The Cost of Debt Capital

Cost of equity capital

Return required by investors on equity investments

Debt capital

Capital raised through interest-bearing loans

Irredeemable debt

Debt that is never repaid

Irredeemable (undated) bonds

Bonds not expected to be repaid, with perpetual interest payments

Price of irredeemable debt

PD = (i * VD) / KD

KD

Cost of irredeemable debt, bond's yield to maturity

Ex int market price

Cum int price - int payment

Redeemable debt

Debt with fixed interest payments and a maturity payment

Price of redeemable debt

PD = (C + M) / (1 + KD)^t

Present value of an annuity

PV = ANr

ANr

Present value of a constant cash flow for N years

Linear interpolation

Method to solve for KD when bond cash flows extend over more than two points in time

NPV

Net present value of bond cash flows

Corporation tax

Tax offset for interest payments

After-tax cost of debt capital

Cost of debt capital adjusted for corporation tax

Benchmark Kds

High and low costs of debt used for linear interpolation

NPVkd high

Net present value of bond cash flows using high Kd

NPVkd low

Net present value of bond cash flows using low Kd

What is the security market line (SML)?

A line that shows the relationship between expected return and systematic risk.

What does the SML help us understand?

The alternatives available to an investor in the capital markets.

What does this chapter focus on?

The perspective of companies that issue securities.

What is the return an investor receives on a security?

The cost of that security to the company that issued it.

What does the required return on an investment mean?

The investment will have a positive NPV only if its return exceeds the required return.

How can the required return be interpreted?

The firm must earn the required return to compensate its investors for the use of capital.

What is another term for the required return?

The cost of capital associated with the investment.

How is the required return determined for a risk-free project?

By observing the current rate offered by risk-free investments in the capital markets.

What is the cost of capital for a risk-free investment?

The risk-free rate.

What happens to the required return if a project is risky?

It is higher than the risk-free rate.

What is the cost of capital for a risky project?

Greater than the risk-free rate.

What is the appropriate discount rate for a risky project?

Higher than the risk-free rate.

What is the relationship between the required return and the cost of capital?

They are the same thing.

What does the cost of capital represent?

The return required by investors to compensate for the use of capital.

What does the cost of capital depend on?

The riskiness of the investment.

What is the cost of capital for a risk-free project?

The risk-free rate.

What is the cost of capital for a risky project?

Higher than the risk-free rate.

What is the appropriate discount rate for a risky project?

Higher than the risk-free rate.

What is the relationship between the required return and the cost of capital?

They are the same thing.

What is the risk-free rate?

The rate of return on an investment with no risk.

What are some terms that can be used interchangeably with required return?

Appropriate discount rate, cost of capital.

What does the cost of capital depend on?

The risk of the investment.

What is the common error when thinking about the cost of capital?

Thinking it depends on how and where the capital is raised.

What is capital structure?

The mixture of debt and equity a firm chooses to employ.

What is a firm's target capital structure?

The fixed debt-equity ratio it seeks to maintain.

What does a firm's overall cost of capital reflect?

The returns needed to compensate its creditors and shareholders.

What are the two components of a firm's cost of capital?

Cost of debt capital and cost of equity capital.

What is the most difficult question when determining the cost of capital?

What is the firm's overall cost of equity?

What are the two approaches to determining the cost of equity?

Dividend growth model approach and security market line (SML) approach.

What is the dividend growth model approach?

Estimating the cost of equity capital using the firm's dividend growth model.

What is the formula for the cost of equity capital using the dividend growth model?

RE = (D1/P0) + g

What information is needed to estimate the cost of equity using the dividend growth model?

Dividend just paid (D0), share price (P0), and expected growth rate for dividends (g).

How can the growth rate (g) be estimated?

Using historical growth rates or analysts' forecasts of future growth rates.

What is the primary advantage of the dividend growth model approach?

Its simplicity and ease of use.

What is the primary disadvantage of the dividend growth model approach?

