Term
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Definition
(Wd)(Kd)(1-t) + (Wps) (Kps) +
(Wce) (Kce) |
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Term
| The weighted average cost of capital, or WACC, |
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Definition
| is calculated using weights based on the market values of each component of a firm's capital structure and is the correct discount rate to use to discount the cash flows of projects with risk equal to the average risk of a firm's projects. |
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Term
| Interest expense on a firm's debt is... |
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Definition
| tax-deductible, so the pre-tax cost of debt must be reduced by the firm's marginal tax rate to get an after-tax cost of debt capital. |
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Term
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Definition
| Kd (1-firm's marginal tax rate) |
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Term
| The pre-tax and after-tax capital costs are... |
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Definition
| equal for both preferred stock and common equity because dividends paid by the firm are not tax-deductible. |
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Term
| WACC should be calculated based on... |
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Definition
| a firm's target capital structure weights |
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Term
| If information on a firm's target capital structure is not available... |
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Definition
| an analyst can use the firm's current capital structure, based on market values, or the average capital structure in the firm's industry as estimates of the target capital structure. |
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Term
| The firm's marginal cost of capital (WACC at each level of capital investment)... |
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Definition
| increases as it needs to raise larger amounts of capital. This is shown by an upward-sloping marginal cost of capital curve. |
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Term
| An investment opportunity schedule shows... |
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Definition
| the IRRs of (in decreasing orders), and the initial investment amounts for, a firm's potential projects |
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Term
| The intersection of a firm's investment opportunity schedule with its marginal cost of capital curve indicates... |
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Definition
| the optimal amount of capital expenditure, the amount of investment required to undertake all positive NPV projects. |
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Term
| The marginal cost of capital (the WACC for additional units of capital) should be used... |
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Definition
| at the discount rate when calculating project NPVs for capital budgeting decisions. |
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Term
| Adjustments to the cost of capital are necessary when... |
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Definition
| a project differs in risk from the average risk of a firm's existing projects. The discount rate should be adjusted upward for higher-risk projects and downward for lower-risk projects. |
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Term
| The before-tax cost of fixed-rate debt capital, Kd, is... |
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Definition
| the rate at which the firm can issue new debt |
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Term
| The yield-to-maturity approach assumes... |
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Definition
| the before-tax cost of debt capital is the YTM on the firm's existing publicly traded debt |
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Term
| If a market YTM is not available... |
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Definition
| the analyst can use the debt rating approach, estimating the before-tax cost of debt capital based on market yields for debt with the same rating and average maturity as the firm's existing debt. |
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Term
| The cost and yield of noncallable, noncovertible preferred stock is... |
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Definition
| simply the annual dividend divided by the market price of preferred shares. |
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Term
| The cost of equity capital, Kce, is... |
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Definition
| the required rate of return on the firm's common stock. |
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Term
| There are three approaches to estimating Kce: |
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Definition
1) CAPM approach: Kce=RFR + B [E (Rmkr)-RFR]
2) Dividend discount model approach: Kce=(D1/P0)+g
3)Bond yield plus risk premium approach: add a risk premium of 3% to 5% to the market yield on the firm's long-term debt. |
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Term
| When a project's risk differs from that of the firm's average project... |
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Definition
we can use the beta of a company or a group of companies that are exclusively in the same business as the project to calculate the project's required return. This pure=play method involves the following steps:
1) Estimate the beta for a comparable company or companies
2) Unlever the beta to get the asset beta using the marginal tax rate and debt-to-equity ratio for the comparable company
3) Re-lever the beta using the marginal tax rate and debt-to-equity ratio for the firm considering the project
4) Use the CAPM to estimate the required return on equity to use when evaluating the project
5) Calculate the WACC for the firm using the project's required return on equity |
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Term
| A country risk premium should be... |
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Definition
| added to the market risk premium in the CAPM to reflect the added risk associated with investing in a developing market. |
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Term
| The country risk premium for a developing country can be estimated as.. |
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Definition
| the spread between the developing country's sovereign debt (denominated in a developed country's currency) and the developed country's sovereign debt (eg US T-bills), multiplied by the ratio of the volatility of the developing country's equity market to the volatility of the market for its developed-country-denominated sovereign debt. |
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Term
| The marginal cost of capital schedule shows... |
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Definition
| the WACC for successively greater amounts of new capital investment for a period, such as the coming year. |
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Term
| The MCC schedule is typically upward-sloping because.. |
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Definition
| raising greater amounts of capital increases the cost of equity and debt financing. |
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Term
| Break points (increases) in the marginal cost of capital schedule occur at... |
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Definition
| amounts of total capital raised equal to the amount of each source of capital at which the component cost of capital increases, divided by the target weight of that source of capital. |
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Term
| The correct method to account for flotation costs of raising new equity capital is to... |
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Definition
| increase a project's initial cash outflow by the flotation cost attributable to the project when calculating the project's NPV. |
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