Capital Asset Pricing Model (CAPM)

An estimate of the cost of equity given by $r_e=r_f+\beta\times\text{MRP}$.

A measure of how sensitive a stock's returns are to movements in the market.

Constant dividend growth model

An approach to estimating equity cost that requires dividends and an assumption of constant future growth.

Total short-term and long-term debt minus cash and cash equivalents.

Corporate financeLesson 2 of 2 in the course How Firms Raise Capital

WACC Estimation: Capital Weights, Equity Costs, and Net Debt

5 flashcards · 5 quiz questions · 5 match pairs · 5 fill-in sentences · English

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Summary

The weighted average cost of capital (WACC) combines the costs of a company's financing sources into one overall required return. It reflects how much the firm relies on debt, preferred stock, and common equity, as well as the cost of each source.

$\text{WACC}=D\%\times r_d(1-T)+P\%\times r_{pfd}+E\%\times r_e$

Here, $D\%$ , $P\%$ , and $E\%$ are the proportions of the firm's financing supplied by debt, preferred stock, and common equity. The corresponding costs are $r_d$ for debt before tax, $r_{pfd}$ for preferred stock, and $r_e$ for common equity. $T$ is the corporate tax rate.

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Weighted average cost of capital (WACC): A firm's weighted average financing cost, using each source's share of total financing and applicable cost.
Capital Asset Pricing Model (CAPM): An estimate of the cost of equity given by $r_e=r_f+\beta\times\text{MRP}$ .
Beta: A measure of how sensitive a stock's returns are to movements in the market.
Constant dividend growth model: An approach to estimating equity cost that requires dividends and an assumption of constant future growth.
Net debt: Total short-term and long-term debt minus cash and cash equivalents.

Quiz questions

Which equation does the CAPM use to estimate the cost of equity?Answer: $r_e=r_f+\beta\times\text{MRP}$
Which measure is commonly used as a proxy for the risk-free rate in a long-term cost-of-equity estimate?Answer: Yields on long-term U.S. Treasury securities
What does a stock beta above 1 generally indicate?Answer: Its returns are more sensitive to market movements than the market overall.
When is the constant dividend growth model suitable for estimating a company's cost of equity?Answer: When the company pays dividends expected to grow at a constant rate.
A firm has $90 million of total debt and $25 million of cash and cash equivalents. What is its net debt?Answer: $65 million

Based on Principles of Finance by Julie Dahlquist, Rainford Knight (OpenStax), licensed CC BY 4.0. Adapted into a summary, flashcards and quizzes.

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