33:390:400 Study Guide - Summer 2018, Comprehensive Midterm Notes - Advertisement Film, Net Present Value, Retained Earnings
12 Oct 2018
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33:390:400
MIDTERM EXAM
STUDY GUIDE
Fall 2018
Chapter 13: Cost of Capital
13.1 The Cost of Capital
Capital Structure: The mixture of debt and equity for a firm
When a company has extra cash, it can either give it to shareholders through dividends or it can
invest it in a new project
Cost of Capital = Required Return = Discount Rate
WACC: Weighted Average Cost of Capital
- WACC becomes the required return
- The discount rate of the project should be the expected return on a financial
asset of comparable risk
- WACC can only be used when the project’s risk is EQUAL to the risk of the company!
13.2 Estimating the Cost of Equity Capital with the CAPM
E(R) of Equity = (Risk Free rate) + [ Beta * (E(R) of Market – Risk Free Rate) ]
- (E(R) of Market – Risk Free Rate) also known as Market Risk Premium
- Beta is the systematic risk of the company
- Risk Free Rate is the riskless rate, Treasury Bill rate, bonds, etc.
- Government securities have never defaulted, have lowest possible risk
Security Market Line (SML) Graph: Positive linear relationship
- Y-axis: Expected Return
- X-axis: Beta
- Riskier the project, the higher expected return
- If project return is under the line you reject, if above you accept
Estimating the Cost of Equity Capital with the Dividend Growth Model
Current Price of a Stock (P0) = (Dvd1) / (R – g) → R = [ (Dvd1) / (P0) ] + g
- Dvd1 = Dvd0 x (1 + g)
- Dividend Yield = (Dvd1) / (P0)
- Capital Gains Yield = g
find more resources at oneclass.com
find more resources at oneclass.com
13.3 Estimation of Beta
Normally we assume Beta is given, but if we have to estimate it ourselves we will use:
Beta of Security i = (Covariance of a security with the market) / (Variance of the market)
Beta of Security i = [ Cov (Ri, RM) ] / [ Var(RM) ]
Average beta across all stocks in an index = Average market beta = 1
A firm’s beta will change if it enters a new industry
A firm’s beta will incur small changes due to random variation if it stays in the same industry
Some think it is better to estimate the industry’s beta instead of a specific firm’s beta
- Greater chance of error in estimating beta of a single stock, than estimating for an entire
industry
- A company can still use either their beta or the industry beta, their preference
13.4 Determinants of Beta
- Cyclical nature of revenues, operating leverage, and financial leverage are the 3 determinants
Cyclicality of Revenues:
- Higher revenues during expansion phase of business cycle
- Lower revenues during contraction phase of business cycle
- Highly cyclical stocks → high betas
- Cyclicality ≠ Variability
Operating Leverage: Deals with a firm’s fixed costs of production
- Fixed costs – do not change with changes in quantity
- Variable costs – do change with changes in quantity
- Firms might buy a factory but have low sales → High FC, low VC
- Firms can outsource their production to others → Low FC, high VC
- Firms w/ high fixed costs & low variable costs are said to have high operating leverage
- Firms w/ low fixed costs & high variable costs are said to have low operating leverage
- Operating leverage magnifies the effect of cyclicality of revenue
Financial Leverage and Beta: Deals with a firm’s fixed costs of finance
- Unlevered firm = all equity // Levered firm = Has debt
- Financial leverage: The extent to which a firm relies on debt
- It is obligated to pay interest on debt regardless of sales (fixed cost)
E + D = V
BetaPortfolio = BetaAsset = [ (BetaE) x (E/V) ] + [ (BetaD) x (D/V) ]
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
The discount rate of the project should be the expected return on a financial asset of comparable risk. Wacc can only be used when the project"s risk is equal to the risk of the company! Capital structure: the mixture of debt and equity for a firm. When a company has extra cash, it can either give it to shareholders through dividends or it can invest it in a new project. Cost of capital = required return = discount rate. 13. 2 estimating the cost of equity capital with the capm. E(r) of equity = (risk free rate) + [ beta * (e(r) of market risk free rate) ] Security market line (sml) graph: positive linear relationship. Estimating the cost of equity capital with the dividend growth model. Current price of a stock (p0) = (dvd1) / (r g) r = [ (dvd1) / (p0) ] + g. Riskier the project, the higher expected return.
