Cost of capital

Question 1

What does WACC stand for?

Answer 1

Weighted average cost of capital

Question 2

WACC formula

Answer 2

( (MVe x ke) + (MVp x kp) + (MVd x kd) ) / (MVe + MVp + MVd) )

Question 3

WACC: Cost of equity: Assumptions

Answer 3

In a perfect market:

1. Current share price = PV of expected future dividends, discounted at the investor’s required return (Ke)

(Therefore)

2. The investor’s required rate of return (Ke) = the IRR when investing at the current price and receiving the future dividends

Question 4

WACC: Ke formula

Answer 4

D1/P0 + g

( (D0(1+g)) / P0 ) + g

g = growth %
p = market price of a share (ex div)
d = dividend

Question 5

WACC: 2 ways to calculate (estimate) growth

Answer 5

1. Historic method (extrapolation)
   Extrapolating based on past dividend patterns
2. Earnings retention method
   Aka Gordon growth model
   Assuming growth is dependent on the level of earnings retained in the business

Question 6

WACC: Growth: Historic method: Formula

Answer 6

POWER ( [newest value] / [oldest value] , 1/[no. periods])

!No. periods -1 i..e not T0 i.e. the gaps between periods i.e. times div paid (?)!

Question 7

WACC: Growth: Earnings retention model: Formula

Answer 7

[ARR] X [Earnings retention rate]

Question 8

WACC: Growth: Historic method: How to treat bonus issues

Answer 8

The earlier dividends per share must be calculated by adjusting the number of shares for subsequent bonus issues.

Question 9

WACC: Kp: Formula

Answer 9

D / P0

Question 10

WACC: Kd: Irredeemable debentures: Assumption

Answer 10

Price of a debenture = Present value of the future interest stream received in perpetuity discounted at the investor’s required return

And therefore:

The investors’ required rate of return = The IRR achieved by investing the current price and receiving the future interest

Question 11

WACC: Kd: Irredeemable debentures: Formula

Answer 11

i(1-T)/P0

i = interest
T = corp tax rate
P = market price of a share (ex div)

Question 12

WACC: Kd: Redeemable debentures: Assumption

Answer 12

Price of a debenture = Present value of the future interest received up to redemption plus the redeemed amount all discounted at the investors’ required return

And therefore:

The investors’ required
rate of return = The IRR achieved by investing the current price and receiving the future interest and redemption payment

Question 13

WACC: Kd: Redeemable debentures: Formula

Answer 13

None - calculate manually:

1. Market/issue price
2. Yield and cost of debt

Question 14

WACC: Kd: Redeemable debentures: Formula: Market/issue price

Answer 14

PV ( [investor’s required return], [no. periods], [interest value], [redemption
value] )

Question 15

WACC: Kd: Redeemable debentures: Formula(s): Gross yield

Answer 15

1.
RATE ( [number of time periods], [interest payment], [market value], [redemption value])

2.
=IRR( [cash flows] )

Question 16

WACC: Kd: Redeemable debentures: Formula: Cost of debt

Answer 16

[Yield] * (1-T)

T = corp tax rate

Question 17

WACC: Kd: Convertible debentures: Treatment

Answer 17

1. compare the redemption value with the value of the conversion option
2. select the higher of the two values as the amount to be received at t(n) (the redemption date)
3. find the internal rate of return of the cash flows

Question 18

WACC: Kd: Non-tradable debt: Treatment

Answer 18

Bank and other non-tradable fixed interest loans simply need to be adjusted for
tax relief

Cost = [interest rate] × (1 – T)

Question 19

When is it appropriate to use WACC as a discount rate for a project?

Answer 19

If the proportions of debt and equity (gearing) are NOT going to change over the life of the project. If the gearing changes, then the WACC itself will change – and another approach (the APV approach, described in Chapter 6) is used.

If the level of risk is NOT going to change. The company’s current ke is
dependent on the current level of risk the shareholders are suffering – which will depend on the type of business that the company is in. If the new project is in a different business sector to the existing operations, then the level of risk (and therefore the ke) may be different (CAPM).

If the finance is NOT project-specific. The WACC utilises several different types of finance in order to calculate an average. If we use only one method of
finance to invest in the project, then an average is not required and we will need to use an alternative approach, such as APV.

Question 20

Assumptions when using the dividend valuation model (WACC)

Answer 20

A perfect market is operating to ensure that the share price is the present value of the future dividends discounted at ke. (In practise this will only be true if the shares/debentures are listed).

Dividends are paid only once a year (and either have just been or are just about to be paid. (In practise, a company will often pay interim dividends). Dividend
growth is expected to be reasonably constant and predictable (In practise
dividends may be non-existent or at best erratic).

Growth assumption

If using historic dividends to predict growth – then we are assuming that the past is a good guide to the future (If circumstances change – for example the
company getting a listing, this may not be true).

If using the earnings retention model to predict growth we are assuming that both the rate of return and the retention rate will remain constant over time
(again, this may not be true if circumstances change).

Question 21

Other issues when using the dividend valuation model (WACC)

Answer 21

1. Other sources of income
Ideally we should only be using permanent long term sources of finance in the calculation of WACC (equity, prefs, debentures, loans), but arguably, some
companies use overdrafts, leasing and even trade creditors for finance over long periods of time. Although we would not conventionally include these as part of our
WACC calculation, there is no doubt that they could affect the true cost of capital.

2. Small companies
Calculating a WACC for a small, unquoted company is very difficult, because there are no market values to obtain accurate returns and the small size usually results in more expensive finance.