Cost of Capital Practice Flashcards

This flashcard set covers the essential vocabulary and formulas for determining the cost of debt, preferred stock, common stock, and the weighted average cost of capital (WACC) as presented in the Topic 8 lecture notes.

Cost of capital

The firm’s cost of financing represents the minimum rate of return that a project must earn to increase firm value.

Net proceeds

The funds actually received by the firm from issuing a security (a stock or bond) after all flotation costs have been paid.

Flotation costs

The total costs of issuing and selling a security, consisting of underwriting costs and administrative costs.

Underwriting costs

Compensation earned by investment bankers for selling a security.

Administrative costs

Issuer expenses such as legal, accounting, and printing associated with issuing a security.

Before-tax cost of debt ($r_d$)

The rate of return the firm must pay on new borrowing, which can be observed via market quotations of yield to maturity (YTM) on existing or similar risk bonds.

After-tax cost of debt ($r_i$)

The cost of debt for the firm calculated by multiplying the before-tax cost by 1 minus the tax rate ($T$), expressed as $r_i = r_d \times (1 - T)$.

Cost of preferred stock ($r_p$)

The ratio of the preferred stock dividend to the firm's net proceeds from the sale of the preferred stock.

Cost of common stock equity ($r_s$)

The rate at which investors discount the expected dividends of the firm to determine its share value.

Constant-growth valuation (Gordon) model

A model that assumes the value of a share of stock equals the present value of all future dividends, assumed to grow at a constant rate ($g$), over an infinite time horizon.

Dividend yield

A component of the required return on common stock found by dividing the dividend expected at the end of year 1 ($D_1$) by the current market price of the stock ($P_0$).

Capital gains yield

The expected growth rate ($g$) of dividends in the constant-growth valuation model.

Capital asset pricing model (CAPM)

A model describing the relationship between the required return ($r_s$) and the non-diversifiable risk of the firm as measured by the beta coefficient ($b$), given by the formula $r_s = R_F + [b \times (r_m - R_F)]$.

Beta coefficient ($b$)

A measure of the non-diversifiable risk for an asset used in the Capital asset pricing model (CAPM).

Cost of retained earnings ($r_r$)

The cost of equity financing equivalent to the cost of common stock equity ($r_s$), as retained earnings represent a fully subscribed issue of additional common stock.

Cost of a new issue of common stock ($r_n$)

The cost of common stock net of underpricing and associated flotation costs, typically greater than the cost of existing issues ($r_s$).

Underpriced stock

A condition where new shares are sold at a price below the current market price ($P_0$).

Weighted average cost of capital (WACC) or $r_a$

The expected average future cost of capital over the long run, found by weighting the cost of each specific type of capital by its proportion in the firm’s capital structure: $r_a = (w_i \times r_i) + (w_p \times r_p) + (w_s \times r_r \text{ or } r_n)$.

Internal Rate of Return (IRR)

The annual rate of growth that an investment is expected to generate, which indicates whether to accept a project if it exceeds the WACC.