Chapter 11 - The cost of capital

Question 1

Why is the cost of equity higher than the cost of debt?

Answer 1

Higher risk means a higher return is required

Question 2

What are the components of the Gordon’s growth model ‘g=br’?

Answer 2

• b = balance % of profits reinvested

- r = return on reinvested funds (ARR)

Question 3

What are the disadvantages of the dividend growth model?

Answer 3

• Assumes constant growth
• Assumes it is a dividend paying company
• Only works for listed companies

Question 4

What does a beta factor measure?

Answer 4

Systematic risk

Question 5

What is the formula for estimating growth using the historic growth model?

Answer 5

Square root to for no. growth periods (latest dividend/earliest divided)

Question 6

What is unsystematic risk?

Answer 6

The risk associated with investing in a particular company

Question 7

What is systematic risk?

Answer 7

The risk remaining even if a diversified portfolio has been created

Question 8

What is the market risk premium / equity risk premium?

Answer 8

The difference between the market return and risk free return

Question 9

What are the disadvantages of CAPM?

Answer 9

• Single period model
• Beta is historic - may be out of date
• Ignores size of company
• Assumes diversified portfolio

Question 10

What is the formula for cost of irredeemable loan notes?

Answer 10

Kd = (I x (1-t)) / P0

Question 11

What is the formula for IRR?

Answer 11

AAABBA

a% + (NPVa/NPVa - NPVb) x (b% - a%)

Question 12

How is the cost of redeemable debt calculated?

Answer 12

IRR

Question 13

When can WACC be used?

Answer 13

POP

• Project is marginal
• Operating risk is the same
• Proportion of funds raised is the same

Question 14

What is the formula for cost of irredeemable preference shares?

Answer 14

I / P0

Question 15

What is the approach for calculating convertible debt cost %?

Answer 15

1. Calculate conversion value of shares at now and at redemption date
2. Treat it like redeemable debt - time 0 uses the current MV conversion value and redemption date uses the future MV conversion value
3. State assumption that they will convert

Question 16

What should be done with short term debt in WACC calculation?

Answer 16

It should be ignored

Question 17

Why is MV WACC preferred to book value WACC for investment decisions?

Answer 17

• Book value understates proportion of equity in capital structure as MV of ordinary shares is significantly higher than book value
• Understating cost of equity causes WACC to be understated as cost of equity is greater than cost of debt - this will skew investment appraisal as lower discount rate used
• Understate value of debt