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FM - Financial Management > Chapter 17 - The cost of capital > Flashcards

Chapter 17 - The cost of capital Flashcards

1
Q

The discount rate used in investment appraisal, known as the cost of capital represents what?

A

the company’s costs of long-term finance

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2
Q

If an investor takes on higher risk in their investment, they will seek what?

A

a higher return

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3
Q

What are the steps in calculating a cost of capital?

A
  1. Identify the sources of finance used
  2. for each type calculate the cost
  3. calculate a weighted average of all the costs
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4
Q

The cost of each source of finance can be equated with what?

A

the return that the providers of finance (investors) are demanding on their investment

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5
Q

PV of future returns discounted at investors’ required return less what equals 0?

A

MV of investment

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5
Q

What does the market value of investment equal in a perfect market?

A

PV of expected future returns discounted at the investors required rate of return

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5
Q

What is the perpetuity calculation?

A

future cash flow value / r

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6
Q

What does the investors’ rate of return equal?

A

IRR of investing at current market price and receiving the future expected returns

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6
Q

What is the dividend valuation model (DVM) with no growth in dividends calculation?

A

re = D / Po
re= shareholders’ required return, expressed as a decimal
D = constant dividend from year 1 to finity
Po = ex div market price of a share (ex div = AFTER dividend paid)

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7
Q

What is the ex-div share price calculation?

A

Cum-div share price - dividend due

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8
Q

What is the DVM with dividend growth at a fixed rate (in exam)?

A

re = (Do (1+g) / Po) + g
Do = current div
D1 = div in 1 years time
g = constant rate of growth in dividends

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9
Q

What calculation would we use to find the DVM with growth?

A

(D1 / Po) + g

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10
Q

What is the calculation for estimating growth for past dividends?

A

g = ([Do/Dn] ^1/n) -1
Dn = dividend n years ago
n = number of years of growth

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11
Q

What is the calculation for earnings retention model (Gordon’s growth model) (in exam)?

A

g = bre
b = earnings retention rate
re= accounting rate of return

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12
Q

How do we calculate earnings retained?

A

Profit after tax - dividends

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13
Q

How do we calculate the earnings retention rate (b)?

A

Retained earnings / PAT

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14
Q

How do we calculate the accounting rate of return on equity (r)?

A

Profit after tax / equity at start of the year

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15
Q

What is the calculation for the cost of preference shares?

A

Kp = D / Po
Kp = cost of the preference share
D = constant annual preference dividend
Po= ex div market price of a share

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16
Q

What is one of the main difference when it comes to debt finance in comparison to equity finance?

A

that interest paid on debt is a tax-deductible expense for the company

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17
Q

How do we calculate the post tax figure?

A

Interest amount x ( 1 - tax rate)

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18
Q

Debt is always quoted in what?

A

$100 nominal blocks

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19
Q

Interest paid on the debt is stated as what?

A

a percentgae of nominal value, called the coupon rate

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19
Q

What is Ex-interest and cum-interest?

A

Ex - after interest
cum - before interest

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19
Q

What is the impact on tax relief?

A

companies receive tax relief on interest payments

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20
Q

What are the calculations for irredeemable debt?

A

Kd = I/MV (investor)

‘Kd(1-T)’ = I(1-T) / MV (company)

Kd = debt holders’ required rate of return
I = annual interest starting in 1 years time
MV = ex-int market price of the loan note
‘Kd(1-T)’ = cost of debt to the company
T= rate of corporation tax

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21
Q

When an investor invests in a bond, loan note etc they receive a return known as what?

A

a yield

22
Q

The return received by the investor when they invest in bond, loan note etc is in the form of what?

A

the interest received and if redeemable also the redemption amount due to be received on the redemption date

23
Q

The return received is also known as what?

A

the yield to maturity

24
Q

What does the yield to maturity represent?

A

the effective average annual percentage return to the investor, relativ to the current market value of the bond

25
Q

What is the calculation for the YTM for irredeemable debt?

A

interest / bond price x 100

26
Q

What is the calculation for the YTM for redeemable debt?

