Chapter 17 - Cost Of Capital

Question 1

Why is there a cost to equity

Answer 1

Because shareholders expect a dividend which is the equivalent to interest

Question 2

Why would a company care about what people would want as a rate of return ?

Answer 2

Imagine an individual wants .30c dividend and the share is 2.40 then their rate of return is 12.5% but why would a company care ?

Well, regardless if originally they sold the shares for £1, if they want to raise more finance today they need to set a price that would take into effect the individuals rate of return otherwise they will buy shares elsewhere

Question 3

How to calculate the rate of return for non constant rate of return ?

Answer 3

It’s the same as the other formula just in a different order

Re = d0 (1 + g) / P0 + g

Question 4

What are the 2 ways to look at future growth in estimating dividend growth rates ?

Answer 4

1. Look at past growth trends to work out future trends
2. It is called “RB Growth” - this approach considers the reason for dividend growth which is growth in earnings (profits). It’s like a compound effect, if a company gives out all of its £100 profits as dividend without any retained earnings then they won’t grow and pay out more dividends than £100 whereas if you only pay out £40 as dividend and retain £60 and out of that £60 you reinvest 10% then next year you expect profits to be £106 which would increase the 40% dividend policy

Question 5

What is the rb growth rate formula ?

Answer 5

g = rb

Where;

b = the proportion of earnings retained in the company
r= the rate of return that the company can earn on re-investment

For example if a company retains 40% each year and is able to reinvest to earn a return of 20% each year then the expected growth rate in dividends is 20% x 40% = 8% per year growth

Question 6

Cost of debt - how to work out the cost to the company (irredeemable debt)

Answer 6

Remember with interest it is tax allowable

For example if the issue is 8% and debenture is quoted at 90 p.c currently then the return to investor is 8.89% and the cost to the company (corporation tax @ 30%) is 8.89% x 70% (because we save 30%) = 6.22%

Question 7

Cost of debt - how to work out the cost to the company (redeemable debt)

Answer 7

Unfortunately no quick way, have to work out the internal rate of return

Imagine company has 6% quoted at 85 and in 5 years debentures are redeemable at 10% then we have to work out IRR by plotting 2 % to work out.

Note that the interest is tax allowable so the cost of the company will only be £4.20 (£6 x 70%) whereas the repayment isn’t so is £110

So @ 10%

Year 0 - = 85
Year 1-5 - 4.20 x 3.791 = 15.92
Year 5 - 110 x 0.621 = 68.31
- 0.77

As it’s a - we have to go lower

@ 5%

Year 0 - = 85
Year 1-5 - 4.20 x 4.329 = 18.18
Year 5 - 110 x 0.784 = 86.24
+ 19.42

Therefore we know answer is somewhere between

5% + (19.42 / 20.19 x 5%) = 9.81%

Note if you need to work out the return to investors do exactly the same out don’t tax allowable the £6 because it doesn’t apply to investors

Question 8

What is the weighted average cost of capital

Answer 8

I’m reality companies don’t just have debt capital of equity capital they have a blend of the two which is what this approach looks at

Question 9

Example of weighted average

Answer 9

Equity - 5 mil shares @ £2.18 with dividend of 32c

Debt - £4m 8% debenture quoted at 92

Start with equity. Use the cost of equity formula

D0 1+g / P0 + g

G is growth but as it’s constant dividend it’s just 32/2.18 = 14.68%

Cost of debt

If not mention of redemption assume it’s irredeemable

(8 x 70% ) / 92 = 6.09%

To get overall we take weighted average

Equity - 14.68%
Debt - 6.09%

We weight it by the total market values of each

Equity - 5 mil shares X £2.18= £10.9m

Debt - 4 mil debts X (92/100) = £3.68m

Total is 14.58m therefore

Equity = 10.9 / 14.58 x 14.68% = 10.975

Debt = 3.68 /14.58 x 6.09% = 1.537

Total is 12.51%