9) Cost of Capital (17)

Question 1

what are the two methods that can be used to calculate the cost of equity?

Answer 1

Dividend valulation/growth model

CAPM

Question 2

What is the dividend valuation model and what is it based on

Answer 2

The dividend discount model (DDM) is a quantitative method used for predicting the price of a company’s stock based on the theory that its present-day price is worth the sum of all of its future dividend payments when discounted back to their present value.

The cost of equity finance to the company is the return the investors expect to achieve on their shares. We will be able to determine the return investors expect to receive by looking at how much they are prepared to pay for a share.

Question 3

What are the assumptions of DVM?

Answer 3

DVM states that:

Future income stream is the dividends paid out by the company
Dividends will be paid in perpetuity
Dividends will be constant or growing at a fixed rate.

Therefore:
Share price = Dividends paid in perpetuity discounted at the shareholder’s rate of return.

Question 4

The formula for valuing a share is therefore?

Answer 4

P0= D ÷ re

P0=Share price now T0
D= Constant dividend from year 1 to infinity
re= shareholder’s required return

Question 5

Although in reality a firm’s dividends will vary year on year, a practical assumption is to assume a constant growth rate in perpetuity. The share valuation formula then becomes:

Answer 5

P0= [D0(1+g)] ÷ [re-g]

g = constant rate of growth in dividends, expressed as a decimal

D0(1+g) = dividend just paid, adjusted for one year’s growth (equivalent to D1)

Question 6

What is the ex div share price and explain what the formula for P0 is?

Answer 6

P0 represents the ‘ex div’ share price.

The DVM model is based on the perpetuity formula, which assumes that the first payment will arise in one year’s time

If the first dividend is receivable immediately, then the share is termed cum div. In such a case the share price would have to be converted into an ex div share price, (ex div meaning 1st dividend is payable in a years time) so that we can use the DVM formula

Before dividend= Cum div share price
Dividend occurs
After dividned= Ex div share price

Ex Div share price= Cum div- dividend due

Question 7

How do you calculate the g (growth rate) in the DVM formula?

name the specific terms used to describe the methods rather than the names of the method

Answer 7

Two ways of estimating the likely growth rate of dividends are:

extrapolating based on past dividend patterns
assuming growth is dependent on the level of earnings retained in the business

Question 8

What is the historic method?

Answer 8

This method assumes that the past pattern of dividends is a fair indicator of the future.

the formula for extrapolating growth is

G=[ n√(D0÷ Dn) ] - 1

n = number of years of dividend growth.

Question 9

what is the gordons growth model and the formula and the assumption

Answer 9

Assumption : The higher the level of retentions in a business, the higher the potential growth rate.

g= bre

b= earnings retention rate (Profit retained/ Profit after tax)

re= RETURNS ON EARNING retained. This is ROE (Return on equity)

(Profit after tax- preference dividend)
/
(Ordinary shares)

Question 10

what is the weakness of the DVM

Answer 10

The model does not incorporate risk

 the input data used may be inaccurate:
– current market price of the share is subject to other short-term fluctuations due to influences, such as rumoured takeover bids affecting the price. This means that your answer too might keep changing

– It assumes dividends grow at a constant rate ‘g’ - for simplicity, we usually assume no growth or constant growth.

• future growth is predicted from past results- these are unlikely growth patterns. growth estimates based on the past are not always useful; market trends, economic conditions, economic events, inflation, etc. need to be considered

the growth in earnings is ignored.

-Earnings do not feature as such in the DVM. However, earnings should be an indicator of the company’s long-term ability to pay dividends and therefore in estimating the rate of growth of future dividends, the rate of growth of the underlying profits must also be considered. E.g. dividend growing 10% and earnings 5%= bad and vice versa

Question 11

How do you estimate the cost of preference shares and the formula

Answer 11

Preference shares usually have a constant dividend. So the same approach can be used as we saw with estimating the cost of equity with no growth in dividends.

Kp= D÷ P0

D = the constant annual preference dividend 
P0 = ex div MV of the share 
Kp = cost of the preference share.

