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FM > 5. FM - Cost of Capital > Flashcards

5. FM - Cost of Capital Flashcards

1
Q

What does WACC stand for?

A

Weighted average cost of capital

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2
Q

What does the WACC consider?

A

The rate of return a company achieves on its projects to be sufficient to satisfy the required returns of its investors

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3
Q

Who are the investors that consider the WACC when determine whether to invest?

A

Equity SH
Preference SH
Debt holders

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4
Q

How do equity shareholders earn their return?

What is the return needed for equity shareholders known as?

A

Return is in the form of a constant or growing dividend stream
Ke (cost of equity)

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5
Q

What is Ke?

A

Cost of equity

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6
Q

How do preference shareholders earn their return?

What is the return needed for preference shareholders known as?

A

Return is in the form of a fixed dividend stream

Return needed = Kp (cost of preference shares)

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7
Q

How do debt holders earn their return?

What is the return needed for debt shareholders known as?

A

Return is in the form of fixed interest and repayment (or interest in perpetuity for irredeemable debt)
Return the company needs to make to afford interest/repayment = Kd (cost of debt)

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8
Q

Describe the WACC

A

The average of Ke, Kp and Kd, weighted according to the current market values of equity, preference and debt within the company’s capital structure

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9
Q

What are the basic assumptions about the cost of equity in a perfect market?

A

Current share price = PV of the expected future dividends discounted at the inv required return (Ke)

Therefore investors required rate of return (Ke) = the IRR achieved by investing the current price and receiving the future dividends

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10
Q

What is the formula for calculating P0 if dividends are expected to grow at a rate o g%

A

P0 (Price) = D0 x (1 + g) / Ke - g

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11
Q

How can you find Ke for a listed company and why?

A

By rearranging P0 formula, since the share price is known and future divs are normally predictable.
Ke = (D0(1+g)/ P0) + g

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12
Q

What does it mean if a dividend is deemed to be ex dividend?

A

Ex dividend = directly after the dividend payment

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13
Q

What is cum dividend?

A

Before the share price

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14
Q

Should the cum div share price or ex div share price be used to calculate the cost of equity?

A

Ex dividend should always be used

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15
Q

Is you are given cum dividend to calc the cost of equity, what adjustment must be made?

A

Cum div share price - dividend due = ex div share price

Can then use ex div share price to calc the cost of equity

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16
Q

What are the 2 ways to estimate the likely growth rate of dividends?

A
  1. Historic method - Extrapolating based on past dividend patterns
  2. Earnings retention model- assuming growth is dependent of the level of earnings retained in the business
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17
Q

What is the historic method and what does it relate to?

A

Used to estimate the likely growth rate of dividends

Assumes growth rate of dividends can be calculated by extrapolating them based on past dividend patterns

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18
Q

What is the earnings retention model and what does it relate to?

A

Used to estimate the likely growth rate of dividends

Assumes growth rate is dependent on the level of earnings retained in the business

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19
Q

What is the formula for estimating growth using the historic method?

A 
- Where we have past dividend stream showing reasonably consistent growth, can assume it will continue indefinitely 
Annual growth (g) = ( D0 / dividend n yrs ago ) ^ 1/n
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20
Q 
TYU5: A company has paid the following dividends per share 
2000: 10p
2001: 11.9p
2002: 12.7p 
2003: 13.2p
2004: 14.1p
The ex-div share price directly following the 2004 dividend payment is £2 
Calc Ke
A

Assuming constant growth rate, the div of 14.1p is the 10p dividend with 4 years’ growth
Growth rate, g, is therefore
= [ (14.1 / 10) ^ 1/4 ] -1

Ke = [ 14.1p(1.09) / 200p ] + 0.09 = 16.7%

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21
Q

TYU4: Donaldson Press plc is about to pay a div of 15p. SH expect dividends to grow at 6% per annum. Donaldson Press plc’s current SP is £1.25
Calc the cost of equity of D plc

A

Although in practice shares go ex div sometime before divs are paid, phrase ‘about to pay div’ is usually code for share being cum div
So ex div price = 125 - 15 = 110p

Ke = [15(1+0.06)/110 ] + 0.06

Ke = [D0(1 + g) / P0 ] + g

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22
Q

TYU3: P plc has just paid a div of 10p. SH expect dividends to grow at 5% per annum. P plc current share price is £1.05 ex div
Calc the cost of equity of P plc

A

Ke = [10(1+0.05)/105] + 0.05 = 15%

Ke = [D0(1 + g) / P0 ] + g

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23
Q

TYU2: A company has just paid a dividend of 20p. The company expects dividends to grow at 7% in the future. The company’s current cost of equity is 12%

A

P0 = 20(1+ 0.07) / (0.12 - 0.07)
= 428
= £4.28

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24
Q

What is another name for the Earnings retention model?

