Cost of capital

Question 1

How do you calculate the WACC?

Answer 1

MV of the capital multiplied by the cost. Sum all of them and divide by the sum of the market value of capital.

Question 2

What is the basic assumption for the cost of equity?

Answer 2

The current price = PV of all future dividends, discounted at the investers required return, Ke. Therefore, Ke is = to the IRR achived by investing the current price and receiving the future dividends.

Question 3

DVM Ke formular

Answer 3

Ke = (D0(1+g))/P0 + g
Where: D0 = current dividend
g = div growth rate
P0 = current share price

Question 4

What happens if a dividnet has not yet been paid?

Answer 4

Known as cummdiv, need to deduct the dividend to get the ex-div price

Question 5

What are the two ways of estimating dividend growth?

Answer 5

1) Extrapolating based on past dividend patterns (historic method)
2) Assuming growth is dependent on the level of earnings retained by the business ( earnings retention model AKA Gordon Growth Model)

Question 6

What do we need to use historic growth model?

Answer 6

A past dividend stream showing reasonably consistent gowth. We can assume this gowth rate will continue indefinitely.

Question 7

Historic method dividend growth formula

Answer 7

g = (D0/dividends n years ago)^(1/n) -1

Question 8

What is the assumption of the Gordon Growth Model?

Answer 8

The higher the level of retentions in a business, the higer the potential growth rate of dividends.

Question 9

Gordoen growth rate formular

Answer 9

g = r x b
Where: r = accounting rate of return on new investment
b = earnings retention rate

Question 10

How are share issues delt with under the historic growth model?

Answer 10

New issue or rights issue - more shares but also more funds, therefore earnings potential has increased. Make sure dividends per share and carry on as normal.

Bonus issue - more shared but no new money, this will reduce the div per share. Adjust the origional dividend (n years ago) by the number of shares in issue after the bonus issues.

Question 11

What is the assumptions for cost of preference shares?

Answer 11

Same as for Ke, but dividends do not grow

Question 12

Kp formaula

Answer 12

Kp = D / P0

Where D is the dividend (constant) and P0 is the current exdiv market price

Question 13

What is the basic assumption of the cost of irredeemable debt?

Answer 13

Current price = Presnt value of the future income stream recieved in perpetuity discounted at the investor’s required rate of return.

Therefore the investors required rate of return = the IRR achieved by investing at the current price and recivign future interest.

Question 14

Cost of iredeemable debt formular

Answer 14

Kd = (1-T) * r (r is also called the yield)

r = i / P0 (i= annual interest starting in 1 years time; P0 = current market price)

Question 15

What is the basic assumption of the cost of redeemable debt?

Answer 15

Price of debt = present value of the future interest received up to redemption plus the redeemed amount all discounted at the investor’s required rate of return.

Therefore, investor’s required return = IRR achieved by investing the current price and recieving the future interest and redemption payment

Question 16

Cost of redeemable debt formular

Answer 16

Use the IRR or NPV, depending on question.

IRR = yield = Low rate + (NPVlow / (NPVhigh + NPVlow))* (NPVhigh-NPVlow)

Kd = yield * (1-T)

Question 17

How are convertibel debentures treated?

Answer 17

The same as redeemable debt, but compare the redemption value with the conversion option and choose higher as the amount received at tn.

Question 18

How is any non-tradable tebt treated?

Answer 18

E.g. bank loan

Just adjust interest rate for tax: r(1-T)

Question 19

When is it appropriate to use the WACC?

Answer 19

1 - If proportion of debt and equity (gearing) are not going to chnage. If gearning changes, the WACC will change.
2 - If the level of risk are not going to change. E.g. if a project is in a new market, there will be a different risk and the cost will change.
3 - If the finance is not project specific. If only one type fo finance used, use APV approach.

Question 20

Assumptions when using DVM

Answer 20

1 - A perfect market is in operation, and the share price is the value of all future divideds discounted at ke.
2 - Dividends are paid only once per year; dividend growth is exoected to be relitively constand and predictable.
3 - If using historic method, we are assuming that the past is a good predictor of the future.
4 - If using earnings retention, we are assuming that both the rate of return and retention rate will remain constant over time.