2. Cost of Capital Flashcards
Define Cost of Equity
Rate of return shareholders expect to receive
What is the formula for Cost of Equity (Ke) with a Constant Dividend?
Ke = d/P0
d = constant dividend P0 = Ex div market price
What is the formula for Cost of Equity (Ke) Constant Growth for its dividend?
Ke = { d(1+g) / P0 } + g
g = growth rate d = constant divident P0 = Ex div market price
What is the formula for Estimating Growth based on the Averaging Method?
g = [ n√ (d0/dn) ] - 1
n = period d0 = current dividend dn = dividend n years ago"
What is the formula for Estimating Growth based on the Profit Retention Method?
g = r x b
r = % Rate of Return b = proportion of retained funds
*There are a number of assumptions required to apply this model:
• the entity must be all equity financed
• the retained profits are the only source of additional investment
• a constant proportion of each year’s earnings is retained for reinvestment
• projects financed from retained earnings earn a constant rate of return
What is the formula for Cost of Preference Shares (Kp)?
Kp = d/P0
d = constant dividend P0 = Ex div market price
Define Cost of Debt
- Rate of return debt provider require.
- The value of debt is the present value of cash flows.
- It is tax deductible.
- It is always quoted in $100 nominal value denomination
- Interest is paid aka coupon rate
- It can be redeemed at par, premium or discount
What is the formula for Cost of Debt (Kd) Bank Borrowings?
Kd = r ( 1 - T)
r = annual rate of return T = Tax rate
What is the formula for Cost of Debt (Kd) Irredeemable Bonds?
Kd = i ( 1 - T) / P0
i = interest paid per annum T = Tax rate P0 = Ext Interest market price of bond
What is the Internal Rate of Return?
It is the Discount Rate giving zero Net Present Value.
NPV is used at 2 different discount factors and linear interpolation is used to calculate IRR.
What is the formula for Internal Rate of Return?
IRR = L + [ NPVL / (NPVL-NPVH) ] x (H - L)
L = Lowest Discount Factor % H = Highest Discount Factor % NPVL = Result of Lowest Discount Factor % NPVH = Result of Highest Discount Factor %
List the steps for calculating Cost of Debt (Kd) for Redeemable Bonds
STEP 1: Calculating the NPV for the relevant cash flows using 2 different discount factors
Year 0 = Market Value of Bond x 1: P0
1 to n = Annual Interest Payments without Tax x Cumulative PV % : i (1 - T)
n = Redemption Value of Bond x PV % : $100 or $100 + Prem or Final Convertible Amount
STEP 2: Calculate the IRR using the amounts calculated in step 1
IRR = L + [ NPVL / (NPVL-NPVH) ] x (H - L)
List the steps for calculating Cost of Debt (Kd) for Convertible Bonds
STEP 1: Determine the higher of Cash or Convertible option
Cash = $100 or $100 + Prem Convertible = shares x [Current Market Price x (1+ g)^n]
STEP 2: Calculating the NPV for the relevant cash flows using 2 different discount factors
Year 0 = $100 Nom value
1 to n = Annual Interest Payments without Tax x Cumulative PV % : i (1 - T)
n = Redemption Value of Bond x PV % : $100 or $100 + Prem or Final Convertible Amount
STEP 3: Calculate the IRR using the amounts calculated in step 2
IRR = L + [ NPVL / (NPVL-NPVH) ] x (H - L)
Define Weighted Average Cost of Capital
Average cost of entity’s financing activities
Used as discount rate in NPV calcs
List the steps for calculating WACC
- Calculate weight of each source.
Remember to convert no of shares, shares/bond x market value - Estimate cost of each source using Ke, Kd and Kp calculations
- Multiply weight of each source x cost for each source
- Sum all the Results of step 3
What are the disadvantages of using WACC?
- Focus on Long Term finance as it’s for long term investment appraisal but should it include short term financing too?
- Bank Loans do not have market values
- Cost of capital for small companies is difficult to obtain as they are usually unquoted and lack liquidity
What are the Conditions to use WACC as a Discount Rate?
- Constant Capital Structure
- New investment must not have a different risk profile
- New investment must be marginal to entity
What is Yield to Maturity (YTM)?
- From investor’s perspective, purchases traded debt instrument and receive return.
- No tax relieve on return
- Effective average annual % return to investor, relative to current market value of bond
What is the formula for Irredeemable Yield to Maturity?
YTM = Annual Interest received/Current Market Value of Debt
What is the formula for Redeemable Yield to Maturity?
YTM = IRR of bond price, net annual interest received & final redemption amount
- YTM = IRR of bond price, net annual interest received & final redemption amount
t0 = (market value) = 98
t1 - 5 = annual interest received = 7 (7% bond)
t5 = 110 (10% premium redeemable in 5 years)
*Use two discount factors approx. 5% apart - IRR = L + [ NPVL / (NPVL-NPVH) ] x (H - L)
