Cost of Capital

Cost of Preferred Stock

Generally pays a constant dividend every period.

Capital Asset Pricing Model (CAPM)

Model describing the relationship between risk and required return used in pricing risky securities.

Systematic Risk

Market related risk, for example due to inflation or changes in interest rates.

Unsystematic Risk

Firm-specific or unique risk that is diversifiable, such as labor strikes.

Beta

Measurement of market-related risk estimating the volatility of a security relative to that of the market.

Market Risk Premium

Difference between the expected return on a market portfolio and the risk-free rate.

Underpricing in IPOs

Used to induce more investors to participate in the Initial Public Offering.

Cost of Equity

Current price asset equals present value of future cash flows generated by the assets.

Weighted Average Cost of Capital (WACC)

The required return on the firm’s assets based on market perception of risk.

Dividend Growth Model Advantage

The simplicity of the model makes it advantageous for estimating a firm's cost of capital.

YTM (Yield to Maturity)

Interest rate that equates the current price of a bond to the present value of all payments.

Coupon Rate

Interest rate payment promised to bondholders on a periodic basis.

Pure Play Approach

A method using companies with similar products to average their betas.

Subject Approach

Method to compare risk relative to the firm's overall risk.

What statement regarding a firm’s pretax cost of debt is accurate?

It is based on the current yield to maturity of the company's outstanding bonds.

A firm's aftertax cost of debt will increase if there is a(n):

decrease in the company's tax rate.

When calculating a firm’s weighted average cost of capital, the capital structure weights:

are based on the market values of the outstanding securities.

statement regarding the weighted average cost of capital that is accurate

It is the return investors require on the total assets of the firm

Assume a firm employs debt in its capital structure. What can be stated as a result?

The WACC would most likely decrease if the firm replaced its preferred stock with debt.

To determine a firm’s cost of capital, one must include

the returns currently required by both debtholders and stockholders

Which of the following is the main advantage of using the dividend growth model to estimate a firm’s cost of equity

the simplicity of the model

 

In a well diversified portfolio, the only type of risk that matters to investors is

market risk

asset with Beta of how much has more systematic risk and a greater cost of equity?

Beta of greater than one

why does underpricing exist?

underpricing is used to induce more investors to participate in the IPO

Advantages to CAPM

explicitly adjusts for systematic risk, applicable to all companies

Disadvantages to CAPM

using past to predict future, most model assumptions do not hold

how is required return estimated?

computing the yield to maturity on existing debt

If a bond’s coupon rate is more than its YTM, then the bond is selling at a

premium

If a bond’s coupon rate is equal to its YTM then the bond is selling at

par

If a bond’s coupon rate is less than its YTM then the bond is selling at a

discount