What is the cost of capital
The required return investors demand (like a firm’s discount rate)
What does the cost of capital depend on
Risk of the firm’s assets (NOT how it’s financed)
What is the required return
The discount rate used to evaluate projects
What happens if a project earns less than required rate
It destroys value, so you reject it
What is debt financing
Borrowing with required interest payments
What happens if debt payments are missed
Default -> lenders gain control
What is equity financing
Ownership with no guaranteed payments
Why is equity riskier than debt
Equity holders are paid last (residual claim)
What is cost of equity
Return required by shareholders
Two ways to calculate cost of equity
Dividend Growth Model (DGM)
CAPM (SML)
When is DGM used
When dividends grow at a constant rate
What does DGM depend on
Dividend yield + growth rate
How can growth rate be estimated
- historical average
- retention ratio x ROE
What is retention ratio
% of earnings kept (not paid as dividends)
When is retention ratio method valid
- stable ROE
- stable dividend policy
- no new equity issued
What does CAPM use to find cost of equity
Beta (systematic risk)
Which method is more market-based: DGM or CAPM
CAPM - uses beta which is systematic risk, which is market wide
Why might DGM and CAPM give different answers
You use different assumptions (growth vs market risk)
What is cost of debt
Return required by lenders
How do we estimate cost of debt
Yield to Maturity YTM
Why is cost of debt adjusted for taxes
Interest is tax-deductible
How is preferred stock similar to bonds
Pays constant dividend forever
What is WACC
Weighted avg cost of equity and debt
What does WACC represent
Required return on firm’s assets
