Chapter 5 Flashcards
What is cost of capital?
Minimum return required when using company funds
What is cost of equity?
The minimum return that shareholders require from the funds they have invested in the company
Two ways of estimating cost of equity?
Dividend valuation model
CAPM
What is the dividend valuation mode and how is it calculated?
Calculates current price of an ordinary share as the present value of a stream of consistently growing dividends
P0= D0(1+g)/ (ke -g)
P0 current ex div share price
D0 current dividend
G: constant growth in diva
Ke: return on equity or cost of equity
Pros and cons of dividend valuation model?
Pro:
Calculates cost of equity based on current market data
Cons:
Constant div growth assumed
Model falls down if g>ke
Identifying ex div share price is difficult for listed companies and very difficult for unlisted companies so model is based on esimtates
Assumes worth for shareholders is only represented by dividends (what if company is retaining profits to invest, causing a low dividend?)
What are the two methods for estimating growth rates?
- annualisijg growth rate as a geometric avg of the histocial dividend stream
=power(most recent value/oldest value , 1/ number of periods of GROWTH)
- earnings retention model
G=rb
G= growth in future dividends
R= current AROR =PAT/opening shareholder funds
B= proportion of profits retained
What are the 4 problems with using the earnings retention model to estimate growth rates (g)
- reliance on accounting profits: easily manipulated
- assumption that R and B are constant
- inflation can substantially distort the AROR if assets valued on historical cost basis
- model also assumes all new finance comes from equity
What can the CAPM be used to determine and what is the formula?
Used to determine cost of equity of a company based on its exposure to systematic risk
Ke= rf + bj (rm - rf)
Ke= cost of equity
Rf= risk free rate of interest
Rm= return on market portfolio
B= measure of company’s exposure to systematic risk
How do you calculate cost of preference shares?
Usually have constant annual div and value can be considered to be the pv of the future dividends at the cost of preference shares
P0 = d/ kp
D is constant annual dividend
P0 is ex dividend market values
Can be rearranged to find cost of preference shares kp= D/P0
How do you calculate cost of redeemable debt?
Future cash flows include both interest and redemption payments
Use rate=(number of periods, payment, PV, future value, type, guess
Payment is anount of interest paid in any single period
PV is current market value of the asset (the bond) ex interest and inserted as a negative number
FV is the redemption value (amount paid at maturity)
Type and guess can be left blank
This gives the gross redemption yield, which is the pre tax cost of debt. Must be multiplied by (1-T) to find the post tax cost of debt
What is convertible debt and how do you calculate it?
At the end of debts life it can either be redeemed or converted into a certain number of ordinary shares
1) find expected share price at conversation date. If not told, can be estimated as followed (price now x (1+g) = price in n years time)
2) redemption value will then be included as the HIGHER of possibly redemption cash flow and the value of the conversion to shares
3) post tax cost of debt is then IRR of future cash flows and the current market value multipled by (1-T)
When should we use WAAC? What are the four requirement s
Reflects company’s existing business risk and capital structure hence we may use the current WAAC to appraise new projects so long as :
The new project has the same business risk as our existing operations
There will be no change in the long term capital structure of company
We are not using project specific finance (eg government grants)
The project is relatively small (so its NPV will not have a significant effect on MV of equity)
What are two other problems with the WAAC?
- which sources of finance to include : we naturally use long term sources of finance in our WAAC calculations, but include short term finance if it is clear it is being used to fund long term projects
-how to deal with loans that do not have MVs: such as bank loans. Most practical approach is to take the book value of the loans as an approx to MV and use the interest rate (adjusted for tax relief) currently payable on the loan as the cost of the loab
