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
What are the disadvantages of using WACC?
- Focus on Long Term finance as it’s for long term investment appraisal but should it include short term financing too?
- Bank Loans do not have market values
- Cost of capital for small companies is difficult to obtain as they are usually unquoted and lack liquidity
What are the Conditions to use WACC as a Discount Rate?
- Constant Capital Structure
- New investment must not have a different risk profile
- New investment must be marginal to entity
What is Yield to Maturity (YTM)?
- From investor’s perspective, purchases traded debt instrument and receive return.
- No tax relieve on return
- Effective average annual % return to investor, relative to current market value of bond
What is the formula for Irredeemable Yield to Maturity?
YTM = Annual Interest received/Current Market Value of Debt
What is the formula for Redeemable Yield to Maturity?
YTM = IRR of bond price, net annual interest received & final redemption amount
- YTM = IRR of bond price, net annual interest received & final redemption amount
t0 = (market value) = 98
t1 - 5 = annual interest received = 7 (7% bond)
t5 = 110 (10% premium redeemable in 5 years)
*Use two discount factors approx. 5% apart - IRR = L + [ NPVL / (NPVL-NPVH) ] x (H - L)
Define yield to maturity for reddemable bonds
The internal rate of return of the market value of the bond, the annual interest received and the final redemption amount
Define internal rate of return (IRR)
Annual percentage achieved by a project at which the sum of the discounted cash flows over the life of the project is equal to the sum of the discounted outflows
Define yield to maturity for irredeemable bonds
The effective average annual percenatge return to the investor, relative to the current market value of the bond
Define risk-return relationship
Risk is the main driving force behind the return that is expected by investors.
eg - the higher the risk faced by the investor, the higher the return they will expect
