Weighted-Average Cost of Capital Flashcards

Questions and Answers

What is the cost of equity proportional to?

Proportional to the riskiness of the cash flows

What is the return on equity in regards to risk?

The systematic component of the risk

What are three questions to ask when solving discount factors?

How risky is the asset? 2. What is the opportunity cost of the funds? 3. How much must the firm earn to compensate investors for the use of capital?

How can one determine if something is a good investment?

Identify the cost of capital Signup and view all the answers

What makes up the cost of capital?

Managers choose projects with NPV > 0 Signup and view all the answers

How to compute NPV of a project?

Identify the relevant cash flows and determine the appropriate discount rate given the project's risk Signup and view all the answers

What is the cost of equity?

Return required by equity investors given the riskiness of the firm's cash flows Signup and view all the answers

Where does risk come from?

Business risk comes from competition, regulation, and macroeconomics Signup and view all the answers

What is the Required Return on Equity/Cost of Equity Capital?

The risk-adjusted required return that equity investors demand as compensation for risk Signup and view all the answers

In the Dividend Growth Model Approach, if the stock price were below $25, would the implied cost of equity be above or below 11.1%?

Above Signup and view all the answers

How to find dividend growth?

Take the average of the dividend growth to get a number for your 'g' factor Signup and view all the answers

What are some of the disadvantages of finding dividend growth?

Only applicable to companies currently paying dividends, not applicable if dividends aren't growing at a constant rate, and sensitive to estimated growth rate Signup and view all the answers

What is the Security Market Line (SML) or CAPM approach?

Return = Riskless Rate + Risk Premium Signup and view all the answers

What does risk premium come from? Can it be diversified away?

Risk premium comes from exposure to systematic risk and cannot be diversified away Signup and view all the answers

If stock x declines by 2 percent when the general index declines by 1 percent, how is this stock classified?

Risky and heavily exposed to systematic risk Signup and view all the answers

Study Notes

Weighted-Average Cost of Capital (WACC) Overview

Cost of equity is proportional to the riskiness of cash flows.
Return on equity reflects the systematic component of risk.

Evaluating Investment Risk

Key questions for discount factors include assessing asset risk, opportunity cost, and minimum returns necessary to compensate investors.

Investment Decision Considerations

Identify the cost of capital to determine if an investment is worthwhile, acknowledging that investor capital is being utilized.

Components of Cost of Capital

To maximize shareholder value, projects with a Net Present Value (NPV) greater than zero should be pursued.
Required return and cost of capital are synonymous, representing minimum expected returns to attract investment.

Net Present Value (NPV) Calculation

Relevant cash flows must be identified; appropriate discount rates depend on the project’s risk profile.

Understanding Cost of Equity

The cost of equity reflects the return required by equity investors, increasing with the riskiness of the firm's cash flows.

Sources of Business Risk

Business risk originates from competition, regulation, and macroeconomic factors.

Required Return on Equity

This is the risk-adjusted return demanded by equity investors as compensation for equity investment risks.

Dividend Growth Model Example

Cost of equity can be calculated based on expected dividends and growth rates; lower stock prices imply higher expected returns.

Calculating Dividend Growth

The growth rate (g) is derived from the average of past dividend growth.

Limitations of Dividend Growth Approach

The model is only valid for dividend-paying companies and when growth rates are stable. It's also sensitive to growth rate estimates.

Security Market Line (SML) and CAPM

The return on any asset is calculated as the sum of the riskless rate and the risk premium related to the asset.

Systematic Risk and Risk Premium

The risk premium arises from systematic risk, which cannot be diversified away, hence influencing required rates of return.

Stock Sensitivity Example

A stock that declines more than the general index indicates high exposure to systematic risk, making it less hedgable.

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Description

Test your knowledge on the Weighted-Average Cost of Capital (WACC) with these flashcards. Explore key concepts such as cost of equity and the relationship between return on equity and risk. Perfect for finance students looking to strengthen their understanding of WACC.