Cost of Capital

Question 1

What does WACC stand for?

Answer 1

The Weighted Average Cost of Capital

Question 2

What would an entity most likely use WACC for?

Answer 2

The discount rate in a Net Present Value calculation

Question 3

What is the cost of equity (K_e)?

Answer 3

The cost of equity is the rate of return that shareholders expect to see on thier investment?

Question 4

In one sentence, what is the Divdend Valuation Model?

Answer 4

It states that the current share price is determined by future dividends, dscounted at the investors’s expected rate of return.

Question 5

Assuming a constant rate of dividends, what is the formula for the Cum Dividend Share Price (P₀)?

Answer 5

P₀ = 1/k_e

Where:

P₀ = The cum dividend share price; and

k_e = the cost of equity.

Question 6

How to switch between the Cum Div share price and Ex Div share price?

Answer 6

Ex Div = Cum Div - Div

Question 7

What are the two main methods for estimating growth within the DVM?

Answer 7

1. Averaging method;
2. Growth model based on profit retention rate.

Question 8

What are the four assumptions required for the profit retention rate model to hold true?

Answer 8

1. The entity must be fully financed by equity;
2. The entity’s future investment will solely draw from retained earnings;
3. The entity will withold a fixed proprtion of retained earnings for investment;
4. Projects funded from coampny investment will provided a constant rate of return.

Question 9

Define cost of debt.

Answer 9

Cost of debt is rate of return debt providers require on the funds that they provide.

Question 10

The value of debt is presumed to be what?

Answer 10

The present value of the future cashflows

Question 11

What is the cost of debt for bank borrowings?

Answer 11

k_d = r(1-T)

r = rate of return

T = Tax rate

Question 12

Define the terms of the formula:

k_d = i(1-T)/P₀

It can be applied to work out the cost of debt in which circumstances?

Answer 12

k_d - Cost of Debt

i = interest paid each year

T = Corporation tax rate

P₀ = The ex interest market price of the bonds, quoted per $100 unit of the bond.

1. Iredeemable bonds;
2. Redeemable bonds where:

• the redemption value = the current market price; or
• as an approximation for long-dated debt.

Question 13

For redeemable bonds, the cost of debt is given by what?

Answer 13

The cost of debt is the Internal Rate of Return of the debt

Question 14

For a redeemable bond describe how to calculate the cashflows in each year from 0 to n.

Answer 14

Year 0: -P₀

Years 1 - n: Discounted interest payments, net of tax

Year n: Discounted Par value

Question 15

For a convertible bond describe how to calculate the cashflows in each year from 0 to n.

Answer 15

Year 0: -P₀

Years 1 - n: Discounted interest payments, net of tax

Year n: The higher of the Discounted Par value and the discounted conversion option

Question 16

What values does the WACC calculation use in its weightined

Answer 16

MArket values of finance as opposed to book values (wherever is possible).

Question 17

What three conditions must be met for WACC to be used for the discount rate or the internal rate of return within calculations?

Answer 17

1. The capital structure is constant. If the capital structure/gearing ration changes as will the weightings in the WACC equation.
2. The new investment carries a similar risk profile to the exisintg body of operations within the company. If this risk level changes, equity investors may rewuire a higher rate of return on their investment.
3. The new investment is marginal to he business.