Question 12

what’s the difference between Kd and ‘Kd (1 – T)

Answer 12

 ‘Kd’ – the required return of the debt holder (pre-tax)
 ‘Kd (1 – T)’ – the cost of the debt to the company (post-tax).

Care must be taken since it is not always possible to simply calculate ‘Kd (1 – T)’ by taking Kd and multiplying by (1 – T). You should therefore regard ‘Kd (1 – T)’ as a label for the post-tax cost of debt rather than as a mathematical formula.

Note also that Kd, the required return of the debt holder can also be referred to as the ‘yield’, the ‘return on debt’ and as the ‘pre-tax cost of debt’.

Question 13

what are irredeemable debt

Answer 13

Irredeemable debt – no repayment of principal – interest in perpetuity.

Question 14

what is the formula for the lenders of irredeemable debt

Answer 14

Market price (MV) = Future expected income stream from the debt discounted at the investor’s required return.

 expected income stream will be the interest paid in perpetuity. The formula for valuing a loan note is therefore: MV = I÷ Kd

where: I = annual interest in $ starting in one year’s time
P0/MV = market price in $ of the loan note now (year 0)
Kd = debt holders’ required return (pre-tax cost of debt), expressed as a decimal.

required return (pre tax cost of debt) of the lenders can be found by rearranging the formula

Kd= I / MV

Question 15

what is the formula for the COMPANY of irredeemable debt

Answer 15

Kd (1-T)= I (1-t) / Mv

Question 16

what are redeemable debt

what is it’s market price

what is the expected income stream

Answer 16

Redeemable debt – interest paid until redemption of principal (sometimes at a premium or a discount to the original loan amount)

Market price = Future expected income stream from the loan notes discounted at the investor’s required return (pre-tax cost of debt).

Expected income stream will be:
– interest paid to redemption
– the repayment of the principal.

Hence the market value of redeemable loan notes is the sum of the PVs of the interest and the redemption payment.

Question 17

What is the formula for redeemable debt?

Answer 17

Note that for the investor the purchase is effectively a zero NPV project, as the present value of the income they receive in the future is exactly equivalent to the amount they invest today.

The investor’s required return is therefore the internal rate of return (IRR) (breakeven discount rate) for the investment in the loan notes.

Question 18

the return an investor requires is therefore found by calculating the IRR of the:

Answer 18

T0- MV (X)
T1..N- Interest payments X
Tn- Capital repayment X

Question 19

the cost of debt for the company is therefore found by calculating the IRR of the:

Answer 19

T0- MV (X)
T1..N- Interest paymentsx(1-T) X
Tn- Capital repayment X

Question 20

where the debt is redeemable at its current market price, the position of the investor is?

Answer 20

the same as a holder of irredeemable debt.

so both formulas will be the same

Question 21

what is the convertible debt?

Answer 21

A form of loan note that allows the investor to choose between taking the redemption proceeds or converting the loan note into a pre-set number of shares.

Question 22

how do you calculate the cost of convertible debt?

Answer 22

(1) Calculate the value of the conversion option using available data
(2) Compare the conversion option with the cash option. Assume all investors will choose the option with the higher value.
(3) Calculate the IRR of the flows as for redeemable debt

Note: There is no tax effect whichever option is chosen at the conversion date.

Question 23

what is non tradeable debt cost to the company and whats the formula

Answer 23

Bank and other non-tradeable fixed interest loans simply need to be adjusted for tax relief:

Cost to company = Interest rate × (1 – T)

Question 24

what is WACC- in terms of explaining why do we use it

Answer 24

if a question tells you that a project is to be financed by the raising of a particular loan or through an issue of shares, in practice, the funds raised will still be added to the firm’s pool of funds and it is from that pool that the project will be funded.

The general approach is to calculate the cost of each individual source of medium-long term finance and then weight it according to its importance in the financing mix.

A firm’s average cost of capital (ACC) is the average cost of the funds, normally represented by the WACC. The computed WACC represents the cost of the capital currently employed. This represents financial decisions taken in previous periods.

Question 25

The formula for WACC is quite complicating (though given) so better to use the profoma: what is it?

Answer 25

Step 1 Calculate weights for each source of capital.
Step 2 Estimate cost of each source of capital.