A

Gordon Growth model

25
Q

What is another name for the gordon growth model?

A

Earnings retention model

26
Q

What is the basis behind the earnings retention model?

A

The higher the level of retentions in the business, the higher the potential growth rate of dividends

27
Q

What is the formula for earnings retention model?

A

Growth can be estimated as
g = r x b
r = accounting rate of return on the new investment
b = earnings retention rate

28
Q

TYU6: A company is about to pay an ordinary dividend of 16p/share
The share price is 200p
The current accounting rate of return is 20% and 40% of earnings are paid out as dividends.
Calc the cost of equity for the company

A 
Ke = [ 16 (1 + 0.12) / 184 ] + 0.12
= 12.7%
where P0 = 200 - 16 = 184
D0 = 16
b = 1 - dividend payout % = 1 - 0.4 = 0.6

g = r x b = 0.2 x 0.6 = 0.12

29
Q

What other factors must be considered when dealing with share issues?

A

Share issues must also be considered when calculating dividend growth

30
Q

What are the 2 issues in terms of issuing shares that can affect calculating dividend growth ?

A

New issues and rights issues

Bonus issues

31
Q

How do new issues and rights issues affect calculating dividend growth?

A

New issues and rights issues raise funds for the company, therefore although the number is shares has increased, so has the earnings potential o the company
As long as the growth is calculated using dividend per share, then this won’t be a problem

32
Q

How do bonus issues affect calculating dividend growth?

A

Bonus issues simply increase the number of issues in issue without adding any funds to increase earnings potential
So although number of dividends should remain consistent, div per share will be artificially reduced

Here, the approach is still to calc g using div per share, but earlier DPS must be calculated by adjusting the number of shares for subsequent bonus issues

33
Q

What are the assumptions for Kp in a perfect market?

A

Current share price = PV of the expected future dividends discounted at the inv required rate of return (Kp)
therefore investors’ required rate of return Kp = the IRR achieved by investing the current price and receiving the future dividends

34
Q

What is the formula for calculating price when using the cost of preference shares?

A

P0 = D/Kp
Note: although there is no distinction between D0 or D1 etc, it is still necessary to make sure that P0 that you are working with is ex div

35
Q

How do you calculate Kp?

A

Kp = D / P0
ote: although there is no distinction between D0 or D1 etc, it is still necessary to make sure that P0 that you are working with is ex div

36
Q

TYU8: A company has 50,999 8% pref shares in issue, nominal value £1.
The current ex-div market value is £1.20/share
What is the cost of the preference shares?

A 
Kp = D / P0
Kp = 8/120 = 0.06666 = 6.7%
37
Q

What is the basic assumption about the current price of the cost of debt?

A

Current price = present value of the expected future income discounted at the inv required return

Holds true for debt as well as equity
However the income stream from the investment depends on whether the debt is irredeemable or redeemable

38
Q

What is the basic assumption for irredeemable debt?

A

Price of debentures = PV of the future interest stream received in perpetuity discounted at the investor’s required return
Therefore the inv required rate of return = the IRR achieved by investing the current price and receiving the future interest

39
Q

What is the formula to calculate price for irredeemable debentures?

A

P0 = i/r

and r = i/P0
i = annual interest starting in one year’s time
r = debt holders’ required return (known as yield)

40
Q

Why do you not use Kd when talking about the cost of debt ?

A

Use yield instead as debt interest attracts tax relief, so required return of debt holders (yield) does not equal the company’s cost of debt (Kd)

41
Q

What is the difference between yield and the cost of debt (kd)

A

Use yield instead as debt interest attracts tax relief, so required return of debt holders (yield) does not equal the company’s cost of debt (Kd)

42
Q

How does tax affect questions around cost of various types?

A

Cost of debt is net of tax relief on interest paid
For each £1 of interest required by the inv, the company gets tax relief of 17p
So ‘i’ will only cost i x 0.83
i = annual interest starting in one years time

43
Q

How is Kd calc adjusted for tax?

A

P0 = i(1-T)/Kd
Kd = i(1-T)/P0
Where T = corporation tax rate

44
Q

TYU9: A company has irredeemable debt currently trading at £40 ex interest
The coupon rate is 5% and the rate of corporation tax is 17%
What is the cost of debt to the company?

