Ch3 Cost of Capital Flashcards
Cost of capital
required rate of return - The return (ROI) that providers of capital (shareholders and lenders) required to earn on their invested funds.
Aka. benchmark rate of return
hurdle rate
CPA way: analyzing financing alternatives
Three steps:
Step 1: assess the situation
Step 2: analyze major issues
Step 3: concllude and advise
PA way: analyzing financing alternatives
- Step 1 assess the situation
- identify the need to calculate the cost of capital for the entity or a project
- identify relevant information, including:
- why the cost of capital is required
- costs and weighting of capital
- key stakeholders and their objectives - if applicable, state calculation method(s) and purpose
- plan sequence of analyses
CPA way: analyzing financing alternatives
- Step 2 analyze major issues
- calculate the appropriate cost of capital (based on how it will be used)
- if appropriate, state and justify key assumptions
- if appropriate, provide sensitivity analysis using various inputs
- prepare alternative calculations if required
CPA way: analyzing financing alternatives
- Step 3 conclude and advise
- conclude on the appropriate cost of capital and state reasons to support your conclusion
- if appropriate, provide further advice or additional information
WACC
a mixture of required returns needed to compensate all its debtholders and shareholders
The average of the pro-tax financing costs of all debt and equity are weighted for the proportion of each in the capital structure
Appropriate cost of capital for a project
To assess whether a project should be accepted or rejected, the discount rate used for similar risk investments must be used.
If the risk of the new project is different from current business, either use WACC from a “pure play” company or adjust the current WACC to reflect the different risk.
Value of a firm
The value of a firm is its future cash flows discounted at its cost of capital
A company should choose the capital structure (debt and equity) that results in lowest cost of capital.
Calculating the cost of capital
- WACC formula
- current costs of debt
- current costs of equity
- weighting of each source of debt and equity in the entity’s current capital structure
- income tax rate
= D/V (Rd)(1 – T) + P/V (Rp) + E/V (Re)
where
D is the market value of debt
V is the total of market value of debt, preferred shares, and equity
Rd is the current cost of debt
T is the marginal tax rate
P is the market value of preferred shares outstanding
Rp is the current cost of preferred shares
E is the market value of common shares outstanding
Re is the current cost of equity
Used for:
1) capital budgeting: as a discount rate for a project with similar risk in current business
2) calculate the value of entire company
WACC is calculated at a single point in time using current costs and market values
Cost of debt
Include: long-term debt
Exclude: short-term debt and long-term libilities e.g. provisions and pension obligations
Cost of debt: current yield on the debt as at the time of the calculation, not the interest payable on the bond or the coupon rate.
Cost of deblt
- fixed rate or variable rate
- Fixed rate: cost of debt changes as interest rate fluctuate; compute using spreadsheet recommended
Rate (N, PMT, -PV, FV) - Variable rate: prime rate + premium
After tax cost of debt
After-tax cost of debt = cost of debt / (1 - tax rate)
Assessment of default risk
- how much debt the entity currently have
(the more the higher) - how volatile are the operating cash flows
(the more the higher) - any collaterial (the more, the lower)
- any enforced covenants (the more the lower)
- current yield rate on similar-risk debt
- term of the loan (the longer, the higher)
S&P credit rating: the higher the rating, the lower the risk hence the lower the interest rate
Cost of equity - preferred shares
Total annual perferred dividends paid on preferred shares / total market value of all preferred shares outstanding
per unit method:
total annual dividend paid per preferred share / current market price per preferred share
Cost of equity - common equity
CAPM - Capital Asset Pricing Model
Cost of equity
= Risk-free return (Rf) + Risk premium related to risk of investment
= Risk-free return (Rf) + Beta x Market risk premium (Rpm)
Investors are compensated by:
1) time value of money +
2) additional risk related to the investment (risk related to this investment, or systematic risk + risk related to market price of risk)
Beta = 1, returns on a share perfectly correlated with returns on the market
Beta > 1, returns on a share greater than returns on market, bull markets, and returns are more volatile
Beta < 1, returns on a share less than returns on market, bear markets, worse returns and market declines
CAPM particularly relevant for public companies that have the ability and opportunity to create competitive advantage by having the lowest cost of capital.
