What is the conceptual definition of “cost of capital”
opportunity cost that reflects the returns investors expect from other investments of similar risk
How is WACC calculated?
E/(D*E) * r +D/(D+E) * r * (1- taxshield)
How to get an estimate of the cost of equity
Using the CAPM
Out of which two components does the total risk of a company consist?
total risk = market risk + company specific risk
aka
total risk = systematic risk + unsystematic risk
give the formula for CAPM
E(R) = Rf + ß * (E (Rm)-Rf)
what are the three “financing alternatives” that a firm can choose to reduce the cost of capital?
- straight debt (loans, bonds)
- straight equity (retained earnings, new equity issues)
- hybrid instruments (convertibles, preferred shares)
Which are factors for debt-equity choice?
- tax shield (from interest payments)
- cost of financial distress
- agency cost (shareholder; manager conflicts)
- asymmetric information (capital structure serving as informative signal for the market)
what are direct and indirect costs of financial distress?
direct: payment of lawyer, accountants, … for reorganization, debt renegotiation, avoidance of bankruptcy
indirect: loff of reputation and confidence, inability to raise new capital for projects
