Cost of Capital

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30 Terms

1

Cost of Preferred Stock

Generally pays a constant dividend every period.

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2

Capital Asset Pricing Model (CAPM)

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

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3

Systematic Risk

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

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4

Unsystematic Risk

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

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5

Beta

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

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6

Market Risk Premium

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

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7

Underpricing in IPOs

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

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8

Cost of Equity

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

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9

Weighted Average Cost of Capital (WACC)

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

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10

Dividend Growth Model Advantage

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

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11

YTM (Yield to Maturity)

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

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12

Coupon Rate

Interest rate payment promised to bondholders on a periodic basis.

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13

Pure Play Approach

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

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14

Subject Approach

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

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15

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.

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16

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

decrease in the company's tax rate.

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17

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

are based on the market values of the outstanding securities.

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18

statement regarding the weighted average cost of capital that is accurate

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

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19

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.

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20

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

the returns currently required by both debtholders and stockholders

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21

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

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22

 

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

market risk

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23

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

Beta of greater than one

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24

why does underpricing exist?

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

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25

Advantages to CAPM

explicitly adjusts for systematic risk, applicable to all companies

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26

Disadvantages to CAPM

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

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27

how is required return estimated?

computing the yield to maturity on existing debt

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28

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

premium

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29

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

par

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30

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

discount

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