Chapter 9 - Cost of capital

Question 1

What is the cost of equity finance?

Answer 1

The return investors expect to receive on their shares

Question 2

What are the three assumptions with the dividend valuation model?

Answer 2

• Future income is in dividends
• Dividends paid in perpetuity
• Dividends are constant growing at a fixed rate

Question 3

What is the share price using the dividend valuation model?

Answer 3

Dividends paid in perpetuity discounted at shareholders rate of return

Question 4

What is the formula for the share price using DVM?

Answer 4

P0 = D/re

re is shareholder required return

Question 5

What are two weaknesses of DVM?

Answer 5

• Input data may be inaccurate

- Growth in earnings is ignored

Question 6

What is the formula for cost of preference shares?

Answer 6

ke = D/P0

Question 7

What is the risk free rate of return? (Rf)

Answer 7

This is the minimum rate of return required by all investors for an investment who’s return is certain.

Question 8

What is risk free rate of return given as in a question?

Answer 8

• Return on treasury bills

- Return on government guilts

Question 9

What is the creditor hierachy?

Answer 9

• Secured lenders
• Legally protected creditors (tax authorities)
• Unsecured creditors
• Preference shareholders
• Ordinary shareholders

Question 10

What does the CAPM estimate?

Answer 10

Estimates the cost of equity

Question 11

What is reducing risk by combining investments known as?

Answer 11

Diversification

Question 12

What is systematic risk?

Answer 12

The market wide factors due to the state of the economy

Question 13

What is unsystematic risk?

Answer 13

The company / industry specific factors

Question 14

What does the CAPM show?

Answer 14

The minimum required return on a quoted security dependent on its risk

Question 15

What is the risk premium comprised of?

Answer 15

Relative level of systematic risk x market risk premium for a specific investment

Question 16

Bi

Answer 16

Systematic risk of an investment in relation to the market

Question 17

What are the four assumptions for the CAPM?

Answer 17

• Well diversified investors
• Perfect capital markets
• Unrestricted borrowing at risk free rate of interest
• All forecasts are made in the context of a single period transaction horizon

Question 18

What are three advantages of CAPM?

Answer 18

• works well in practice
• focuses on systematic risk
• Useful for appraising specific projects

Question 19

What are three disadvantages of CAPM?

Answer 19

-Less useful if investors are undiversified
-Ignores tax situations of investors
Actual data inputs are estimates and may be hard to obtain

Question 20

What does the asset beta (Ba) represent for a business?

Answer 20

βAsset reflects purely the systematic risk of the business area

Question 21

What does the equity beta (Ba) represent for a business?

Answer 21

βEquity reflects the systematic risk of the business area and the company-specific financial structure.

Question 22

Whats the process for using betas for project appraisal?

Answer 22

• Fund asset beta using the comparable companies gearing and equity beta
• Use the Asset beta with our companies gearing to find the equity beta
• Use the formula to find the Ke