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Management Accounting 4 > Cost of Capital > Flashcards

Cost of Capital Flashcards

1
Q

What is the WACC?

A

It is the weighted Average Cost of Capital

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2
Q

How is the WACC calculated?

A
  1. Calculate the marginal cost of capital for each category according to market values and rates
  2. Establish the Market Values for those capital categories IF NOT BASED ON TARGET CAPITAL STRUCTURE
  3. Establish the relevant weight to be used for each category
  4. Determine the final percentage from each category and add them together
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3
Q

Why is the WACC based on market values and rates?

A

Because our funders will want to be compensated the same way as the rest of the market, we will need to match the market if we want people to give us money

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4
Q

What are the different categories of capital that you can raise?

A
  • redeemable debt
  • non-redeemable debt
  • Retained earnings
  • ordinary share capital
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5
Q

How do we calculate the cost of redeemable debentures?

A
  1. (maybe?) comp the PV because they gave the market related interest rate without the flotation costs adjustment
  2. Calculate the PV by taking into account any flotation costs (if any)
  3. Comp the market related rate
  4. Adjust the rate for Tax, it is tax deductible
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6
Q

How do we calculate the market value of redeemable debentures

A
  1. Calculate the PV by taking into account any flotation costs (if any)
    OR
  2. COMP the PV with market rate they give you
  3. adjust for flotation costs

the PV is the market value, but you would need the market related rate adjusted for floations costs if you don’t have the PV to COMP IT

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7
Q

How do we calculate the cost of non-redeemable debentures?

A
  1. We workout the MV per share without issue costs
    - old MV = face value * (coupon rate/market rate)
  2. We adjust for issuing costs (if any)
    - new MV = face value * (100% - issue cost %)
  3. recalculate the new market rate for us
    - (coupon rate/old MV) *face value = new market rate
  4. we adjust it for tax by lowering it by 28% or whatever the tax rate is (again because the interest is tax deductible)
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8
Q

How do we calculate the Market value of our non-redeemable debentures?

A
  1. We workout the MV per share without issue costs
    - old MV = face value * (coupon rate/market rate)
  2. We adjust for issuing costs (if any)
    - new MV = face value * (100% - issue cost %)
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9
Q

How do we calculate the cost of redeemable preference shares?

A
  1. (maybe?) comp the PV because they gave the market related interest rate without the flotation costs adjustment
  2. Calculate the PV by taking into account any flotation costs (if any)
  3. Comp the market related rate

These interest payments are not tax deductible

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10
Q

How do we calculate the Market value of redeemable preference shares?

A
  1. Calculate the PV by taking into account any flotation costs (if any)
    OR
  2. COMP the PV with market rate they give you
  3. adjust for flotation costs

the PV is the market value, but you would need the market related rate adjusted for flotations costs if you don’t have the PV to COMP IT

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11
Q

How do we calculate the cost of non-redeemable preferences shares?

A
  1. We workout the MV per share without issue costs
    - old MV = face value * (coupon rate/market rate)
  2. We adjust for issuing costs (if any)
    - new MV = face value * (100% - issue cost %)
  3. recalculate the new market rate for us
    - (coupon rate/old MV) *face value = new market rate
  4. we adjust it for tax by lowering it by 28% or whatever the tax rate is (again because the interest is tax deductible)
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12
Q

How do we calculate the market value of redeemable preference shares?

A
  1. We workout the MV per share without issue costs
    - old MV = face value * (coupon rate/market rate)
  2. We adjust for issuing costs (if any)
    - new MV = face value * (100% - issue cost %)
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13
Q

Name and show the methods used to calculate the cost of equity

A
  1. Dividend yield and growth method
    - Ks = D1/[P0(1 – F)] + g
    * D1 = expected dividend for next year
    * P0 = current market share price
    * F = flotation costs %
    * g = growth rate
  2. Capital asset pricing model (CAPM)
    - Kr = Rf + β (Rm – Rf)
    * Kr = cost of equity
    * Rf = return on risk free investment
    * β = beta for your firm
    * Rm = Return of market
  3. Bond yield plus risk premium
    - Ke = X + Pr
    * Ke = cost of equity
    * X = interest rate on firms own long borrowings
    * Pr = firms idea of premium for risk
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14
Q

How do we know what weightings to use in the WACC calculation?

A

the weightings would always be most accurate if based on the target capital structure, which might not be their current structure, but it should still be used for the weightings

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15
Q

What is a break point in the WACC?

A
  • It is the amount of finance of a certain category that can be raised before you have to break the capital structure in order to Raise more finance.
  • there are breakpoints for each category in the WACC
  • When you go past the breakpoint, you will need to change the capital structure because you couldn’t get more capital of a certain type at a certain cost
  • or the structure can stay the same but the WACC changes
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16
Q

How do I calculate a break point in the WACC?

A

Breakpoint = relevant capital available amount / weighting of same relevant capital

17
Q

How should a company invest in a project that requires more finance than they are able to raise without changing the structure or WACC

A
  • If it is divisible, then only invest in the portion that you can
  • if it is not, you will need to calculate if it is going to cover your new cost of capital
  • qualitative factors should also be considered
18
Q

What is a beta?

A

an indicator of the risk relating solely to the operations (business risk) of a
firm regardless of how it is financed – it is a weighted average of the equity
and debt betas i.e. between zero (the debt beta) and the equity beta

19
Q

What does it mean to relever a beta and unlever it? and why would you need to?

A

a beta is specific to a type of business and if your business is not similiar to that business, your beta will be different

This means that in order to change it into your beta, you need to unlever it and relever it

20
Q

How do you unlever and relever a beta?

A
  • unlever formula
  • relever formula
  • it should always be relevered at the target capital structure

Management Accounting 4 (27 decks)

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