Chapter 12 Cost of Capital

The Institutional Brokers' Estimate Service (IBES) gathers and summarizes analysts' short-term earnings forecasts and long-term earnings growth rates which can be helpful for future investment decisions.

Historically, common stocks have generated higher returns compared to Treasury bills, with an average difference of 8 to 9 percentage points.

The cost of equity for non-dividend-paying stocks can be determined by using the Capital Asset Pricing Model (CAPM) and by estimating the cost of equity for comparable dividend-paying stocks in the same industry.

For a company with a stable target capital structure, the proportions of debt and equity used in calculating the weighted cost of capital should be based on the current market values of each component.

The cost of capital represents the rate of return that investors demand from the company's securities, reflecting the risk and opportunity cost.

When a firm has a fixed cost of debt and preferred stock, the marginal cost of capital for amounts up to a certain limit will be lower compared to the cost of new equity.

The Capital Asset Pricing Model (CAPM) assumes that investors are primarily concerned with systematic risk, which is measured by beta.

If a firm takes on a significant amount of above-average risk projects, without compensating below-average risk projects, its cost of capital will increase.

The most appropriate weights to use in calculating a firm's cost of capital are the proportions of the components in the firm's long-range target capital structure.

For firms operating under a 34% marginal tax rate, the after-tax cost of long-term debt is roughly two-thirds the cost of preferred stock due to tax deductions on interest payments.

The risk premium on a specific security reflects several factors, including business risk, financial risk, and interest rate risk.

The required rate of return on any security is composed of a risk-free rate and a risk premium, reflecting both time value of money and the inherent risk of the investment.

The claims of preferred stockholders on a firm's earnings are junior to those of debt-holders, meaning debt holders have priority in claiming assets in case of bankruptcy. Also, increasing financial risk through recapitalization leads to a higher required rate of return. However, long-term state government securities are not necessarily less risky than corporate long-term securities due to factors like creditworthiness.

Break points in the marginal cost of capital schedule are calculated by dividing the amount of funds available from each financing source at a fixed cost by the target capital structure proportion for that financing source.

The constant growth valuation model assumes that earnings, dividends, and stock price will grow at a constant rate indefinitely.

The total return to stockholders, K_e, is composed of the dividend yield (annual dividend divided by stock price) plus the price appreciation of the security.

When a firm is losing money, the after-tax cost of debt is equal to the pre-tax cost of debt because there are no tax benefits available.

A company's historical beta is less useful in predicting future systematic risk characteristics when it is expanding into a new product line or market, as the risk profile may be significantly different.

The cost of external equity is greater than the cost of retained earnings because of flotation costs which are the expenses associated with issuing new equity.

Retained earnings are a cheaper source of funds compared to selling new equity because there are no flotation costs associated with retaining earnings and the firm avoids paying dividends immediately.

Historical average capital costs are not relevant for making new (marginal) resource allocation decisions as they reflect past conditions and may not accurately represent current market scenarios.

The optimal capital budget aligns with the matching principle, ensuring that the cost of funds is closely matched with the returns expected from projects to maximize the value of the firm.

The cost of depreciation-generated funds is equivalent to the firm's weighted cost of capital because depreciation is a non-cash expense that releases funds for reinvestment.

Business risk refers to the variability in a firm's operating earnings, driven by factors like competition, technology, and economic conditions.

Financial risk refers to the additional risk borne by shareholders resulting from a company's use of debt financing.

The optimal capital budget is determined by comparing the expected project returns to the company’s marginal cost of capital schedule.

The risk premium on a security reflects factors like business risk, financial risk, and interest rate risk, but it does not include the real rate of return risk.

The relative riskiness of securities typically increases as follows: long-term government debt (lowest risk), corporate debt, preferred stock, and common stock (highest risk).

Investors' required rates of return typically increase in this order: corporate debt (lowest return), preferred stock, and common stock (highest return), reflecting the hierarchy of risk and return.

For companies that do not pay dividends, the cost of equity capital can be estimated using the Capital Asset Pricing Model (CAPM), but not using the dividend capitalization model, as there are no dividend payments available.

The optimal capital budget is indicated by the point where the investment opportunity curve and the marginal cost of capital curve intersect.

The marginal cost of capital (MCC) schedule illustrates how the cost of capital increases as the firm raises more capital due to increasing risk and financing costs.