Cost of Capital

Question 1

How do you reach a suitable discount rate?

Answer 1

Calculate the cost of each source of long term finance separately and the combine them to get WACC.

Question 2

D0=

Answer 2

dividend just paid.

Question 3

P0=

Answer 3

ex-div market share price.

Question 4

g=

Answer 4

growth.

Question 5

Rf=

Answer 5

risk free rate.

Question 6

Rm=

Answer 6

average market return.

Question 7

β=

Answer 7

beta factor.

Question 8

How do you calculate Kp?

Answer 8

D/P0

Question 9

D=

Answer 9

constant dividend.

Question 10

How do you calculate Kd?

Answer 10

Yield(1-T)

Question 11

How do you calculate yield? Redeem/Irredeem

Answer 11

IRR with 2 DFs or I/P0

Question 12

T=

Answer 12

corporation tax rate.

Question 13

I=

Answer 13

interest paid.

Question 14

What 5 assumptions are made when using the DVM model?

Answer 14

• Perfect markets.
• All investors have the same expectations.
• Constant growth in dividends.
• Interim dividends ignored.
• Personal tax issues ignored.

Question 15

Name 2 issues with Ke.

Answer 15

• Share prices change so P0 can be inaccurate.

- Difficult to predict growth.

Question 16

What should you do if gearing isn’t constant?

Answer 16

Use APV.

Question 17

What should you do if business risk isn’t constant?

Answer 17

Use CAPM to generate Ke.

Question 18

What is the Gordon Growth Model?

Answer 18

g=r(accounting rate of return on new investment) x b(earnings retention rate)

Question 19

What are the 5 limitations of the Gordon growth model?

Answer 19

• Relies on accounting profits.
• Assumes b and r are constant.
• Can be distorted by inflation.
• Relies on historic information.
• Assumes all new finance is from equity and gearing is constant.

Question 20

Market Premium=

Answer 20

(Rm-Rf)

Question 21

Dividend in 2016 was £10 and in 2020 it was £20. How do you calculate the average growth?

Answer 21

(20/10)^(1/4) - 1

Question 22

How do you calculate “r” (accounting rate of return on new investment)?

Answer 22

Earnings/(£1/50p ordinary share capital+RE at the start of the year)

Question 23

How do you calculate “b” (earnings retention rate)?

Answer 23

(Earnings-Dividend paid)/Earnings

Question 24

Should you include a “Special Dividend” when calculating the DVM, and why?

Answer 24

No, as it’s a one off. STATE THIS.