Chapter 14 FIN3403

Advantages of SML Approach

-Explicitly adjusts to risk -applicable to companies other than just those with steady dividend growth

Disadvantages of SML Approach

-Market risk premium and Beta Coefficient have to be estimated -Rely on the past to predict the future

Floatation Costs

Paid by the company that issues the new securities and includes expenses such as underwriting fees, legal fees, and legislation fees.

cost of preferred stock

fixed dividend paid every period forever; perpetuity

Taxes affect on WACC

if we are determining the discount rate appropriate to those cash flows, then the discount rate also needs to be expressed on an aftertax basis

disadvantages of dividend growth model

only applicable to companies that buy dividends reasonably steady growth has to occur the estimated cost of equity is very sensitive to the estimated growth rate doesn't consider risk

advantages of dividend growth model

simplicity easy to understand and easy to use

subjective approach

the firm places projects into one of several risk classes. The discount rate used to value the project is then determined by adding or subtracting an adjustment factor to or from the firms WACC. This results in fewer incorrect decisions than if the firm simply used the WACC to make the decision

Required Return

the minimum annual percentage earned by an investment that will induce individuals or companies to put money into a particular security or project

Cost of Capital

the rate of return that capital could be expected to earn in an alternative investment of equivalent risk

Cost of Equity

the return that equity investors require on their investment in the firm

cost of debt

the return that lenders require on the firms debt

pure play approach

the use of WACC that is unique to a particular project, based on companies in similar lines of business Used to find: the estimate beta coefficient of a company whose stock is not publically traded. - used to find the cost of capital for a project that is different from the company's mainstream business

Weighted average cost of capital

the weighted average of the cost of equity and the aftertax cost of debt. it is the overall return the firm must earn on its existing assets to maintain the value of its stocks the required return on any investments by the firm that have essentially the same risks as existing operations