Chapter 3 - WACC

Question 1

What is the Weighted average cost of capital ?

Answer 1

The weighted average cost of capital represents the average cost of a company’s finances weighted by the proportion each element makes up in the pool of funds.

Question 2

How do you calculate the WACC?

Answer 2

WACC=(Ve/(Ve+Vd))Ke+(Vd/(Ve+Vd))Kd * (1-t)

Ve= Market value of equity
Vd = Market value of debt
Ke= cost of equity
Kd= cost of debt
t = tax rate

Question 3

What are the Key assumptions needed to evaluate investments with WACC?

Answer 3

• No change in capital structure i.e gearing is optimal
• No change from business risk
• Projects are small relative to company
• Perfect capital markets

Question 4

How do you calculate market values of sources of financing ?

Answer 4

Ordinary shares & Preference : ex-div value * # of shares in issue

Debentures: (Book value * Market value)/ 100

Bank loans : Book value

Question 5

How do you calculate the cost of equity?

Answer 5

Ke = ([Do * (1 + g)]/Pex-div) + g

Do= current divided
g = divided growth rate
Pex-div = Ex-div market price
Ke = cost of equity

Question 6

What is the difference between cum-div & ex-div ?

Answer 6

Cum-div : price immediately before dividend
Ex-div : price immediately after dividend

Pcum-div = Pex-div + Do

Question 7

How do you calculate the dividend growth rate using the historic method ?

Answer 7

g = Root(n, (Do/Dn)) - 1

g = divided growth rate
n = number of years
Do = current dividend
Dn = divided @ year n

Question 8

How do you calculate dividend growth rate using Gordon growth model?

Answer 8

g = r * b

r = return on reinvested funds
b = proportion of funds retained
g = dividend growth rate

Question 9

How do you calculate the cost of preference shares ?

Answer 9

Ke = Do/Pex-div

Ke = cost of equity
Do = current dividend
Pex-div = Ex-div market price

Question 10

How do you calculate the cost of non-tradable debt ?

Answer 10

Kd = interest rate % * (1-t)

Question 11

What types of tradable debt exist?

Answer 11

• Irredeemable
• Redeemable
• Convertible

Question 12

How do you calculate the cost of Irredeemable debt ?

Answer 12

Kd = I(1-t)/Pex-int

I = Coupon interest rate

Question 13

How do you calculate the cost of redeemable debt ?

Answer 13

You need to calculate the IRR using the following time-formula variable:

T0} Pex-int
T1-n} I(1-t) = annual coupon interest rate
Tn} RV = Redeemable value of debt

Question 14

How do you calculate the cost of convertible debt ?

Answer 14

You use the same formula as redeemable debt but

Rv = to the greater of either the convertible share value or the cash redemption value