Chapter 10 Flashcards
Cost of Capital
The creditor hierarchy
Secured loans and loan notes are repaid first
Trade creditors and unsecured debt are repaid next
Preference share owners are repaid next
Ordinary shareholders rank last in liquidation
Risk/Return Pay off
Risk faced by each class of investor, drives the required return of that investor and the required return drives the company’s cost of each source of finance
Secured loans
Debt investors have legally binding contracts for the payment of interest and repayment of principal. Interest must be paid in priority to dividends. Therefore, secured debt is considered low risk and investors receive relatively low returns thus creating relatively cheap finance for the company.
Unsecured debt
A legally binding contract and must be paid before dividends. However, there is no guarantee of full repayment upon liquidation so the required return will be higher
Preference shares
These dividends are a fixed percentage of a share’s nominal value paid after interest on debt and before any ordinary dividends so the required rate of return will be more than secured and unsecured debt but lower than on ordinary shares
Ordinary shares
Equity share holders have no guarantee of receiving dividends, ordinary dividends are discretionary, (whereas preference dividends are committed) and rank last on liquidation. Therefore, ordinary shareholders face high risk and expect high returns to compensate.
Ex div market value
market value assuming that a dividend has just been paid or is about to be paid
Underlying assumptions of the DVM Model
All investors have the same expectations and therefore the same required rate of return
Dividends are paid once a year and one year apart
Dividends are either constant or growing at a constant rate
Perfect capital market assumptions - no taxes, no transaction costs, no individual can affect the share price, perfect information is freely available to all investors
Advantages of DVM
Easy to understand and can be applied to any share that offers a dividend.
For minority shareholders who have no control over a company’s policies, dividends are the only available metric.
Model is not subjective (e.g. there is no ambiguity in determining amounts of dividends whereas “profit” is open to interpretation).
Suitable for “mature” companies paying regular dividends.
Based only on dividends, taking no account of market conditions, making comparisons across companies of different sizes and industries easier.
Disadvantages of DVM
Cannot be applied to shares that do not pay dividends and so cannot be used for smaller business
Assumes shares have no issue costs.
It does not explicitly incorporate risk.
It is overly simplistic. It can only be an approximation because dividends do not grow at a constant rate in reality.
Makes no allowance for non-dividend factors that influence the value of a share (e.g. brand loyalty and other internally generated intangible assets).
It makes no allowance for the effect of taxation.
It ignores capital gains tax on investors (although it could be argued that the change of ownership of a share does not affect the PV of a dividend stream).
Loan note
a security instrument (so it is tradable) that acknowledges a company’s debt.
Features of a loan note aka bond or debenture
Usually pays a fixed coupon.
May be secured or unsecured.
If quoted, it will trade on an exchange at a price determined by that market
Coupon rate
the interest rate printed on the loan note certificate.
Annual interest formula
Annual interest = coupon rate × nominal value
