Cost of Capital Flashcards
Dividend valuation model (Gordon growth model)
~ current share price is determined by the anticipated divs
~ assumes divs are paid annually
~ formula given in exams
Cum-div price
the share price when the price rises in anticipation of a dividend payment
Ex-div price = (formula)
Cum-div price - Do
Growth: retention (formula)
g = rb
= (PAT/ net assets bf) x [(PAT - Div)/PAT]
Earnings retention model (Gordon growth model)
growth estimate is based on idea that retained profits are the only source of funds
(growth formula)
Problems with Earnings retention model
~ assumes r and b will be constant
~ relies on accounting profit
~ assumes all new finance comes from equity (ignores debt)
Shortfalls of dividend valuation model
~ assumes shares have value because of dividend (not always true)
~ assumes divs do not grow, or grow at consant rate (not true)
~ share price subject to volatility
Captial Asset Pricing Model (CAPM)
~ provides relationship between risk and return
~ alternative to dividend valuation model for deriving cost of equity
(formula given in exam)
Cost of Preference Shares (formula)
Kp = D/ Po D = constant annual dividend Po = ex-div MV
Effect of tax (formula)
Net of tax cost of debt = pre-tax cost of debt x (1 - T)
Irredeembale debt (formula)
Kd = Int x (1 - T)/ Po Po = price of bond ex-interest Int = interest paid on bond Kd = required return of debt holder
Redeemable debt (formula)
Kd = IRR x (1 - T)
IRR: T 0 MV 1-n Int n Redemption/Conversion
Growth: extrapolation (formula)
g = n sqrt (Do/ Dn) -1 Do = div per share now Dn = div per share then
IRR
= a + (b - a) x NPVa/ (NPVa - NPVb)
a = lower DF
Convertible Debt
~ compare redemption value to conversion value (using redeemable debt calc)
~ choose higher of the two