A

Kd = [ i (1-T) ]/ MVd

Kd = 5(1 - 0.17) / 40
= 0.1037 = 10.4%

45
Q

What is the assumption for redeemable debentures?

A

Price of debenture = PV of the future interest received up to redemption + the redeemed amount all discounted at the inv required return
Therefore inv required RoR = IRR achieved by investing the current price and receiving the future interest and redemption payment

46
Q

What is the formula for calculating the price of redeemable debenture?

A

There isn’t one
because the cash flows aren’t simply a perpetuity, there isn’t a simple calc for NPV or IRR
Instead, have to go back to basics and calc the NPV or IRR longhand

47
Q

What is the calc for Kd for irredeemable debt?

A 
Yield x (1 - Tax) 
Because the company achieves tax relief on the debt finance
48
Q

What do you treat convertible debentures?

A

Treated as redeemable debt with the following adjustment

  • Compare the redemption value with the value of the conversion option
  • Select the higher of the 2 values as the amount to be received at tn
  • Find the internal rate of return of the cash flows
49
Q

How is non-traceable debt treated?

A

Bank and other non-tradable fixed interest loans simply need to be adjusted for tax relief
Cost = interest rate x (T-1)

50
Q

When it is appropriate to use WACC as a discount rate for a project
IMPORTANT TO LEARN

A
  • If proportions of debt and equity (gearing) aren’t going to change over life of project. If gearing changes, then WACC itself changes, and APV approach is used
  • if the level of risk is NOT going to change. Current Ke is dependent on the level of risk SH are suffering, which depends on type of business. If a new project is in a diff sector, then level of risk (and so Ke) will be diff, Use CAPM
  • If the finance is NOT project specific. WACC utilises several types of fin to calc the average. If we only use one methodd of finance to inv in the project, then the average isn’t required and can simply discount at the cost of that type of fin
51
Q

Can you use WACC if proportions of debt and equity (gearing) are NOT going to change over the live of the project?

A

Yes
- If proportions of debt and equity (gearing) aren’t going to change over life of project. If gearing changes, then WACC itself changes, and APV approach is used

52
Q

Can you use WACC if proportions of debt and equity (gearing) ARE going to change over the live of the project?

A

No
- If proportions of debt and equity (gearing) aren’t going to change over life of project. If gearing changes, then WACC itself changes, and APV approach is used

53
Q

Can you use WACC is the level of risk is NOT going to change?

A

Yes
- if the level of risk is NOT going to change. Current Ke is dependent on the level of risk SH are suffering, which depends on type of business. If a new project is in a diff sector, then level of risk (and so Ke) will be diff, Use CAPM

54
Q

Can you use WACC is the level of risk is going to change?

A

No
- if the level of risk is NOT going to change. Current Ke is dependent on the level of risk SH are suffering, which depends on type of business. If a new project is in a diff sector, then level of risk (and so Ke) will be diff, Use CAPM

55
Q

Can you use WACC if the finance is NOT project specific?

A

YES
- If the finance is NOT project specific. WACC utilises several types of fin to calc the average. If we only use one methodd of finance to inv in the project, then the average isn’t required and can simply discount at the cost of that type of fin

56
Q

Can you use WACC if the finance is project specific?

A

NO
WACC utilises several types of fin to calc the average. If we only use one methodd of finance to inv in the project, then the average isn’t required and can simply discount at the cost of that type of fin

57
Q

What are the assumptions when using the dividend valuation model?

A
  • Perf market is operating to ensure that share price = PV of future dividends discounted at Ke (in practice, only true if shares/debentures are listed)
  • Div only paid only once a year (and either have just been or are just about to be paid) Dividends growth is expected to ebb reasonably constant and predictable (in practice, may be non-existent or at best erratic)
  • If using historic div to predict growth then we are assuming that the past is a good guide to the future (if circumstances change, e.g. the comp is getting listed, this may not be true)
  • If using the earnings retention model to predict growth we are assuming that both rate of return and retention rate will remain constant over time (may not be true if circs change)
58
Q

What are some of the issues with the WACC?

A

Ideally, only use permanent LT sources of fin when calc the WACC e.g. equity, prefs, debentures and loans
But arguably some companies use overdrafts, leasing and even trade CR over long periods of time
Although we wouldn’t conventionally include these as part of WACC, they could affect the true cost of cap

Calc the WACC for a small, unquoted company is v difficult, as there are no market values to obtain accurate returns and the small size usually results in more expensive finance

FM (12 decks)

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