Chapter 17 - The cost of capital Flashcards
The discount rate used in investment appraisal, known as the cost of capital represents what?
the company’s costs of long-term finance
If an investor takes on higher risk in their investment, they will seek what?
a higher return
What are the steps in calculating a cost of capital?
- Identify the sources of finance used
- for each type calculate the cost
- calculate a weighted average of all the costs
The cost of each source of finance can be equated with what?
the return that the providers of finance (investors) are demanding on their investment
PV of future returns discounted at investors’ required return less what equals 0?
MV of investment
What does the market value of investment equal in a perfect market?
PV of expected future returns discounted at the investors required rate of return
What is the perpetuity calculation?
future cash flow value / r
What does the investors’ rate of return equal?
IRR of investing at current market price and receiving the future expected returns
What is the dividend valuation model (DVM) with no growth in dividends calculation?
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)
What is the ex-div share price calculation?
Cum-div share price - dividend due
What is the DVM with dividend growth at a fixed rate (in exam)?
re = (Do (1+g) / Po) + g
Do = current div
D1 = div in 1 years time
g = constant rate of growth in dividends
What calculation would we use to find the DVM with growth?
(D1 / Po) + g
What is the calculation for estimating growth for past dividends?
g = ([Do/Dn] ^1/n) -1
Dn = dividend n years ago
n = number of years of growth
What is the calculation for earnings retention model (Gordon’s growth model) (in exam)?
g = bre
b = earnings retention rate
re= accounting rate of return
How do we calculate earnings retained?
Profit after tax - dividends
How do we calculate the earnings retention rate (b)?
Retained earnings / PAT
How do we calculate the accounting rate of return on equity (r)?
Profit after tax / equity at start of the year
What is the calculation for the cost of preference shares?
Kp = D / Po
Kp = cost of the preference share
D = constant annual preference dividend
Po= ex div market price of a share
What is one of the main difference when it comes to debt finance in comparison to equity finance?
that interest paid on debt is a tax-deductible expense for the company
How do we calculate the post tax figure?
Interest amount x ( 1 - tax rate)
Debt is always quoted in what?
$100 nominal blocks
Interest paid on the debt is stated as what?
a percentgae of nominal value, called the coupon rate
What is Ex-interest and cum-interest?
Ex - after interest
cum - before interest
What is the impact on tax relief?
companies receive tax relief on interest payments
What are the calculations for irredeemable debt?
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
When an investor invests in a bond, loan note etc they receive a return known as what?
a yield
The return received by the investor when they invest in bond, loan note etc is in the form of what?
the interest received and if redeemable also the redemption amount due to be received on the redemption date
The return received is also known as what?
the yield to maturity
What does the yield to maturity represent?
the effective average annual percentage return to the investor, relativ to the current market value of the bond
What is the calculation for the YTM for irredeemable debt?
interest / bond price x 100
What is the calculation for the YTM for redeemable debt?
the internal rate of return (IRR) of the bond price, the annual interest received and the final redemption amount
What is the IRR in relation to the redeemable debt?
where the rate of return where the NPV = zero
What is the calculation for the IRR?
L + [NL / (NL - NH)] x (H - L)
What is the calculation for the investor return (kd)?
T0 MV (x)
T1-n Interest payments x
Tn Capital repayment x
What is the calculation for the cost of debt (kd (1-T))?
T0 MV (x)
T1-n Interest payments x (1-T) x
Tn Capital repayment x
A company may offer convertible debt to investors to give what?
to give them more choice about the type of lending they make
What is the calculation for non-tradeable debt?
cost to company = Interest rate x (1-T)
What is the calculation for the cost of a bank loan that a company is taking out?
Kd = r (1-T)
What do Ve and Vd represent in the WACC calculation?
the values of the long-term funding sources
How do we extend the WACC calculation when would we do this?
Ve + Vd1 + Vd2 + Vp
When a company has ordinary shares, preference shares and two sources of long-term debt
What is WACC used for?
funds for each source of long-term finance are pooled together an used to finance the various investment projects
When would we use the existing WACC?
-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
Risk has a direct impact on what?
on the return that investors are willing to accept on their investments
The total return demanded by an investor is dependent on what 2 specific factors?
- the prevailing risk-free rate (Rf) of return
- the reward investors demand for the risk they take in advancing funds to the firm
What is the risk-free rate (Rf)?
the minimum rate required by all investors for an investment whose returns are certain
Are loan notes riskier than government gilts?
yes
Are loan notes riskier than equity investment and why?
No because:
- interest is a legal commitment
- interest will be paid before any dividends
- loans are often secured
The return required by equity investors can be shown as what?
Required return = risk-free return + risk premium
What does the capital asset pricing model calculate?
the required return from an investment given the level of risk associated with the investment
What is systematic risk?
caused by general, macroeconomic factors (recession, interest rates, exchange rates)
What is unsystematic risk?
Caused by factors specific to the company or industry (system failures, R+D, success, strikes)
As an investor increases the size of their portfolio does what to the overall risk?
reduces risk
If an investor has approx. 15-20 well-chosen shares in their portfolio what happens to unsystematic risk?
it will be eliminated
Can systematic risk be eliminated by diversification?
no
What is beta factor?
a measure of the systematic risk of investment i relative to the market
What does B (beta) = 1 give in terms of risk?
denotes average systematic risk
What does B (beta) > 1 give in terms of risk?
for a riskier than average investment
What does B (beta) < 1 give in terms of risk?
lower risk than average investment
What would a beta of 1.80 mean?
that a company is 80% more exposed than the average company
What does E(ri) stand for in the CAPM calculation?
required rate of return of the investor (equivalent to Ke)
What does Rf stand for in the CAPM calculation?
risk free rate of return - the return that can be earned on government debt
What does Bi stand for in the CAPM calculation?
the company specific level of exposure to systematic risk
What does E(rm) stand for in the CAPM calculation?
the market return - the average return that an investor will get for investing in shares
What does E(rm) - Rf stand for in the CAPM calculation?
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
