Chapter 3 - Cost Of Capital

Question 1

Dividend Valuation Model

Answer 1

Ke = d/p0

d = annual dividend 
p0 = Market price of equity

Question 2

Dividend Growth Model

Answer 2

Ke = [d0(1+g)/p0] + g

Ke = Cost of equity
d0 = annual dividend 
p0 = Market price of share
g = Annual growth of dividend

Question 3

d1 = d0(1 + g)

Answer 3

d1 = Next year’s dividend 
cum-dividend = before dividend 
ex-dividend = after dividend

Question 4

Cost of Debt

Coupon / interest amount

Answer 4

Coupon / interest amounts are based on the face value of the bond

Question 5

Cost of debt

Coupon / interest rate

Answer 5

Calculated on the market value of the debt

Question 6

Irredeemable debt

Answer 6

Kd = i(1+t)/p0

Kd = cost of debt (after tax)
i = annual interest 
t = rate of income tax
p0 = market value of debt

Question 7

Redeemable Debt

Answer 7

Cost of redeemable debt is calculated using an IRR approach.

Question 8

Cost of redeemable debt

Answer 8

Kd = r1 + (NPV1 / NPV1-NPV2) x (r2-r1)

Question 9

Convertible Debt

Answer 9

Redemption payment would become the higher of the market value at year n of the ordinary shares into which the debt is to be converted or the redemption value of the bond

Question 10

Convertible debt

Answer 10

Pn = P0 x (1+g)^n

This is also the compound formula previously seen as:

S = x(1+r)^n

Question 11

Coat of preference shares

Answer 11

Kpref = d/p0

Kpref = cost of preference shares
d = annual dividend 
p0 = current ex-div market price

Question 12

WACC

Answer 12

Found by calculating the cost of each long term source of finance weighted by the proportion of finance used

Question 13

WACC

Answer 13

K0 = ke [Ve/Ve+Vd+Vpref]
+kd [Vd/Ve+Vd+Vpref]
+kpref [Vpref/Ve+Vd+Vpref]

Question 14

Gearing = 40%
Cost of equity = 10%
Cost of debt = 7%

Calculate WACC

Answer 14

WACC = (%age of equity x cost of equity) + (%age of debt x cost of debt)

WACC = (60% x 10%) + (40% x 7%)