From the case study a few financial concepts from FIN 301 were refreshed
From the case study a few financial concepts from FIN 301 were refreshed. One was the weighted average cost of capital (WACC). A firm’s cost of capital is the cost it must pay to raise funds. With the WACC it is the calculation of a firm’s cost of capital in which each category is proportionately weighted. The sources of capital in the WACC are long-term debt, preferred stock and common stock. The weights in the formula are determined by the firm’s capital structure. A company’s weighted average cost of capital is used to discount future cash flows from investment projects. The lower the WACC, the cheaper it is for a company to fund new projects.
A bond is a fixed income investment in which an investor loans money to an entity which borrows the funds for a distinct period of time at a variable or fixed interest rate. Some common characteristics of bonds are face value, coupon rate and date, maturity date and issue price. A coupon is the annual interest rate paid on a bond, expressed as a percentage of the face value. This gives investors a way to compare bonds because of its pricing. Bonds with coupons are called bearer bonds because the bearer is entitled to the interest. When bond prices fall, interest rate increases and rises when interest rates falls. The size of a bond’s coupon shows how sensitive the bond’s price will be to interest rate changes. The higher the coupon rate, the less price will change when interest rate fluctuates.
Dividends are payments regularly made by corporations directly to their shareholders. If someone is a shareholder, their dividend is their share of a company’s profits. Dividends are offered to entice, reward and retain investors.
Capital Asset Pricing Model (CAPM) is a model that describes the relationship between risk and expected return for assets. In finance, it is used for the pricing of risky securities, generating expected returns for assets given the risk of those assets and calculating cost of capital. The CAPM can also be used to decide what price you should pay for a given stock. If one stock is riskier than the other, the price of the stock should be decreased to compensate investors taking the increased risk.
Another concept is flotation cost. It is the cost incurred when a firm raises funds by issuing a particular type of security. It includes underwriting fees, legal fees and registration fees. When considering how much capital a company can raise from a new issue, the impact of these fees should be taken into account. The flotation cost is expressed as a percentage of the issue price and then combined into the cost of new shares as a reduction.
Market risk premium is the difference between the expected return on a portfolio and the risk-free rate. It is equal to the slope of the security market line. A change in the risk profile of an asset causes a movement along the security market line. Risk-free rate is an interest rate that would be paid by an investment with zero risk.