Step 3 Multiply proportion of total of each source of capital by cost of that source of capital. Step 4 Sum the results of

Step 3 to give the WACC. All of the above can be summarised in the following formula, which is provided for you in the exam.

Question 26

Which method is more optimal in deciding which weight to choose

Book value or MV

• mention which values are included in both
• which is better

Answer 26

Wherever possible MVs should be used.

The value of shareholders’ equity shown in a set of accounts will often reflect historic asset values, and will not reflect the future prospects of an organisation or the opportunity cost of equity entrusted by shareholders. Consequently, it is preferable to use MV weights for the equity.

Note that when using BVs, reserves such as share premium and retained profits are included in the BV of equity, in addition to the nominal value of share capital.

Note that when using MVs, reserves such as share premium and retained profits are ignored as they are in effect incorporated into the value of equity as designated by the share price.

Question 27

What are the assumptions of WACC

Answer 27

1) the historic proportions of debt and equity will remain unchanged (assuming that gearing of the entity will remain constant in the long term)
2) Any new project will have the same risk as the existing activities of the company

OR

The new project is assumed to be very small in relation to the existing activities of the company

Question 28

The weighted average cost of capital (WACC) can be used as the discount rate in investment appraisal provided that some restrictive assumptions are met. These assumptions are as follows:

Answer 28

These assumptions are as follows:

• the investment project is small compared to the investing organisation
• the business activities of the investment project are similar to the business activities currently undertaken by the investing organisation
• the financing mix used to undertake the investment project is similar to the current financing mix (or capital structure) of the investing company
• existing finance providers of the investing company do not change their required rates of return as a result of the investment project being undertaken.

These assumptions are essentially saying that WACC can be used as the discount rate provided that the investment project does not change either the business risk or the financial risk of the investing organisation.

Question 29

What is the impact of risk for DVM and WACC

Explain what is risk

Answer 29

When considering the return investors require, the trade-off with risk is of fundamental importance. Risk refers not to the possibility of total loss, but to the likelihood of actual returns varying from those forecast.

The DVM and WACC calculations above assume that an investor’s current required return will remain unchanged for future projects. For projects with different risk profiles, this assumption may not hold true.

DVM assumes that the return currently being paid to ordinary shareholders will continue to be their required return in the future. We have seen that the return required is a reflection of the risk the investor faces. Therefore, by using the DVM we are effectively assuming that all future investment projects will be subject to the same risk as those currently undertaken.

However, if the company is considering an investment project in a different business area, these assumptions may not be appropriate and an alternative approach to finding the cost of equity is needed

Question 30

What is CAPM

Answer 30

It is alternative to measuring of determining the cost of equity. It is based on measuring the systemic risk of an investment.

Question 31

What is unsystematic risk?

Answer 31

This is the risk that is unique to a company or the industry within which a company operates.

Examples of unsystematic risk are poor management, a poor business strategy or a new competitor entering the market.

This risk can be diversified away. If an investor invests in a significant number of shares which are spread across the stock market unsystematic risk factors tend to cancel each other out.

Question 32

What is systematic risk?

Answer 32

This is the risk due to market wide factors or factors affecting all companies on the stock market.

Examples of systematic risk are a rise in interest rates, a reduction in the level of economic growth or significant exchange rate changes.

Systematic risk cannot be diversified away.

All companies on the stock market are affected by systematic risk but not all companies are affected to the same extent. The beta factor measures the level of systematic risk of a share.

Question 33

What is the CAPM formula

Answer 33

E(r)i = Rf + βi (E(rm) – Rf)

where:
E(r)i = expected return on investment i (often expressed as the required return)
Rf = risk-free rate of return

E(rm) = the expected average return on the market.
This is often simply written as Rm (E(rm) – Rf) = equity risk premium (sometimes referred to as average market risk premium)

βi = systematic risk of investment compared to the market and therefore amount of the premium needed.

Question 34

What is Beta

Answer 34

it measures a shares volatility in terms of systematic risk

Question 35

what is the mean and it’s meaning for 0, <1, >1

Answer 35

If an investment is riskier than average (i.e. the returns are more volatile than the average market returns) then the β > 1.

If an investment is less risky than average (i.e. the returns are less volatile than the average market returns) then the β < 1.

