ch. 10: the cost of capital

DCF: rs = (D1 / Po) + g, Po = D1 / r + g = dividend yield + growth equity.

what is the formula for DCF, the discounted cash flow (constant growth stock model) method? how do we rearrange this model to find the price of the stock?

WACC = wdrd(1 - T) + wprp + wsrs weights, cost

what is the formula for calculating the weighted average cost of capital (WACC)? the w's refer to the firms's capital structure _______________, the r's refer to the _______ of each component, since there is a required return for each source of capital.

accept, reject (rate of return > WACC for project L) all projects *accept if rate of return > WACC, reject if rate of return < WACC. only use WACC with risk similar to firm's regular projects when looking at typical projects.

*there's importance to risk-adjusting the cost of capital - refer to image on pg. 6 of notes.* if the company correctly risk-adjusted the WACC, then it would __________ Project L and _________ Project H. alternatively, if the company didn't risk adjust and instead used the composite WACC for _______ __________, it would mistakenly select Project H and reject Project L.

rs (r sub s) re (r sub e)

_____ is the marginal cost of common equity using the retained earnings. the rate of return investors require on the firm's common equity using new equity is ______.

new bonds YTM (yield to maturity) *YTM on existing, outstanding (long-term) bonds = indicator/goal for the cost of new bonds.

______ _________ that are issued must at least match the YTM/current price on existing bonds. the ________ on outstanding L-T debt is often used as a measure of rd.

adjusted hurdle rate (WACC)

different projects have different risk. the project's WACC should be ______________ to reflect the project's risk. for an average project, the __________ _______ has an average amount of risk associated with it.

reinvested, paid out other securities

earnings can be ________________ or ______ ______ as dividends. investors could buy __________ ____________ and earn a return.

capital structure dividend policy investment policy

factors the firm can control: ~firm's _______________ ____________: can adjust, change target weights. ~firm's ______________ ___________: how much it returns versus distributes. ~the firm's ________________ _________: does it take riskier versus safer projects.

market conditions macroeconomic conditions

factors the firm cannot control are ____________ _____________ such as interest rates and tax rates. firms cannot control _________________ ____________ like fiscal policy and tax rates.

retained earnings (RE) net income retained/reinvested, dividends

firm's internal equity = _____________ ___________. ______ _________ belongs to shareholders as equity, and it can be: 1. _____________/______________ in firms through RE and equity investments. 2. paid out as _____________.

common, raise, gain control

firms try to pay preferred dividend because if they don't, then: 1. cannot pay ___________ dividend, 2. difficult to ________ additional funds, and 3. preferred stockholders may ________ ____________ of the firm.

unique maximizing shareholder value

firms use various sources of financing, but every firm uses __________ amounts/combinations of debt, preferred stock and equity. any financial decision is driven by the objective of _______________ ______________ _________/stock price in the long run.

higher WACC false!

firms with riskier projects generally have a ___________ _________. true or false: the company should use the composite WACC as the hurdle rate for each of its projects.

market value, book value rd (r sub d)

for WACC, financial decisions (weights & costs) should focus on ___________ _________, which reflect current situations, rather than ________ _________. _______ is the marginal cost of debt capital.

opportunity cost similar stocks, repurchase *this is why there is a cost for retained earnings: earning a particular rate of return to offset the opportunity cost of retained earnings comes at a cost.

if earnings are retained, there is an ______________ _________: the return that stockholders COULD earn on alternative investments of equal risk. investors could buy ____________ _________ and earn rs, a firm could ______________ its own stock and earn rs.

decreases inside, outside

if investor confidence goes up, risk premium ___________. there are factors __________ and __________ a company's control that influence the composite WACC.

sources of capital assets, liability, stockholders' equity (total A has to equal total L + SE.) *liabilities include: accounts payable, notes payable, long-term debt, and preferred stock.

in order to identify the ___________ of __________, we have to understand the financial structure of the firm, reported in the balance sheet. from the balance sheet, we can find short-term and long-term __________ the firm owns and how the firm finances them through ____________ and __________________ _________ and the bottom line has to equal one another.

