CHAPTER 12:Cost of Capital
E=market value of firm's equity= # shares outstanding*Price per share D=market value of firm's debt, For long-term debt, we calculate this by multiplying the market price of a single bond by the number of bonds outstanding. If debt is not publicly traded then we must observe the yield on similar publicly traded debt & then estimate the market value of the privately held debt using this yield as the discount rate. V=Combined Market value of equity and debt
V=E+D , what does each variable stand for?
It is both easy to understand and easy to use.
What are the Advantages of using the Div.GrowthModel approach?
adjusts for risk and applicable to companies other than just those with steady dividend growth
What are the advantages to using the SML approach?
risk isn't taken into consideration, limited to only co. that pay dividends, assumes g=constant
What are the disadvantages of using the Div.GrowthModel approach?
SML approach requires that two things be estimated: the market risk premium and the beta coeffi- cient. To the extent that our estimates are poor, the resulting cost of equity will be inaccurate
What are the disadvantages to using the SML approach?
Dividends Growth Model Approach and SML approach
What are the two approaches of calculating cost of equity?
Opportunity cost of making a specific investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk.
What is Cost of Capital?
The interest rate the firm must pay on new borrowing, (we can observe interest rates in the financial markets)
What is Cost of Debt?
The return that equity investors require on their investment in the firm. (Firms perspective) [in the investor's perspective it's called the required return]
What is Cost of Equity?
The cost of capital for the firm as a whole, and can be interpreted as the required return on the overall firm. [The weighted average of the cost of equity and the aftertax cost of debt]
What is WACC?
**coupon rate on the firm's outstanding debt is irrelevant here. That rate just tells us roughly what the firm's cost of debt was back when the bonds were issued, not what the cost of debt is today.
What is irrelevant when considering the Cost of Debt interest rate?
Re=(D1/P0)+g
What is the return on equity equation derived from the Dividend Growth Model Approach?
percentages that can be interpreted just like portfolio weights. (% of the total capital represented by the debt and equity) 100%=(E/V)+(D/V)
what are capital structure weights?