If an investment is risk free then β = 0.

Question 36

what is the assumption for CAPM 6

Answer 36

▪ CAPM assumes that investors hold a well-diversified portfolio. If investors don’t hold a well-diversified portfolio then they are likely to want a return that compensates for both systematic and unsystematic risk

▪ CAPM assumes that markets are perfect. This assumption means that all securities are valued correctly and that their returns will plot on to the SML. A perfect capital market requires the following: that there are no taxes or transaction costs; that perfect information is freely available to all investors, investors are rational and risk averse

▪ Unrestricted borrowing or lending at the risk free rate of interest- Investors cannot in the real world borrow at the risk-free rate. The reason for this is that the risk associated with individual investors is much higher than that associated with the government.

▪ All forecasts are made in the context of a single period transaction

▪ CAPM only considers the level of return required by the providers of finance. It does not consider whether investors would prefer dividends or capital gains or, alternatively whether investors might be indifferent between dividends and capital gains

▪ The beta factor is determined by comparing past historic returns from one share with the past historic returns from the stock market. The information is, however, used to estimate the future returns that an investor in the shares would require. An investor may require a different return in the future to the returns that have been achieved in the past.

▪ The Rf rate of interest may change and if this happens then the cost of equity will change

Question 37

what is a single period transaction horizon

Answer 37

single-period transaction horizon A holding period of one year is usually used in order to make comparable the returns on different securities. A return over six months, for example, cannot be compared to a return over 12. This assumption appears reasonable because even though many investors hold securities for much longer than one year, returns on securities are usually quoted on an annual basis.

Question 38

What are the disadvantages of CAPM

Answer 38

 less useful if investors are undiversified
 ignores tax situation of investors- dividend vs capital gains treatments for tax are different

 It is strictly a one-period model and should be used with caution, if at all, in the appraisal of multi-period projects. Some of the required data inputs are extremely difficult to obtain or estimate.

 actual data inputs are estimates and may be hard to obtain.

-Rf of ST gov debt is used as substitue. This is not fixed and changes regularly with changing economic circumstances. To overcome this, a short term average value can be used to smooth out this volatility.

Finding equity risk premium is difficult. The return on a stock market is the sum of the average capital gain and the average dividend yield. In the short term, a stock market can provide a negative rather than a positive return if the effect of falling share prices outweighs the dividend yield. It is therefore usual to use a long-term average value taken from empirical research. But it has been found that ERP is not stable over time. Uncertainty about ERP value intruduces uncertainty into the calculated value for the required return

Beta values are now calculated and published regularly for all stock exchange-listed companies. The problem here is that uncertainty arises in the value of the expected return because the value of beta is not constant, but changes over time.

Question 39

what are some of the issues with Beta

think about of the figure is derived and issues with that

Answer 39

Beta – the measure of systematic risk. Here an estimate is usually required.

Such estimates may be derived from subjective judgement, sensitivity analysis or, in some cases, by analysing the beta coefficient of quoted firms which are thought to display the same risk characteristics as the project being appraised

Use of regression analysis is subject to statistical error, the presence of unsystematic risk, and the effects of not having a perfect investment market – security prices not always simply reflecting underlying risk.

Question 40

what are some of the issues with Rm

Answer 40

Rm is extremely difficult to determine as the market is volatile and the expected return is likely to vary with changes in the Rf.

Hence, users often attempt to estimate (Rm – Rf), the equity risk premium or excess return on the market. Historically in the UK this excess return has varied between 3% and 9% and similar figures may be used

Question 41

what is the relationship between beta and CAPM

what does the CAPM result generally show

at which situations does the CAPM does not perform as expected

what is used to overcome this issue

Answer 41

Generally, the basic CAPM is seen to overstate the required return for higher beta securities and understate the required return for low beta securities. (Explained by SML- in reality they are plotted over and under the SML line)

However, this problem mostly disappears when the effects of taxation are introduced to develop the basic model.

It’s been found that CAPM also does not perform as expected, e.g. investments with low betas, investments with low price/earnings (PE) ratios, investments with a strong seasonality.

