Cost of Capital Flashcard

Front

The required rate of return that the debt investment must yield to protect shareholders' interest.

Back

Cost of debt

Answer explanation

The required rate of return that the debt investment must yield to protect shareholders interest is called Cost of debt.

Front

Which of the following factors affecting the cost of capital can be controlled by the firm?
Level of interest rates,
Dividend policy,
Tax rates,
None of the above

Back

Dividend policy

Answer explanation

A firm can decide its dividend payout ratio, whether to retain earnings or distribute them, which can impact its cost of equity.

Front

What does the cost of capital represent for a business?

Back

The minimum rate of return a business must earn before creating value

Answer explanation

The cost of capital is the minimum return a business needs to generate before it starts creating value. If a company does not earn enough to cover its cost of capital, it means that its investments are not generating sufficient returns, which can lead to financial losses over time. It is crucial for businesses to ensure that their projects generate returns above the cost of capital to remain profitable and sustainable.

Front

What is the Weighted Average Cost of Capital (WACC) also known as?

Back

Marginal Cost of Capital (MCC)

Answer explanation

The Weighted Average Cost of Capital (WACC) represents the average rate of return a company must pay to its debt holders and equity investors. It is also called the Marginal Cost of Capital (MCC) because it reflects the cost a company incurs when it raises additional capital. Understanding WACC helps businesses make investment decisions and assess whether their returns exceed their financing costs.

Front

How do taxes affect the cost of debt in the WACC calculation?

Back

Taxes reduce the cost of debt because interest expenses are tax-deductible.

Answer explanation

In many tax systems, interest on debt is tax-deductible, meaning that companies can subtract interest payments from their taxable income. This lowers the effective cost of debt because companies actually pay less after accounting for the tax savings. In the WACC formula, this is reflected by multiplying the cost of debt (rd) by (1 - tax rate) to determine the after-tax cost of debt. This makes debt financing more attractive compared to equity, which is not tax-deductible.

Front

What does the Investment Opportunity Schedule (IOS) represent?

Back

The returns on investment opportunities available to a company

Answer explanation

The Investment Opportunity Schedule (IOS) shows the potential returns a company can earn from different investment opportunities. Since high-return investments are usually limited, companies prioritize them first and then move on to lower-return investments as they expand. This is why the IOS slopes downward—more investments lead to diminishing returns. Understanding the IOS helps businesses allocate capital efficiently to maximize profitability.

Front

What does the Capital Asset Pricing Model (CAPM) help determine?

Back

The cost of common equity based on risk and expected market returns

Answer explanation

The Capital Asset Pricing Model (CAPM) is used to estimate the cost of common equity by considering risk-free returns, market risk, and a company's sensitivity to market movements (beta). It helps businesses and investors determine the expected return on equity investments, ensuring that they earn a return that compensates for the level of risk taken.

Front

What does the Bond Yield Plus Risk Premium Approach assume when estimating the cost of common equity?

Back

Riskier cash flows lead to a higher cost of capital

Answer explanation

The Bond Yield Plus Risk Premium Approach estimates the cost of common equity by adding a risk premium to the company's before-tax bond yield. This method assumes that equity investments are riskier than bonds, so investors require a higher return.

Front

What does a high Degree of Operating Leverage (DOL) indicate?

Back

The company has high fixed costs and greater operating risk.

Answer explanation

The Degree of Operating Leverage (DOL) measures how sensitive a company’s operating income is to changes in sales. A high DOL means the company has a high proportion of fixed costs, making it riskier because profits can decline sharply if sales drop. Since fixed costs do not decrease in the short term, companies with high operating leverage must generate sufficient revenue to cover these costs and maintain profitability.

Front

What does a high Degree of Financial Leverage (DFL) indicate?

Back

Higher sensitivity of net income to changes in operating income, increasing financial risk

Answer explanation

The Degree of Financial Leverage (DFL) measures how much net income changes in response to changes in operating income (EBIT). A higher DFL means that even a small change in EBIT can lead to a large change in net income, increasing financial risk. This happens because companies with high DFL rely more on debt financing, which amplifies both gains and losses.