cost of capital

Question 1

what is cost of capital

Answer 1

unique cost of each business that we use to evaluate (present value) the cash flows of future projects

for each project the internal rate of return is calculated

Question 2

what do we do if the projects overall internal rate of return exceeds our cost of capital

Answer 2

we accept the project as we believe that it will add value to the firm

Question 3

what do we do if we dont know the internal return rate?

Answer 3

we present value all the cash flows using our cost of capital and if the overall result is positive we accept the project and if its negative we reject the project

Question 4

what is included in liabilities/debt?

Answer 4

any long term liability that bears interest such as long term loans or bonds or debentures. Bank overdrafts and short term debt are general short term financing as they fund net working capital

Question 5

what is the cost of debt (rd)

Answer 5

would be the market rate of the debt after tax

the South African tax rate is 28% and because a business can deduct interest for tax purposes the actual cost would be 72% of the market rate. We say that we multiply the market cost of debts by (1- tax rate). So if debt has a market rate of say 9% the after tax cost of debt for the business would be 9% (1 - 0.28) = 9% x 0.72 = 6.48%

Question 6

what is included in equity?

Answer 6

For a sole proprietor or partnership it will be the capital account. For companies it is the share capital, any reserves and the retained income (accumulated profits). Equity has a cost but this is not reflected anywhere in the annual financial statements.

Preference shares are also form of equity funding.

Question 7

If we wish to calculate the effective rate of the preference shares we rearrange the formula (and you must be able to do this) …

Answer 7

rps = Dps/Pps

Question 8

what are flotation costs

Answer 8

when a company issues new pref shares there is a cost called flotation costs

Question 9

formula to calculate the effective rate of the preference share, accounting for flotation costs

Answer 9

rps = Dps/Pps(1-F)

Question 10

capm formula

Answer 10

Expected Return or cost of equity = Risk-Free Rate + Beta (Market Return – Risk-Free Rate)

Question 11

average beta = 1

Answer 11

more risk = more than 1

less risk = less than 1

Question 12

what is the market premium

Answer 12

market rate - risk free rate

Question 13

what is the risk free rate

Answer 13

• The rate for along‐term government debt security because the equity claim is a long‐term claim on the firm’s cash flows.
  note: a long term risk free rate better reflects the long term inflation expectations and the cost of getting investors to part with with their money for a long time period than a short term rate

Question 14

using the constant growth dividend model

Answer 14

Rs = (D1/P0) +growth

Question 15

the cost of issuing new shares

Answer 15

Rs = (D1/P0(1-F)) +growth

Question 16

how to calculate the weighted average cost of capital

Answer 16

Wacc = Weight of debt * Rate of debt(1-Tax) + Weight of pref shares * Rate pref shares+Weight ord shares *Rate ord shares