Managerial Finance II - Ch 13: Weighted Average Cost of Capital (WACC)

Flashcards covering key vocabulary from a lecture on the Weighted Average Cost of Capital (WACC), including definitions for various capital components, valuation models, and related financial concepts.

Cost of Capital

The opportunity cost of the funds used to finance a project, reflecting the rates of return investors expect from alternative investments of similar risk.

Cost of Debt

The yield investors require to hold or buy a firm's debt, typically represented by the Yield to Maturity (YTM).

Cost of Preferred Stock

The rate of return required by investors on a firm's preferred stock, calculated by dividing the fixed dividend per share by the market price per share.

Cost of Common Stock (Cost of Equity)

The rate of return required by investors on a firm's common stock, often estimated using the Capital Asset Pricing Model (CAPM) or the Constant Dividend Growth Model (CDGM).

Weighted Average Cost of Capital (WACC)

A firm's overall cost of capital, reflecting the blend of costs for equity, debt, and other capital sources, weighted by their respective market values in the firm's capital structure.

Capital

A firm's sources of financing, including debt, equity, and other securities such as preferred stock.

Capital Structure

The relative proportions of debt, equity, and other securities that a firm has outstanding.

Market Value of Securities

The current price at which a security can be bought or sold in the market, used for WACC calculations rather than historical book values.

Unlevered Firm

A firm that is financed with 100% equity.

Levered Firm

A firm that is financed with both debt and equity.

Leverage

The amount of debt on a firm's balance sheet; more leverage generally means higher financial risk.

Coupon Rate

The fixed interest rate paid on a bond, used to calculate interest payments, but not the actual cost of debt.

Yield to Maturity (YTM)

The actual rate investors earn if they hold a bond to maturity, representing the cost of debt before taxes.

Effective Cost of Debt

The after-tax cost of debt, calculated as YTM multiplied by (1 - marginal tax rate), used in WACC calculations due to interest tax deductibility.

Tax Shield

The reduction in a firm's taxable income and overall tax bill due to the tax deductibility of interest payments.

Capital Asset Pricing Model (CAPM)

A model used to estimate the cost of equity (required return on common stock) by connecting risk-free rate, beta, and market risk premium.

Risk-Free Rate (rF)

The return on a long-term U.S. Treasury bill or bond, considered free from default risk, used in CAPM.

Beta (ß)

A measure of a firm's systematic risk, indicating the volatility of its returns relative to the overall market.

Market Risk Premium (rM - rF)

The additional return investors expect for holding the market portfolio compared to a risk-free asset.

Constant Dividend Growth Model (CDGM) / Gordon Model

A model used to estimate the cost of equity for companies with dividends expected to grow at a constant rate, using the next expected dividend, current stock price, and growth rate.

Incremental Free Cash Flows (FCF)

The additional cash flows (inflows and outflows) directly generated by a project, used for project valuation.

Net Present Value (NPV)

A capital budgeting decision rule that discounts a project's future cash flows at the appropriate cost of capital; a project is accepted if NPV is greater than zero.

Project-Based Costs of Capital

The specific cost of capital assigned to a project based on its unique risk profile and financing, which may differ from the company's overall WACC.

Issuance (Flotation) Costs

Direct costs incurred when raising external capital, such as investment banker fees and legal fees, which should be included as project cash outflows in NPV analysis.