Chapter 17 - The cost of capital

Question 1

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

Answer 1

the company’s costs of long-term finance

Question 2

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

Answer 2

a higher return

Question 3

What are the steps in calculating a cost of capital?

Answer 3

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

Question 4

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

Answer 4

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

Question 5

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

Answer 5

MV of investment

Question 5

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

Answer 5

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

Question 5

What is the perpetuity calculation?

Answer 5

future cash flow value / r

Question 6

What does the investors’ rate of return equal?

Answer 6

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

Question 6

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

Answer 6

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)

Question 7

What is the ex-div share price calculation?

Answer 7

Cum-div share price - dividend due

Question 8

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

Answer 8

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

Question 9

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

Answer 9

(D1 / Po) + g

Question 10

What is the calculation for estimating growth for past dividends?

Answer 10

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

Question 11

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

Answer 11

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

Question 12

How do we calculate earnings retained?

Answer 12

Profit after tax - dividends

Question 13

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

Answer 13

Retained earnings / PAT

Question 14

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

Answer 14

Profit after tax / equity at start of the year

Question 15

What is the calculation for the cost of preference shares?

Answer 15

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

Question 16

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

Answer 16

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

Question 17

How do we calculate the post tax figure?

Answer 17

Interest amount x ( 1 - tax rate)

Question 18

Debt is always quoted in what?

Answer 18

$100 nominal blocks

Question 19

Interest paid on the debt is stated as what?

Answer 19

a percentgae of nominal value, called the coupon rate

Question 19

What is Ex-interest and cum-interest?

Answer 19

Ex - after interest
cum - before interest

Question 19

What is the impact on tax relief?

Answer 19

companies receive tax relief on interest payments

Question 20

What are the calculations for irredeemable debt?

Answer 20

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

Question 21

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

Answer 21

a yield

Question 22

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

Answer 22

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

Question 23

The return received is also known as what?

Answer 23

the yield to maturity

Question 24

What does the yield to maturity represent?

Answer 24

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

Question 25

What is the calculation for the YTM for irredeemable debt?

Answer 25

interest / bond price x 100

Question 26

What is the calculation for the YTM for redeemable debt?

Answer 26

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

Question 27

What is the IRR in relation to the redeemable debt?

Answer 27

where the rate of return where the NPV = zero

Question 28

What is the calculation for the IRR?

Answer 28

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

Question 29

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

Answer 29

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

Question 30

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

Answer 30

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

Question 31

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

Answer 31

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

Question 32

What is the calculation for non-tradeable debt?

Answer 32

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

Question 33

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

Answer 33

Kd = r (1-T)

Question 34

What do Ve and Vd represent in the WACC calculation?

Answer 34

the values of the long-term funding sources

Question 35

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

Answer 35

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

Question 36

What is WACC used for?

Answer 36

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

Question 37

When would we use the existing WACC?

Answer 37

-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

Question 38

Risk has a direct impact on what?

Answer 38

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

Question 39

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

Answer 39

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

Question 40

What is the risk-free rate (Rf)?

Answer 40

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

Question 41

Are loan notes riskier than government gilts?

Answer 41

yes

Question 42

Are loan notes riskier than equity investment and why?

Answer 42

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

Question 43

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

Answer 43

Required return = risk-free return + risk premium

Question 44

What does the capital asset pricing model calculate?

Answer 44

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

Question 45

What is systematic risk?

Answer 45

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

Question 46

What is unsystematic risk?

Answer 46

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

Question 47

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

Answer 47

reduces risk

Question 48

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

Answer 48

it will be eliminated

Question 49

Can systematic risk be eliminated by diversification?

Answer 49

no

Question 50

What is beta factor?

Answer 50

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

Question 51

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

Answer 51

denotes average systematic risk

Question 52

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

Answer 52

for a riskier than average investment

Question 53

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

Answer 53

lower risk than average investment

Question 54

What would a beta of 1.80 mean?

Answer 54

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

Question 55

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

Answer 55

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

Question 56

What does Rf stand for in the CAPM calculation?

Answer 56

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

Question 57

What does Bi stand for in the CAPM calculation?

Answer 57

the company specific level of exposure to systematic risk

Question 58

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

Answer 58

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

Question 59

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

Answer 59

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