insider new capital, marginal costs *calculating cost of capital is more forward-looking, so it would be more appropriate to use new (marginal) costs rather than historical (embedded) costs.

on the other hand, an ____________ would use target weights/capital structure since they have access to more company-specific information. the cost of capital is used primarily to make decisions that involve raising ______ ___________. so, we should focus on today's ______________ _______ for WACC.

tax adjustments match

preferred dividends are not tax-deductible, so no ______ _______________ are necessary - just use nominal rp. we look at existing preferred stock - current dividends & price - at also the required return of existing PS: new PS would have to at least __________ these values.

more risky try

preferred stock is _______ _________ to investors than debt because the company is not required to pay preferred dividend. however, firms _______ to pay preferred dividend.

perpetuity price of preferred stock (Po) = D (dividend) / rp (rate of return).

preferred stock is a _____________, so we need to find price and required return. what is the formula to find the price of preferred stock?

lower 70% *PS is more risky than bonds, but the before-tax yield is lower for PS than bonds because of TAX differences: interest expense is tax-deductible, preferred dividends are not.

preferred stock will often have a __________ before-tax yield than the before-tax yield on debt. corporations own most preferred stock, so _______% of preferred dividends are excluded from corporate taxation.

weight outsider

the ____________ is what percent of the firm's capital comes from that specific component. when looking at cost of capital, an ___________ would observe what the firm is currently doing and assume that current conditions reflect the target weights/capital structure.

higher higher risk *important to look at the after-tax yields of components: AT return on debt < AT return on PS.

the after-tax yield to an investor, and the after-tax yield to the issuer, are ___________ on preferred stock than debt. this is consistent with the ________ ______ of preferred stock.

average project average risk *any project a firm invests in should have a higher rate of return than costs.

the composite WACC reflects the risk of an ______________ __________ undertaken by the firm. therefore, the WACC only represents the "hurdle rate" for a typical project with _____________ ________.

bonds current price

the primary/largest source of debt capital for a firm is selling _________. so we could look at the ____________ _________ of bonds, the established market price/YTM on existing bonds.

debt, preferred stock, and common equity (common stock). notes payable (short-term debt) and long-term debt (i.e. bonds).

there are 3 categories under sources of capital. what are two subcategories underneath debt?

CAPM (capital asset pricing model), DCF, and bond-yield-plus-risk-premium. CAPM: rs = rrf + (rm - rrf) (or MRP) beta *CAPM uses systematic risk, known as beta.

there are three ways to determine the cost of common equity. what are they? what is the formula for CAPM?

raise funds decisions

this chapter focuses on how a firm determines its costs and how to _________ _______. there are multiple capital projects that firms could invest in, so the question becomes: how do firms make these important investment _____________?

tax deductible rp (r sub p)

we tax-adjust for debt capital - rd (1 - T) - because with interest payments, we reduce the tax rate for debt since it is ______ _______________. _______ is the marginal cost of preferred stock, which is the return investors require on a firm's preferred stock.

market values/ market weights (rather than accounting weights) target capital structure *could look at actual numbers vs. target capital structure - but target capital structure could be better as more future-oriented/forward-looking.

weights can be determined for WACC equation by: ~adjusting the balance sheet to the current ____________ _________ before producing weights. ~using the _________ ________ ______________ by looking at the balance sheet, accounting statement which reflects historical costs of things - see what the company is trying to achieve in the long run.

retained earnings and new common stock (new equity issued). WACC (weighted average cost of capital)

what are the two subcategories under common equity (common stock)? ___________ is the weighted average of the cost of various components, specifically debt, preferred stock, and equity.

rs = rd + RP (RP estimated in the 3%-5% range) risk premium

what is the bond-yield-plus-risk-premium formula? the ________ _____________ fluctuates based on economic conditions.

rate of return (rp) = D (dividend) / Po (price of preferred stock). more, less *PS is like bonds in that preferred dividends can be deferred, and PS is like stock in that preferred dividends are known (and paid before common stock).

what is the formula to find the rate of return for preferred stock? so, preferred stock is _______ risky than bonds, but _______ risky than stocks.