A

the internal rate of return (IRR) of the bond price, the annual interest received and the final redemption amount

27
Q

What is the IRR in relation to the redeemable debt?

A

where the rate of return where the NPV = zero

28
Q

What is the calculation for the IRR?

A

L + [NL / (NL - NH)] x (H - L)

29
Q

What is the calculation for the investor return (kd)?

A

T0 MV (x)
T1-n Interest payments x
Tn Capital repayment x

30
Q

What is the calculation for the cost of debt (kd (1-T))?

A

T0 MV (x)
T1-n Interest payments x (1-T) x
Tn Capital repayment x

31
Q

A company may offer convertible debt to investors to give what?

A

to give them more choice about the type of lending they make

32
Q

What is the calculation for non-tradeable debt?

A

cost to company = Interest rate x (1-T)

33
Q

What is the calculation for the cost of a bank loan that a company is taking out?

A

Kd = r (1-T)

34
Q

What do Ve and Vd represent in the WACC calculation?

A

the values of the long-term funding sources

35
Q

How do we extend the WACC calculation when would we do this?

A

Ve + Vd1 + Vd2 + Vp
When a company has ordinary shares, preference shares and two sources of long-term debt

36
Q

What is WACC used for?

A

funds for each source of long-term finance are pooled together an used to finance the various investment projects

37
Q

When would we use the existing WACC?

A

-if historic proportions of debts and equity are not to be changed
- if the operating risk of the business will not be changed
- if the finance is not project-specific
or
the project is small in relation to the company so any of these changes are insignificant

38
Q

Risk has a direct impact on what?

A

on the return that investors are willing to accept on their investments

39
Q

The total return demanded by an investor is dependent on what 2 specific factors?

A
  • the prevailing risk-free rate (Rf) of return
  • the reward investors demand for the risk they take in advancing funds to the firm
40
Q

What is the risk-free rate (Rf)?

A

the minimum rate required by all investors for an investment whose returns are certain

41
Q

Are loan notes riskier than government gilts?

A

yes

42
Q

Are loan notes riskier than equity investment and why?

A

No because:
- interest is a legal commitment
- interest will be paid before any dividends
- loans are often secured

43
Q

The return required by equity investors can be shown as what?

A

Required return = risk-free return + risk premium

44
Q

What does the capital asset pricing model calculate?

A

the required return from an investment given the level of risk associated with the investment

45
Q

What is systematic risk?

A

caused by general, macroeconomic factors (recession, interest rates, exchange rates)

46
Q

What is unsystematic risk?

A

Caused by factors specific to the company or industry (system failures, R+D, success, strikes)

47
Q

As an investor increases the size of their portfolio does what to the overall risk?

A

reduces risk

48
Q

If an investor has approx. 15-20 well-chosen shares in their portfolio what happens to unsystematic risk?

A

it will be eliminated

49
Q

Can systematic risk be eliminated by diversification?

A

no

50
Q

What is beta factor?

A

a measure of the systematic risk of investment i relative to the market

51
Q

What does B (beta) = 1 give in terms of risk?

A

denotes average systematic risk

52
Q

What does B (beta) > 1 give in terms of risk?

A

for a riskier than average investment

53
Q

What does B (beta) < 1 give in terms of risk?

A

lower risk than average investment

54
Q

What would a beta of 1.80 mean?

A

that a company is 80% more exposed than the average company

55
Q

What does E(ri) stand for in the CAPM calculation?

A

required rate of return of the investor (equivalent to Ke)

56
Q

What does Rf stand for in the CAPM calculation?

A

risk free rate of return - the return that can be earned on government debt

57
Q

What does Bi stand for in the CAPM calculation?

A

the company specific level of exposure to systematic risk

58
Q

What does E(rm) stand for in the CAPM calculation?

A

the market return - the average return that an investor will get for investing in shares

59
Q

What does E(rm) - Rf stand for in the CAPM calculation?

A

Difference between the market return and the risk free rate shows the extra return that is earned on the shares, because of their exposure to systematic risk

FM - Financial Management (20 decks)

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