Chapter 2 Cost of Long term funds Flashcards
Define Cost of Equity
Rate of return required by a shareholder for investing in the business. The cost of equity is expressed as Ke
What is the formula for Cost of Equity (Ke) with a Constant Dividend?
Ke = d/P0
d = constant dividend P0 = Ex div market price
What is the formula for Cost of Equity (Ke) Constant Growth for its dividend?
Ke = { d(1+g) / P0 } + g
g = growth rate d = constant divident P0 = Ex div market price
What is the formula for Estimating Growth based on the Averaging Method?
g = [ n√ (d0/dn) ] - 1
n = period d0 = current dividend dn = dividend n years ago"
What is the formula for Estimating Growth based on the Profit Retention Method?
g = r x b
r = % Rate of Return b = proportion of retained funds
*There are a number of assumptions required to apply this model:
• the entity must be all equity financed
• the retained profits are the only source of additional investment
• a constant proportion of each year’s earnings is retained for reinvestment
• projects financed from retained earnings earn a constant rate of return
What is the formula for Cost of Preference Shares (Kp)?
Kp = d/P0
d = constant dividend P0 = Ex div market price
Define Cost of Debt
- Rate of return debt provider require.
- The value of debt is the present value of cash flows.
- It is tax deductible.
- It is always quoted in $100 nominal value denomination
- Interest is paid aka coupon rate
- It can be redeemed at par, premium or discount
What is the formula for Cost of Debt (Kd) Bank Borrowings?
Kd = r ( 1 - T)
r = annual rate of return T = Tax rate
What is the formula for Cost of Debt (Kd) Irredeemable Bonds?
Kd = i ( 1 - T) / P0
i = interest paid per annum T = Tax rate P0 = Ext Interest market price of bond
What is the Internal Rate of Return?
It is the Discount Rate giving zero Net Present Value.
NPV is used at 2 different discount factors and linear interpolation is used to calculate IRR.
What is the formula for Internal Rate of Return?
IRR = L + [ NPVL / (NPVL-NPVH) ] x (H - L)
L = Lowest Discount Factor % H = Highest Discount Factor % NPVL = Result of Lowest Discount Factor % NPVH = Result of Highest Discount Factor %
List the steps for calculating Cost of Debt (Kd) for Redeemable Bonds
STEP 1: Calculating the NPV for the relevant cash flows using 2 different discount factors
Year 0 = Market Value of Bond x 1: P0
1 to n = Annual Interest Payments without Tax x Cumulative PV % : i (1 - T)
n = Redemption Value of Bond x PV % : $100 or $100 + Prem or Final Convertible Amount
STEP 2: Calculate the IRR using the amounts calculated in step 1
IRR = L + [ NPVL / (NPVL-NPVH) ] x (H - L)
List the steps for calculating Cost of Debt (Kd) for Convertible Bonds
STEP 1: Determine the higher of Cash or Convertible option
Cash = $100 or $100 + Prem Convertible = shares x [Current Market Price x (1+ g)^n]
STEP 2: Calculating the NPV for the relevant cash flows using 2 different discount factors
Year 0 = $100 Nom value
1 to n = Annual Interest Payments without Tax x Cumulative PV % : i (1 - T)
n = Redemption Value of Bond x PV % : $100 or $100 + Prem or Final Convertible Amount
STEP 3: Calculate the IRR using the amounts calculated in step 2
IRR = L + [ NPVL / (NPVL-NPVH) ] x (H - L)
Define Weighted Average Cost of Capital
The average cost of an entity long term funds ( ordinary shares , preferences shares , bank loans and bonds) weighted according to the proportion each type of long term fund bears to the total pool of capital based on market values.
Used as discount rate in NPV calcs
List the steps for calculating WACC
- Calculate weight of each source.
Remember to convert no of shares, shares/bond x market value - Estimate cost of each source using Ke, Kd and Kp calculations
- Multiply weight of each source x cost for each source
- Sum all the Results of step 3
