Cost Of Capital Flashcards
What is cost of capital?
The discount rate used in investment appraisal, known as the cost of capital, represents the company’s costs of long-term finance.
The costs of each source of finance will differ depending on the risk levels taken on by the investor in that finance.
If an investor takes on higher risk in their investment they will seek a higher return.
How do you calculate the COC?
identify the sources of finance used – look for equity, preference share and debt sources, bearing in mind that there may be more than one debt source
for each type calculate the cost – the cost will relate to the risk levels taken on by the investor in that finance
If an investor takes on higher risk in an investment they will seek a higher return, increasing the cost to the company of getting that finance
calculate a weighted average of all the costs – the weighting will be the value (either book or market value) of each finance source
How do you calculate return?
In a perfect market:
Market value of investment = PV of expected future returns discounted at the investors required rate of return
How do you calculate Ex Div price?
Ex div = cum div – dividend
How do you calculate the cost of equity using dividend valuation?
Ke = D/P0
Cost of equity = dividends / share value price
What are gilts?
Debts issued by the government?
How is debt quoted?
In $100 nominal blocks
What is the coupon rate?
Interest paid on the debts as a percentage of nominal value
what is Ex-interest?
After interest payment
What is cum-interest?
before interest payment
What is WACC?
Weighted average cost of capital
Assumption
Funds from each source of long-term finance are pooled together and used to finance the various investment projects.
Therefore, a weighted average cost of these sources of finance is appropriate to evaluate the investment projects.
How do you calculate WACC?
WACC calculation:
Calculate weights for each source of capital.
Estimate the cost of each source of capital.
Multiply proportion of total of each source by its cost and sum the results
What is CAPM?
Capital Asset Pricing Method
Capital asset pricing model to estimate the cost of equity
What is CAPM (Capital Asset Pricing Model) used for?
The CAPM enables us to calculate the required return from an investment given the level of risk associated with the investment (measured by its beta factor).
How do you calculate total risk?
Systematic risk = market wide factors such as state of the economy
Unsystematic risk = company / industry specific factors
