2. Costs of Funds Flashcards
What is the risk return relationship
- Risk is the main driving force behind the return that is expected by investors
- The greater the risk, the higher the rate of expected return
What is the order of payment in event of liquidation
- Creditors with fixed charge
- Creditors with floating charge
- Unsecured creditors
- Preference shareholders
- Ordinary Shareholders
Define Cost of capital
Minimum acceptable return on an investment, gernally computed as a discount rate of use investment appriasal exercises
Define cost of equity
- The rate of return required by shareholders for investing in the business
Ke
Defien cost of debt
Effective rate a company pays on its current debt - Kd
What is the cheapest and most expensive forms of finance
Cheapest: Debt (Especially when secured)
Expensive: Equity (ordinary shares)
How is cost of equity Calculated
- Using Dividend valuation model
Ke= d/P0
Ke= Cost of equity
d= annual dividend per share
P0= current ‘ex div’ share price
Define Cum div share price
Cum Div = with dividend
- Price the share trades at when a dividend has been declared by not paid
- Purchases included rights to next dividend payment
Define div share price
Ex div=without dividend
- Price that the share trades at when the company has cnfirmed the list of shareholders to recieve the dividend
How to calculate cost of equity for preference shares
Kpref= d/P0
d= dividend
P0= ex div share price
What is formula for cost of equity with dividend growth
Ke = (d1/P0)+g
d1= didivend to be paid in one year’s time D0(1+g)
D0= Current dividend
g= constant rate of growth expressed as decimal
What are teh limiations of the dividend valuation model
- Assumes that dividends are paid
- Assumes dividend growth can be estimated and is constant
- Assumes that comny has a share price
What are the two methods to estimate dividend growth
- Historic growth: comparing recent dividend to dividend paid in past
- Current reinvestment levels: increase in level of reinvestment will result in increase in future dividends
How to calculate estimated dividentd growth rate using historic method
Past dividend x (1 + g) ^n = latest dividend
or
g = n√(latest dividend/past dividend) - 1
How to calculate growth rate of dividend using current reinvestment level
G= r x b
r= post-tax accounting Return on equity
b = balance of profits reinvested
How to calculate cost of debt from invesster side
- Bank loan = for investro which is usally a bank the return required is the interest rate charged on the loan
How to calculate cost of debt
Kd= i(1-t)
Kd=cost of debt
i= annual interest rate %
t= corporate tax rate
What are characteristics of irredeemable bonds
- Unsual as company does not have to repay the principal to the bond holder
- So annual return to invester is only fixed interest
- Irredeemable bonds are traded so market value should be considered
What is meant by yield to maturity or interest yield for irredeemable bonds
Effect annual percentage return to the investor, relative to the market value of bond
How to calculate yield to maturity for irredeemable bonds
YTM = i / P0
ytm= Yield to maturity
i = annual interest rate on bond or coupon
p0= ex-interest market price on bond per 100 unit
How to calculate cost of debt for irredeemable bonds for company
Kd = i(1-t)/P0
What is meant by internal rate of return IRR
Annual percentage of return achieved by a project at which the sum of discounted cash flows over the life of hte project is equal to the sum of discounted outflows
What is yield of maturity for redeemable bonds
Internal rate of return of the market value of the bond, the annual interest recievd and the final redemption amount
What is the steps to calculate Internal rate of return IRR
- Calculate net present value of cash flows at any rate
- Calculate the new present value of the cash flows at any other hgiher rate
- Estimate IRR
What is the formula of IRR (Internal rate of return)
IRR = L = [ NPVL/NPV - NPVH x (H-L)]
H = higher discount rate
L = lower discount rate
NPVL = net present value at lower rate
NPVH = net present value at higher rate
What is the approach to calculaate cost of debt for convertible bonds
- Simplified assumption that all investors will make same decision to provide the highest value on redemption
What is the IRR for cost of debt for convertible bonds for investor
Higher of either:
1. cash value on redemption
2. estimated future value of shares on conversion date
What cash flows are involved for convertible bonds from the company’s perspective
Year 0 - market value of bond
Years 1 - redemption - annual interest payment net of tax
Redemption - Higher of cash value and estimated future value of shares
What is meant by Weighted average cost of capital
Average cost of entity’s long term funds ( ordinary shares, preference shares, bank loans and bonds) weighted according to the proportion each type of long term fund bears to the total pool of capital based on market values
Which conditions can WACC be used
- No change in financial risk so capital structure should be constant
- No change to business risk
- New investment is marginal to entity
- Limited by dependent on having market value
How is WACC used in project appraisal
When performing net present value or internal rate of return calculations - if project has positive nPV when discounted using WACC - should be accepted
How do you calculate the cost of debt for redeemable debt?
IRR
