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Questions and Answers
What is the cost of equity proportional to?
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?
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?
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?
How can one determine if something is a good investment?
What makes up the cost of capital?
What makes up the cost of capital?
How to compute NPV of a project?
How to compute NPV of a project?
What is the cost of equity?
What is the cost of equity?
Where does risk come from?
Where does risk come from?
What is the Required Return on Equity/Cost of Equity Capital?
What is the Required Return on Equity/Cost of Equity Capital?
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%?
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%?
How to find dividend growth?
How to find dividend growth?
What are some of the disadvantages of finding dividend growth?
What are some of the disadvantages of finding dividend growth?
What is the Security Market Line (SML) or CAPM approach?
What is the Security Market Line (SML) or CAPM approach?
What does risk premium come from? Can it be diversified away?
What does risk premium come from? Can it be diversified away?
If stock x declines by 2 percent when the general index declines by 1 percent, how is this stock classified?
If stock x declines by 2 percent when the general index declines by 1 percent, how is this stock classified?
Flashcards
Weighted-Average Cost of Capital (WACC)
Weighted-Average Cost of Capital (WACC)
The average rate of return required by all of a company's investors.
Cost of Equity
Cost of Equity
The return required by equity investors, reflecting cash flow risk.
Net Present Value (NPV)
Net Present Value (NPV)
The difference between present value of cash inflows and outflows, guiding investment decisions.
Investment Risk Assessment
Investment Risk Assessment
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Required Return
Required Return
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Business Risk
Business Risk
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Systematic Risk
Systematic Risk
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Risk Premium
Risk Premium
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Dividend Growth Model
Dividend Growth Model
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Discount Rate
Discount Rate
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Security Market Line (SML)
Security Market Line (SML)
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Stock Sensitivity
Stock Sensitivity
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Growth Rate (g)
Growth Rate (g)
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Limitations of Dividend Growth Model
Limitations of Dividend Growth Model
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Return on Equity (ROE)
Return on Equity (ROE)
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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.
