FIN 305 - Chapter 12

SML (CAPM) advantages

1) explicitly adjusts for risk 2) it's applicable to companies other than those with steady dividend growth (useful in a wider variety of circumstances)

Disadvantages of DGM

1) only applicable to companies that pay dividends 2) assumption that the dividend grows at a constant rate 3) estimated cost of equity is very sensitive to the estimated growth rate 4) does not explicitly consider risk

SML (CAPM) disadvantages

1) requires the market risk premium and the beta coefficient to be estimated 2) rely on the past to predict the future, like with DGM

Required/ expected return depends on...

1) the risk-free rate 2) the market risk premium 3) the systematic risk of the asset relative to that in an average risky asset (called the beta coefficient)

WACC formula

= (E/V) x Re + (D/V) x Rd x (1 - Tc)

If a firm has multiple projects, each project should be discounted using ______

A discount rate commensurate with the project's risk

Target capital structure

A fixed debt-equity ratio that the firm wants to maintain

A desirable investment is one that plots _________ the SML

Above

Using an analyst's forecast for a firm's earnings growth and a stock's dividend yield, you can find the cost of equity by:

Adding these two components

Required return in THIS CHAPTER =

Appropriate discount rate and/ or cost of capital

Subjective approach

Consider the project's risk relative to the firm overall; exists because of the difficulties in objectively establishing discount rates for individual projects

The return an investor in a security receives is ______ _____ the cost of the security to the company that issued it

Equal to

If the firm is all-equity, the discount rate is equal to the firm's cost of ______ capital

Equity

Expected growth rate in dividends must be _________

Estimated

T/F: finding the cost of equity is fairly straightforward

False: it is difficult because there is no way to directly observe the return that the firm's equity investors require on their investment

T/F: the discount rate is also known as the expected return

False: it is known as the required return, appropriate discount rate, and cost of capital

True or false: For publicly traded companies, the component of the dividend yield that must be estimated is the dividend

False: the expected growth rate in dividends must be estimated

Preferred stock

Has a fixed dividend paid every period forever (a share is essentially a perpetuity); cost can be estimated by observing the required returns on other, similarly rated shares of preferred stock

Ways to estimate growth rate

Historical growth rates or analysts' forecasts of future growth rates

Incorrect use of WACC can result in...

Incorrectly accepting relatively risky projects and incorrectly rejecting relatively safe ones

If a firm issues no debt, its average cost of capital will equal ______

Its cost of equity

The geometric average is _______ than the arithmetic average

Lower

The most appropriate weights to use in the WACC are the ______ weights

Market value

Other companies that specialize only in projects similar to the project your firm is considering are called _____

Pure plays

Cost of equity equation

R = (D1/P0) + g If we have D0 and g, we can calculate D1 by multiplying D0 by (1 + g)

SML (CAPM) formula

R = Rf + B( Rm - Rf) or = risk-free rate + beta (market return - risk-free rate)

If an all-equity firm discounts a project's cash flows with the firm's overall weighted average cost of capital even though the project's beta is less than the firm's overall beta, it is possible that the project might be:

Rejected, when it should be accepted

Project's discount rates should reflect the project's ______

Risk

The WACC of a firm reflects the _________ and the target capital structure of the firm's existing assets as a whole

Risk

Separate divisional costs of capital

Riskier divisions tend to have greater returns, so one might pass up the less glamorous operation, even if it had great potential

Preferred stock formula

Rp = D/P0 where D is the fixed dividend and P0 is the current price per share

For short-term debt, the book/ accounting value is __________ to the market value

Similar

Advantages of DGM

Simplicity: easy to understand and use

It is difficult to establish discount rate for individual projects, so firm's often adopt an approach that involves making _______ adjustments to the overall WACC

Subjective

(Coupon) Interest paid by corporations is _______

Tax deductible; dividends are NOT

The return an investor receives is the cost of that security to _______

The company that issued it

Weighted Average Cost of Capital (WACC)

The cost of capital for the firm as a whole, and it can be interpreted as the required return on the OVERALL firm; the overall return a firm must earn on its existing assets to maintain the value of its stock; also the required return on any investments by the firm that have essentially the same risks as existing operations

If required return = 10%, this means that...

The investment will have a positive NPV only if its return exceeds 10%; the cost of capital associated with the investment is 10%; what we need to earn to compensate investors

If a firm already has bonds outstanding, then the yield to maturity on those bonds is ________

The market-required rate on the firm's debt; no need to estimate a beta for debt

Cost of capital (cost of money, hurdle rate)

The minimum required return on a new investment; will reflect a firm's cost of debt capital and its cost of equity capital

Cost of equity

The return that equity investors require on their investment in the firm; difficult question because there is no way of directly observing the return that the firm's equity investors require on the investment--we must estimate it

The cost of debt

The return that lenders require on the firm's debt; the return that creditors demand on new borrowing; can be observed either directly or indirectly because the cost of debt is the interest rate the firm must pay on new borrowing (which we can see)

The cost of capital associated with an investment depends on ______

The risk of that investment & the use of the funds, not the source

Cost of capital for a risk-free innvestment

The risk-free rate

If a firm uses its overall cost of capital to discount cash flows from projects in higher risk divisions, it will accept ______ projects

Too many

T/F: the return an investor in a security receives is equal to the cost of the security to the company that issued it

True

T/F: using WACC as the discount rate for future cash flows is only appropriate when the proposed investment is similar to the firm's existing activities

True; ex: opening a new location and expanding production/ markets

Pure play approach

Use of weighted average cost of capital that is unique to a particular project, based on companies in similar lines of business

What is the appropriate discount rate to use only if the proposed investment is a replica of the firm's existing operating activities?

WACC

For a firm with outstanding debt, the cost of debt will be the ________ on that debt

Yield to maturity

Which of the following is true about a firm's cost of debt?

Yields can be calculated from observable data It is easier to estimate than the cost of equity

To estimate the dividend yield of a particular stock, we need:

the current stock price the last dividend paid, D0 forecasts of the dividend growth rate, g