Business Finance and Cost of Capital Flashcards
How do you calculate the dividend growth model?
(Current Div x 1 + Growth)/ (Cost of equity - Growth)
Name an assumption of dividend valuation methods?
The dividend valuation model makes the unreasonable assumption that average dividend growth is constant
Assumptions of CAPM?
- A perfect capital market
- Unrestricted borrowing or lending at the end risk free rate of interest.
- Investors already have a well-diversified portfolio.
- Uniformity of investors expectations.
- It provides a basis for establishing risk adjusted discount rates for capital investment projects.
Limitations of CAPM?
- By concentrating only on systematic risk other aspects of risk are excluded.
- The model considers only the level of return as being important to investors and not the way in which that is return received.
- Assumes perfect market.
Formulae for CAPM
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.
Advantages for CAPM?
- It provides a market based relationship between risk and return.
- It shows why only systematic risk is important in this relationship.
- It is one of the best methods of estimating a quoted companys cost.
- It provides a basis for establishing risk adjusted discount rates for capital investment projects.
Constant Dividend?
P0 = d/re
where:
re = the cost of equity
P0 = the ex-dividend market price of the share
d = the constant dividend
Dividend valuation model?
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
The averaging method?
The averaging method:
g = n (Sq rt) current dividend/dividend n years ago -1
Gordon growths model?
g = bre
where re = accounting rate of return
where b = proportion of funds retained
Assumptions of the DVM?
- Dividends will be paid in perpetuity
- Dividends are constant or gorwing at a fixed rate.
- The cost of equity is larger that the growth rate
What is the cost of equity to 1 decimal place?
0.55 x 1.05 / (5.75- 0.55) + 0.05 = 0.161
16.1% to 1 decimal place
What is the cost of debt of the 7% loan notes?
- 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%
What is the market value of the 6% loan notes?
- 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
Which TWO of the following are consistent with Modigliani and Miller’s with tax theory?
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
Which of the following is consistent with the traditional theory of Capital Structure?
Karooba has low gearing and should increase debt to decrease its weighted average cost of capital
Assuming conversion, what is the market value of each loan note of Coral Co?
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
Which of the following statements about the equity market value of Coral Co is/are true?
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
Why might valuations of the equity and loan notes of Coral Co be necessary?
The company is planning to go to the market for additional finance
The company has received a takeover bid from a rival company
Assumptions of WACC?
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.
Could increase shareholder wealth by reducing its weighted average cost of capital to a minimum level.
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
Discuss the circumstances under which it is appropriate to use the current WACC of
Tufa Co in appraising an investment project.
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.
Discuss THREE advantages to Tufa Co of using convertible loan notes as a source of
long-term finance?
Conversion rather than redemption
Lower interest rate
Attractive to investors
Facilitates planning
Discuss TWO other factors for Tanza Co to consider in making the decision to
raise debt finance or equity finance. (4 marks.
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.
The equity beta?
The equity beta measures the systematic business risk and the systematice financial risk.
The asset beta?
The asset beta: measures the systematic business risk only. Also known as an un-geared beta.
The assumptions underpinning M&Ms theory include?
No taxation
Perfect capital markets
Rational Investors
No transactions costs
Debt is risk free
Problems with high levels of gearing?
Bankruptcy
Agency costs
Tax exhaustion
Effect on borrowing capacity
Risk tolerance of investors may be exceeded.
There are three views concerning the trade off to of these two effects.
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.
Gearing
The higher the cash flow the lower resultant gearing.
Equity may be issued at a time of high information asymmetry.
