Cost of Capital

Question 1

Explain Cost of Equity

Answer 1

The rate of return that ordinary shareholders expect to receive.

This is calculated using the Dividend Valuation Model (DVM):

P0 = d / Ke

or

Ke = d / P0

where

P0 = Ex-Div Market Price
d = the constant dividend
Ke = dividend cash flow / P0

Question 2

Identify the calculation and explain the purpose of the formula each of these are found in:

K0
Ke
Kd
P0
d0
d1
dn
g
IRR
r
VE
VD
i
T
NPV-L
NPV-H

Answer 2

K0 = Weighted Average Cost of Capital
Ke = cost of equity
Kd = cost of debt
P0 = the ex-dividend or ex-interest market price of a share. DVM Model for Ke. Irredeemable or undated bonds for Kd.

d0 = The most recent dividend payment. DVM Model.
d1 = The next dividend payment. DVM Model.
dn = The oldest dividend payment DVM Model
g = Growth rate of dividend %. DVM Model.
IRR = Internal rate of return. 
r = The % rate of return the company receives on its investments. Used to estimate g.

b = The proportion of funds retained (if 30% paid in div 70% retained). Used to estimate g.

VE = Value of equity. Used in the WACC formula.
VD = Value of debt. Used in the WACC formula.
i = interest paid each year (per $100 of bond). Used to calculate cost of debt on irredeemable or undated bonds.

T = Marginal rate of tax.
NPV-L = Net Present Value of the Higher rate.
NPV-H = Net Present Value of the Lower rate.

Question 3

Explain the steps involved to calculating the WACC

Answer 3

Calculate Market Values of Equity (VE) and Debt.(VD)
Calculate Cost of Equity (Ke)
Calculate Cost of Debt (Kd)
Calculate WACC (K0)

K0 = Ke(VE/(VE+VD)) + Kd(VD/(VE+VD))

Question 4

Explain the process and formula for calculating IRR and when it should be used.

Answer 4

IRR Is only applicable for redeemable debt. for Irredeemable debt use Yield To Maturity (YTM)

1. Calculate cash flow from investment
2. Apply discounting with two discount factors (High [10%] & Low[5%]) and calculate the NPV for each.
3. Calculate IRR.
   L+(NPVL/(NPVL - NPVH)] * (H-L)

Question 5

Identify and explain the formula for YTM for irredeemable and redeemable bonds.

Cost of Debt: Yield to Maturity (YTM).

Answer 5

Irredeemable bonds use Yield to Maturity:
Interest / Bond Price * 100 = YTM

Redeemable Bonds use IRR:
IRR = L+[NPVL / (NPVL-NPVH) * (H - L)

Question 6

Calculate the market value of:

$250,000 Ordinary shares
$0.25 nominal value
$1.25 current market price

$250,000 Preference shares
$1 nominal value
$0.65 current market price

$150,000 bonds
$100 nominal value
$85 current market price

Answer 6

Ordinary Shares
$250,000 / $0.25 = 1million shares issued
1m shares * $1.25 = $1,250,000 Market Value (VE)

Preference Shares
$250,000 / $1 = 250,000 shares issued
250,000 shares * $0.65 = $162,500 Market Value (VE)

Bonds
$150,000 / $100 = 1,500 Bonds issued
1,500 * $85 = $127,500 Market Value (VD)