Chapter 5: Estimating cost of capital/debt/shares & WACC Flashcards
What is Cum-Div
If about to be paid ‘Cum Div’ is with or before dividend has been paid
what is Ex Div
Ex Div - ‘After Div’ has been paid
Cost of equity - Dividend Growth Model
Formula given in the exam
What does the following abbreviations mean?
Po
Do
g
Re/Ke
Using the formula for the growth rate you use for example 6% as 0.06
Po - Current ex-div share price (after the dividend has been paid)
Do - Current Dividend
g - Constant growth in dividend
Re/Ke - Return on equity or the cost of equity
Weaknesses of the dividends growth model are:
-Too simplistic as most companies do not pay a constantly growing dividend
-Identifying an ex div share price is difficult for listed companies and very difficult for unlisted companies
Estimating growth (g)
Historic method
Earnings retention method
Historic Method
New div= Old div x (1+g)^n
Rearrange for g
Retention method
g=retention*%return on investments
Retention = 1 - payout ratio
payout ratio example: Profits 100 dividend 25 therefore retention 75
Cost of equity - Capital Asset Pricing model (CAPM)
Using:
Ke = rf + Beta(rm-rf)
also what is risk premium
Ke = Cost of equity
rf = risk free return
Beta = measure of systematic risk
rm=expected return
if you get risk premium that is rm - rf
Capital Asset Pricing Model (CAPM) - theory
Unsystematic risk
Systematic risk
Unsystematic risk
-Company specific
-Can be diversified away (15-20 securities to reduce)
Systematic risk (market risk)
-Cannot be diversified
-affected by macroeconomic factors eg interest rates, inflation etc
1 security - high portfolio risk
15-20 security - lower portfolio risk
CAPM - understanding beta
Shareholders are only concerned by the impact of a new investment on their exposure to systematic risk (market risk) - measured by a Beta Factor
Investments is riskier than average - B>1
Investments is less risky than average B<1
Risk free B=0
Adv and disadv of CAPM
Adv
-Directly links risk and returns
-used to calc cost of equity when dividend are not growing constantly
disadv
-only can be used when investors are diversified
-assumes all components are constant (linear)
-assumes capital markets are perfect ie no trans cost and no dominant investor
-assumes investors can invest and borrow at the risk free rate
Estimating cost of debt
Irredeemable debt
5% interest = $5
as always based on $100 nominal value or par value
Kd = I(1-t) / Po
I = interest
t = tax
Po = Current ex-interest debt price
if you get cum-interest price
do cum interest price - interest
Estimating cost of debt
Redeemable debt
using IRR in excel
Layout in excel
Row 1 - Po (current ex interest debt price)
row 2 - I(1-t) Interest being $ value t=tax
row 3 - Re - redemption value (based on nominal value)
Convertible debt - will the investor redeem the debt in year N or convert it to shares
If you are not told the expected market value of the shares at the time of conversion it can be estimated how?
MV of the ordinary shares now x (1+g)^n
= MV in n years time
Preference shares - similar to ordinary shares expect the dividends are constant and so there is no growth
Formula:
Kp = Do/Po
Kp = cost of preference shares
Do = dividend paid
Po = Current ex div share price
Cost of Bank debt formula
Kb = i(1-t)
Calc WACC - MV
Ke x MVe / SumMV
Kd x MVd / SumMV
Kp x MVp / SumMV
Kb x MVb / SumMV
Why is market value WACC preferred to book value WACC:
Weightings used in WACC need to reflect the relative importance of different sources of finance used.
Equity book value is normally much lower than market value and so if book value was used then this would underestimate the Ke impact on WACC.
This would therefore understate the WACC and lead to sub optimal decisions. Note that debt normally trades close to book value so this has less impact.
