Cost of Capital

Question 1

The ‘cost of capital’ consists of 4 main elements:

Answer 1

• The cost of equity capital (ke)
• The cost of preference share capital (kp)
• The cost of debt capital (kd)
• The weighted average cost of capital (WACC) (k)

Question 2

Rate of return formula

Answer 2

pure interest + inflation risk

Question 3

Dividend Valuation Model

Answer 3

Value of share = PV divs forever from T1 to infinity

Question 4

Extrapolating past growth

Answer 4

T1 Devidend x (1+g)^no. yrs in between = Final yr dividend

Question 5

problems with DVM

Answer 5

• share value may not be PV Dividends
• Share price moves by minute for large companies
• Past growth isn’t same as future growth
• shareholders will require Ke on their money retained by a company and expect them to invest it in projects

Question 6

Irredeemable debt

Answer 6

money borrowed but never redeem the capital
- issued by governments in the real world

Question 7

Interest Paid on Debt

Answer 7

coupon rate x face value (£100)

Question 8

Redeemable debt -

Answer 8

• IRR calculation
• At T0 the CF is negative

Question 9

cost of preference share capital

Answer 9

Kp = d1 / Pp
Pp = d1 / Kp

Question 10

Weighted average cost of capital

Answer 10

• Ve = no shares x price per share
• Vd = no debs x price per deb
• extend formulae with any type of capital
• k = [(KeVe) + (KdVd)] / (Ve+Vd)

Question 11

WACC drawbacks

Answer 11

• market values are used, what about unquoted companies.
• Costs of some forms of finance is tricky. Eg. convertibles, leases etc
• WACC relates to long term finance not short. what about overdrafts which are permanently there?

Question 12

conditions so you can use WACC % to calculate NPV for projects

Answer 12

• Financing mix remains constant. ie debt to equity ratio
• Project has the same systematic business risk as existing projects
• Funds are from a pool