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 that is used in the pricing of risky securities

Systemic or unsystematic risk- risk associated with a security

Systematic risk- market related ex. (inflation, recession, changes in interest rates)

Unsystematic risk- firm-specific or unique risk, diversifiable ex. (labor strikes or death of the company’s CEO)

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

market related risk measurement- measured by Beta which estimates the volatility of a security relative to that of the market

asset with Beta greater- than one has more systematic risk and a greater cost of equity

market risk premium- the difference between the expected return on a market portfolio and the risk-free rate, compensation required by investors for investing in risky stocks rather than in a riskless T-bill

why does underpricing exist- underpricing is used to induce more investors to participate in the IPO

Signal company quality- although costly, may allow the issuer to return to market to sell equity on better terms at a later date

lawsuit avoidance- some companies purposefully sell their stock at a discount rate to reduce the likelihood of future lawsuits from shareholders disappointed with the post IPO performance of their shares

Investors required returns = the firms cost of capital, the cost of financing the firms assets which is through the cost of debt and equity

cost of equity- current price asset = present value of the sum of the future cash flows generated by the assets

to determine a firm’s cost of capital one must include- the returns currently required by both debtholders ad stockholders

Which of the following is the main advantage of using the dividend growth model to estimate a firms cost of capital- the simplicity of the model

3) Which of the following statements regarding a firm’s pretax cost of debt is accurate?
A) It is based on the current yield to maturity of the company's outstanding bonds.
B) It is equal to the coupon rate on the latest bonds issued by the company.
C) It is equivalent to the average current yield on all of a company's outstanding bonds.
D) It is based on the original yield to maturity on the latest bonds issued by a company.
E) It must be estimated as it cannot be directly observed in the market.

4) A firm's aftertax cost of debt will increase if there is a(n):
A) decrease in the company's debt-equity ratio.
B) decrease in the company's tax rate.
C) increase in the credit rating of the company's bonds.
D) increase in the company's beta.
E) decrease in the market rate of interest.
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5) When calculating a firm’s weighted average cost of capital, the capital structure weights:
A) are based on the book values of debt and equity.
B) are based on the market values of the outstanding securities.
C) depend upon the financing obtained to fund each specific project.
D) remain constant over time unless new securities are issued or outstanding securities
are redeemed.
E) are restricted to debt and common stock.

6) Which of the following statements regarding the weighted average cost of capital is accurate?
A) It equals the aftertax cost of the outstanding liabilities.
B) It should be used as the required return when analyzing any new project.
C) It is the return investors require on the total assets of the firm.
D) It remains constant when the debt-equity ratio changes.
E) It is unaffected by changes in corporate tax rates.

7) Assume a firm employs debt in its capital structure. Which of the following statements is
accurate?
A) The WACC would most likely decrease if the firm replaced its preferred stock with
debt.
B) In the WACC calculation, the weight assigned to preferred stock decreases as the
market value of the preferred stock increases.
C) The WACC will decrease as the corporate tax rate decreases.
D) In the WACC calculation, the weight of equity is based on the number of shares
outstanding and the book value per share.
E) The WACC will remain constant unless a company retires some of its debt.

Advantages CAPM= explicitly adjusts for systematic risk, applicable to all companies

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

Cost of debt= required return on our company’s debt (not the coupon rate)

Required return is estimated by computing the yield to maturity on existing debt

YTM= interest rate that equates the current price of the bond to the present value of the sum of all interest payments and principal

coupon rate= interest rate payment promised to bondholders on a periodical basis

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

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

WACC- required return on the firm’s assets, based on the market’s perception of the risk of those assets, weights are determined by how much of each type of financing is used

Pure Play Approach- companies with similar products that take the beta and average it

Subject Approach- compare risk relative to firm overall