It is only applicable to companies that pay dividends.

What is another disadvantage of the dividend growth model approach?

The estimated cost of equity is sensitive to the estimated growth rate.

Does the dividend growth model approach explicitly consider risk?

No, it does not.

What is the next approach discussed for determining the cost of equity?

The security market line (SML) approach.

What is the SML approach?

Security Market Line approach.

What are the three factors that determine the required or expected return on a risky investment?

Risk-free rate, market risk premium, and beta coefficient.

What is the risk-free rate?

The rate of return on a risk-free investment.

What is the market risk premium?

The difference between the expected return on the market and the risk-free rate.

What is the beta coefficient?

A measure of the systematic risk of an asset relative to the average.

How can the expected return on a company's equity be calculated using the SML?

E(R_E) = R_f + (E(R_M) - R_f) * beta_E.

What is the advantage of the SML approach?

It explicitly adjusts for risk and applies to companies with different dividend growth patterns.

What is the disadvantage of the SML approach?

It requires estimation of the market risk premium and beta coefficient, which can lead to inaccurate results.

What can result in different estimates of the market risk premium?

Using different time periods or different equities and markets.

Why may the past not be a good guide to the future when using the SML approach?

Economic conditions can change quickly.

What is the ideal scenario for the SML and dividend growth model?

Both approaches yield similar answers, providing confidence in the estimates.

What can be done to validate the results obtained from the SML approach?

Comparing the results with those of similar companies.

What is the purpose of dropping the 'Es' denoting expectations in the SML approach?

To align it with the dividend growth model.

What is the primary conclusion about the SML approach?

The expected return on a risky investment depends on the risk-free rate, market risk premium, and beta coefficient.

What is the primary advantage of the SML approach?

It explicitly adjusts for risk.

What is the second advantage of the SML approach?

It applies to companies with different dividend growth patterns.

What are the drawbacks of the SML approach?

Estimation of market risk premium and beta coefficient, reliance on past data, and potential inaccuracy of results.

What is the purpose of the SML approach?

To determine the expected return on a company's equity.

What is the purpose of comparing the results with those of similar companies?

To validate the estimates obtained from the SML approach.

What is the potential risk of using the SML approach?

Inaccurate results due to poor estimation of market risk premium and beta coefficient.

What is the cost of debt?

The return that creditors demand on new borrowing.

How is the cost of debt determined?

It can be observed directly or indirectly through interest rates in the financial markets.

What is the relevance of the coupon rate on outstanding debt?

It is irrelevant in determining the current cost of debt.

What symbol is used to represent the cost of debt?

Rd.

How can the cost of debt be calculated if bond prices are available?

By rearranging the present value formulae.

What are floating rate bonds?

Bonds with coupon rates that vary with an underlying benchmark.

What are some examples of underlying benchmarks for floating rate bonds?

SONIA, SOFR, EONIA.

How can the cost of floating rate debt be estimated?

By calculating the cost of debt of a fixed rate bond with a similar maturity for a firm of similar risk and profile.

What is the weighted average cost of capital (WACC)?

The average cost of all the sources of capital employed by a firm.

What is the firm's capital structure?

The specific mix of debt and equity used by the firm.

What is total capitalization?

The sum of a firm's long-term debt and equity.

What is the focus of financial analysts when determining cost of capital?

They often focus on a firm's total capitalization and ignore short-term liabilities.

What is the general approach in determining cost of capital?

It is applicable with either total value or total capitalization.

What is the definition of photosynthesis?

The process by which plants convert sunlight into energy.

What are the main components required for photosynthesis?

Sunlight, water, and carbon dioxide.

What is the role of chlorophyll in photosynthesis?

Chlorophyll absorbs sunlight and converts it into chemical energy.

What is the equation for photosynthesis?

6CO2 + 6H2O -> C6H12O6 + 6O2.

What is the purpose of photosynthesis?

To produce glucose and oxygen for the plant's energy needs.