Chapter 9 - Cost of capital Flashcards
What is the cost of equity finance?
The return investors expect to receive on their shares
What are the three assumptions with the dividend valuation model?
- Future income is in dividends
- Dividends paid in perpetuity
- Dividends are constant growing at a fixed rate
What is the share price using the dividend valuation model?
Dividends paid in perpetuity discounted at shareholders rate of return
What is the formula for the share price using DVM?
P0 = D/re
re is shareholder required return
What are two weaknesses of DVM?
- Input data may be inaccurate
- Growth in earnings is ignored
What is the formula for cost of preference shares?
ke = D/P0
What is the risk free rate of return? (Rf)
This is the minimum rate of return required by all investors for an investment who’s return is certain.
What is risk free rate of return given as in a question?
- Return on treasury bills
- Return on government guilts
What is the creditor hierachy?
- Secured lenders
- Legally protected creditors (tax authorities)
- Unsecured creditors
- Preference shareholders
- Ordinary shareholders
What does the CAPM estimate?
Estimates the cost of equity
What is reducing risk by combining investments known as?
Diversification
What is systematic risk?
The market wide factors due to the state of the economy
What is unsystematic risk?
The company / industry specific factors
What does the CAPM show?
The minimum required return on a quoted security dependent on its risk
What is the risk premium comprised of?
Relative level of systematic risk x market risk premium for a specific investment
Bi
Systematic risk of an investment in relation to the market
What are the four assumptions for the CAPM?
- 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
What are three advantages of CAPM?
- works well in practice
- focuses on systematic risk
- Useful for appraising specific projects
What are three disadvantages of CAPM?
-Less useful if investors are undiversified
-Ignores tax situations of investors
Actual data inputs are estimates and may be hard to obtain
What does the asset beta (Ba) represent for a business?
βAsset reflects purely the systematic risk of the business area
What does the equity beta (Ba) represent for a business?
βEquity reflects the systematic risk of the business area and the company-specific financial structure.
Whats the process for using betas for project appraisal?
- 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
