what size capital budget will maximize shareholder wealth?
if the optimal capital budget is above the marginal cost of capital
Optimal capital budget
determined by comparing the expected project returns to the company's marginal cost of capital schedule
how do you determine the optimal capital budget on a graph?
intersection of the
investment opportunity curve
Marginal cost of capital curve
( to the left of that)
what is the opp cost of depreciation generated funds?
marginal cost of capital using retained earnings
how do you know the cost of depreciation generated funds are available?
shifts MCC to the right of the depreciation
** if shifted out to the left of the depreciation means the funds will be delayed.
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