Question 42

what kind of companies does CAPM not generate accurate forecast for

what time of the year is a good month for investing

Answer 42

CAPM does not seem to generate accurate forecasts for returns for companies with low price/earnings ratios and is unable to account for seasonal factors observed in the UK stock market over the years.

January appears nearly always to be an outstandingly successful month for investing in UK shares, but no one can explain why this is the case.

• Explaining PE ratio

“when a company has a low PE ration, CAPM is less likely to accurately forecast the returns”

It’s been found that firms with low price-earning ratio yielded higher sample return and firms with higher price-earning ratio produced lower returns than justified

We’ve found that stocks with low price/book ratios are typically companies that have recently had some less-than-stellar results and may be temporarily out of favor and low in price. On the flip side, those companies with higher than market price/book ratios might be temporarily pumped up in price because they are in a growth stage.

Sorting firms on metrics like price/earnings ratios expose investors’ subjective reactions, which tend to be extremely good in good times and overly negative in bad times. Investors also tend to over forecast past performance, which leads to stock prices that are too high for high price/earnings firms (growth stocks) and too low for low P/E firms (value stocks).

Question 43

what is D0 (1+g)

Answer 43

Dividend in one years time

Question 44

Q- what is the market value based gearing of the company defined as prior chage capital/equity.

What is prior charge capital / Equity

Answer 44

the prior charge capital consists of bonds, the long-term bank loan and preference shares.

Preference shares are included with prior charge capital, even though they pay a dividend rather than
paying interest.

Question 45

In relation to an irredeemable security paying a fixed rate of interest, What is the relationship between risk, MV and yield

Answer 45

As risk rises, the market value of the security will fall to ensure that investors receive an increased yield.

The higher the risk, then the greater the return (i.e. yield) that the investor will require.

It is the investor who determines the market value – the market value is the present value of future receipts discounted at their required return. The greater the required return, the greater the discount rate, and therefore the lower the market value.

Question 46

under which circumstances can you use WACC for investment appriasal

Answer 46

It can be use in investment appraisal where the project
- project is small in comparison to the company (it won’t have any impact

• where the project doesn’t change the gearing of the companyl (capital structure). because the capital structure of the company, determines Financial risk.
• where the project does not change the risk profile (business risk) of the company. i.e. not a completely different activity/project.
• business risk is the risk of operations. what it is the company is doing. certain companies are inherently more risky than others because of what they do. E.g. supermarkets have low risk because we all need food. e.g. as pub chain/ retail selling luxury - their risk will be higher as those projects, when the economy is bad- demand will be less so their business will suffer.

Question 47

how would you overcome the limitations of WACC as a discount rate?

Answer 47

USE RISK ADJUSTED DISCOUNT RATE

It is often said that ‘the higher the risk, the higher the return’. Investment projects with higher risk should therefore be discounted with a higher discount rate than lower risk investment projects. Better still, the discount rate should reflect the risk of the investment project.

Theoretically, the capital asset pricing model (CAPM) can be used to determine a project-specific discount rate which reflects
an investment project’s systematic risk.

This means selecting a proxy company with similar business activities to a proposed investment project, ungearing the proxy company equity beta to give an asset beta which does not reflect the proxy company
financial risk, regearing the asset beta to give an equity beta which reflects the financial risk of the investing company, and using the CAPM to calculate a project-specific cost of equity for the investment project.

Question 48

what is creditor higherarchy

Answer 48

The creditor hierarchy refers to the order in which financial claims against a company are settled when the company is liquidated. The hierarchy, in order of decreasing priority, is secured creditors, unsecured creditors, preference shareholders and ordinary shareholder.

The return required by a provider of finance is related to the risk faced by that provider of finance. Secured creditors therefore have the lowest required rate of return and ordinary shareholders have the highest required rate of return. The cost of debt should be less than the cost of preference shares, which should be less than the cost of equity.

Question 49

Why will some bonds have different cost of debt

Answer 49

Risk

In general, the cost of a source of finance is related to its level of risk. The higher the risk, the greater the return expected by investors and therefore the higher the cost to the company. In this case, the bonds were issued at the same time by the company so business risk will not be a reason for the difference in cost of debt.

