Cost of Capital Flashcards
What is repaid first in the creditor hierarchy?
Secured bank loans and loan notes (secured creditors)
What is 2nd in the hierarchy in the creditor hierarchy?
Trade payables and unsecured loans (unsecured creditors)
What is 3rd in the hierarchy in the creditor hierarchy?
Preference shares
What is last in the hierarchy in the creditor hierarchy?
Ordinary shares
Why are ordinary shareholders ranked last?
As they would be unlikely to receive anything
Why are secured creditors ranked first?
Secured creditors would expect to receive most, if not all, of what they are owed in the event of liquidation
Is secured debt a low-risk investment?
A low-risk investment and investors in secured debt require relatively low returns
What is meant by secured debt?
Debt investors have legally binding contracts with the company for the payment of interest and repayment of principal
Common characteristic of secured and unsecured debt?
It must be repaid prior to dividends
What is meant by unsecured debt?
Legally binding contract and its interest must be paid prior to dividends. There is no guarantee of full repayment
What are preference shares?
A fixed percentage of the share’s nominal value paid after interest on debt and before any ordinary dividend
Meaning of preference shares ranking between creditors or ordinary shares?
Required return of preference shareholders will be higher than on debt but lower than on ordinary shares
What are ordinary shareholders?
Equity shareholders have no guarantee of receiving dividends
Difference between ordinary and preference shares?
Preference dividends are committed to receive dividends, but equtiy shareholders have no guarantee
Why is a company’s cost of equity high?
Ordinary shareholders face high risk and expect high returns to compensate
Rank on liquidiation (equity vs debt)
Equity: Last
Debt: Higher
Servicing of fiannce (equity vs debt)
Equity: Discretionary dividend
Debt: Committed interest
Risk to investor (equity vs debt)
Equity: High
Debt: Lower
Return required (equity vs debt)
Equity: High
Debt: Lower
Costs to company (equity vs debt)
Equity: High
Debt: Lower
Servicing tax allowable (equity vs debt)
Equity: No
Debt: Yes
What is correct between post-tax cost of debt and pre-tax cost of debt
Post-tax cost of debt < pre-tax cost of debt
Speed of issue (equity vs debt)
Equity: Slow
Debt: Faster
Issue costs (equity vs debt)
Equity: 5-11% (IPO)
Debt: 1-2% (Loan Notes). Arrangement fees (Bank loan)
