Business Finance and Cost of Capital

Question 1

How do you calculate the dividend growth model?

Answer 1

(Current Div x 1 + Growth)/ (Cost of equity - Growth)

Question 2

Name an assumption of dividend valuation methods?

Answer 2

The dividend valuation model makes the unreasonable assumption that average dividend growth is constant

Question 3

Assumptions of CAPM?

Answer 3

1. A perfect capital market
2. Unrestricted borrowing or lending at the end risk free rate of interest.
3. Investors already have a well-diversified portfolio.
4. Uniformity of investors expectations.
5. It provides a basis for establishing risk adjusted discount rates for capital investment projects.

Question 4

Limitations of CAPM?

Answer 4

1. By concentrating only on systematic risk other aspects of risk are excluded.
2. The model considers only the level of return as being important to investors and not the way in which that is return received.
3. Assumes perfect market.

Question 5

Formulae for CAPM

Answer 5

E(rj) = Rf + Bi (E(rm) - Rf)

Where Er is the required return from the investment.
Rf is the risk free rate of return
Bi is the beta value of the investment
E(rm) is the expected return from the market portfolio.

Question 6

Advantages for CAPM?

Answer 6

1. It provides a market based relationship between risk and return.
2. It shows why only systematic risk is important in this relationship.
3. It is one of the best methods of estimating a quoted companys cost.
4. It provides a basis for establishing risk adjusted discount rates for capital investment projects.

Question 7

Constant Dividend?

Answer 7

P0 = d/re

where:
re = the cost of equity
P0 = the ex-dividend market price of the share
d = the constant dividend

Question 8

Dividend valuation model?

Answer 8

Growth
The dividend valuation model with constant growth:

P0 = d1/(re-g)

where:
g = a constant rate of growth in dividends
d1 = dividend to be paid in one year’s time

Question 9

The averaging method?

Answer 9

The averaging method:

g = n (Sq rt) current dividend/dividend n years ago -1

Question 10

Gordon growths model?

Answer 10

g = bre
where re = accounting rate of return
where b = proportion of funds retained

Question 11

Assumptions of the DVM?

Answer 11

1. Dividends will be paid in perpetuity
2. Dividends are constant or gorwing at a fixed rate.
3. The cost of equity is larger that the growth rate

Question 12

What is the cost of equity to 1 decimal place?

Answer 12

0.55 x 1.05 / (5.75- 0.55) + 0.05 = 0.161

16.1% to 1 decimal place

Question 13

What is the cost of debt of the 7% loan notes?

Answer 13

• Coupon Interest is 7% x $100 = $7
• Post tax = $7 * 0.72 = $5.04
• Ex interest Market price is $104.5 - $7 =
  $97.5
• Kd Post tax = 5.04/97.5 = 5.17%

Question 14

What is the market value of the 6% loan notes?

Answer 14

• Redemption Value is $100 x 1.1 = $110
• Market value based on Redemption
  Value as higher.
• Market value will be interest x AF(8%,4)
  plus RV x PV(8%,4)
• Market value per loan note = (6 x 3.312)
  + (110 x 0.735) = $100.72

Question 15

Which TWO of the following are consistent with Modigliani and Miller’s with tax theory?

Answer 15

The weighted average cost of capital falls with increased gearing

The cost of equity is higher when there is a high proportion of debt capital

Question 16

Which of the following is consistent with the traditional theory of Capital Structure?

Answer 16

Karooba has low gearing and should increase debt to decrease its weighted average cost of capital

Question 17

Assuming conversion, what is the market value of each loan note of Coral Co?

Answer 17

Conversion value = 7.10 x 1.086 x 10 = 112.67 per loan note

Market value = (7 x 5.076) + (112.67 x 0.746) = 35.53 + 84.05 = $119.58

Question 18

Which of the following statements about the equity market value of Coral Co is/are true?

Answer 18

The equity market value will change frequently due to capital market forces

Over time, the equity market value of Coral Co will follow a random walk

Question 19

Why might valuations of the equity and loan notes of Coral Co be necessary?

Answer 19

The company is planning to go to the market for additional finance

The company has received a takeover bid from a rival company

Question 20

Assumptions of WACC?

Answer 20

The objective of the firm is to maximise the current market value of the
ordinary shares.

The market is perfect and the share price is the discounted present value of
the dividend stream.

The current capital structure will be maintained.

The project is of the same risk as the existing activities.

The finance for the project comes from a pool of funds and is not project specific.

Question 21

Could increase shareholder wealth by reducing its weighted average cost of capital to a minimum level.

Answer 21

The market value of a company will be equal to the present value of future cash flows available to investors, discounted in perpetuity.

It follows that if WACC could be reduced, the market value of the company would
increase and the wealth of shareholders, as the owners of the company, would
increase.

This view suggests that March Co could reduce its WACC to a minimum level but
it does not give a prediction as to where the optimal gearing level lies.

The WACC remained
constant as a company geared up, with the increase in the cost of equity due to
financial risk exactly balancing the decrease in the WACC caused by the lower before tax
cost of debt

Question 22

Discuss the circumstances under which it is appropriate to use the current WACC of
Tufa Co in appraising an investment project.

Answer 22

The current WACC can be used as the discount rate in appraising an investment project.

The current WACC can therefore be used as the discount rate in appraising an project.

Similarly, the current WACC can be used as the discount rate in appraising an investment project of Tufa Co if the project is financed in a way that mirrors the current
capital structure of the company, as financial risk is then likely to be unchanged.

Question 23

Discuss THREE advantages to Tufa Co of using convertible loan notes as a source of
long-term finance?

Answer 23

Conversion rather than redemption
Lower interest rate
Attractive to investors
Facilitates planning

Question 24

Discuss TWO other factors for Tanza Co to consider in making the decision to
raise debt finance or equity finance. (4 marks.

Answer 24

The finance is needed quickly, this would favour the use of debt which is less time consuming to raise.

The cost of new debt may be lowered if Tanza has any non-current assets to offer as security.

It is important to consider the clientele effect too. The current shareholder-base seems to be comfortable
with a gearing level which is lower average for the industry. By changing that policy, this may change
the investors perceived risk exposure, leading to the sale of their shares.

Question 25

The equity beta?

Answer 25

The equity beta measures the systematic business risk and the systematice financial risk.

Question 26

The asset beta?

Answer 26

The asset beta: measures the systematic business risk only. Also known as an un-geared beta.

Question 27

The assumptions underpinning M&Ms theory include?

Answer 27

No taxation
Perfect capital markets
Rational Investors
No transactions costs
Debt is risk free

Question 28

Problems with high levels of gearing?

Answer 28

Bankruptcy
Agency costs
Tax exhaustion
Effect on borrowing capacity
Risk tolerance of investors may be exceeded.

Question 29

There are three views concerning the trade off to of these two effects.

Answer 29

1 Traditional view - there is an optimal gearing level, which a firm needs to find by trial and error.
2 Modigliani and Miller (without tax) gearing does not affect shaeholder wealth.
3 Modgliani and Miller (with tax) - firms should gear up as much as possible to make use of the tax relief.

Question 30

Gearing

Answer 30

The higher the cash flow the lower resultant gearing.
Equity may be issued at a time of high information asymmetry.