Security

Connected with the concept of risk and return is the amount of security offered. For example, a bond may be secured on a specific asset or group of assets. An unsecured bond will generally have a higher interest rate than a secured one. A lack of security therefore raises the cost of debt. There is no information to suggest a difference in security for Bond A and Bond B.

Time

The yield curve is normally upward sloping which means that long-term financial assets offer a higher yield than short-term assets. This is due to liquidity preference theory which states that investors prefer cash now to later and want compensation in the form of a higher return for being unable to use their cash now.

Longer dated bonds can therefore be expected to have a higher cost of debt than shorter dated bonds. Bond A has a greater time to maturity than Bond B so would therefore be expected to have a higher interest rate and cost of debt.

Size of debt

The amount of finance raised by Bond A is twice that of Bond B and that may have contributed to the higher cost of debt.

Question 50

what are advantages of CAPM

Answer 50

The CAPM has several advantages over other methods of calculating required return, explaining why it has been popular for more than 40 years:

• It considers only systematic risk, reflecting a reality in which most investors have diversified portfolios from which unsystematic risk has been essentially eliminated.
• It is a theoretically-derived relationship between required return and systematic risk which has been subject to frequent empirical research and testing.
• It is generally seen as a much better method of calculating the cost of equity than the dividend growth model (DGM) in that it explicitly considers a company’s level of systematic risk relative to the stock market as a whole.
• It is clearly superior to the WACC in providing discount rates for use in investment appraisal.

Question 51

what is the portfolio theory and CAPM relationship

Answer 51

Portfolio theory suggests that the total risk of a portfolio of investments can be reduced by diversifying the investments held in the portfolio, e.g. by investing capital in a number of different shares rather than buying shares in only one or two companies.

Even when a portfolio has been well-diversified over a number of different investments, there is a limit to the risk-reduction effect, so that there is a level of risk which cannot be diversified away. This undiversifiable risk is the risk of the financial system as a whole, and so is referred to as systematic risk or market risk.

Diversifiable risk, which is the element of total risk which can be reduced or minimised by portfolio diversification, is referred to as unsystematic risk or specific risk, since it relates to individual or specific companies rather than to the financial system as a whole. Portfolio theory is concerned with total risk, which is the sum of systematic risk and unsystematic risk.

The capital asset pricing model assumes that investors hold diversified portfolios, and so is concerned with systematic risk alo

Question 52

when you are asked to calculate the market value of debt- what is the definition and what are you required to do

Answer 52

Market price = Future expected income stream from the loan notes discounted at the INVESTOR’S required return (PRE TAX cost of debt).

Only the INCOME so don’t discount the initial cost of attaining the debt

Question 53

what does the CAPM equattion state

Answer 53

it states that the return required by the shareholders will be in proportion to the systematic (market) risk faced by that share

Question 54

Islamic finance, explain briefly the concept of riba (interest) and how returns are made by Islamic financial instruments

Answer 54

Interest (riba) is the predetermined amount received by a provider of finance, over and above the principal amount of finance provided. Riba is absolutely forbidden in Islamic finance. Riba can be seen as unfair from the perspective of the borrower, the lender and the economy. For the borrower, riba can turn a profit into a loss when profitability is low.

For the lender, riba can provide an inadequate return when unanticipated inflation arises. In the economy, riba can lead to allocational inefficiency, directing economic resources to sub-optimal investmen

Islamic financial instruments require that an active role be played by the provider of funds, so that the risks and rewards of ownership are shared.

In a Mudaraba contract, for example, profits are shared between the partners in the proportions agreed in the contract, while losses are borne by the provider of finance.

In a Musharaka contract, profits are shared between the partners in the proportions agreed in the contract, while losses are shared between the partners according to their capital contributions. With Sukuk, certificates are issued which are linked to an underlying tangible asset and which also transfer the risk and rewards of ownership.

The underlying asset is managed on behalf of the Sukuk holders. In a Murabaha contract, payment by the buyer is made on a deferred or instalment basis. Returns are made by the supplier as a mark-up is paid by the buyer in exchange for the right to pay after the delivery date.

In an Ijara contract, which is equivalent to a lease agreement, returns are made through the payment of fixed or variable lease rental payments