Cost of Capital

Question 1

Define required return

Answer 1

Appropriate discount rate/ Cost of capital (same thing)

Higher than risk free return. Required return depends on associated risk with investment - depends on use of funds not the source

Question 2

what is capital structure of a firm?

Answer 2

Ratio of debt to equity finance - responsibility of financial manager to determine structure.

Question 3

How does a mis of debt and equity effect the cost of capital calculations?

Answer 3

Cost of capital reflects required return on firms assets as a whole. If firm uses both - mis of compensation needed for debt and equity investors

Question 4

Define cost of equity

Answer 4

Return equity investors require of investment in the firm - no way of directly observing this required return

Question 5

Define the dividend growth model (constant growth) and give formula for required return on equity from this model

Answer 5

Assumes firms dividend willl grow at a constant rate g. From the original formula Return is:
R(e) = D1/P0 + g

Question 6

How can you estimate g

Answer 6

Use historical growth rate
Use analysts forecast (only for public firms)
Find average growth rate in previous years

Question 7

What are the advanatges of the DGM?

Answer 7

Simplicity

Question 8

What are the disadvanatges of the DGM?

Answer 8

Applies only to firms paying dividends
Assumption dividend grows at constant rate
Estimate of cost of equity is sensitive to g a lot
Doesnt explicitly consider risk
May not be good indicator of futue

Question 9

Define under CAPM expected return on a security

Answer 9

R(e)= Rf + Be x (Rm - Rf)

Question 10

What are the advantages of SML approach?

Answer 10

Adjusts for risk
useful in many circumstances
Applies to firms other than those with constant g

Question 11

What are the disadvantages of SML approach?

Answer 11

Needs market risk premium and Beta estimate
Relies on past to predict the future
Difficult for private firms with no share price - may have to base B on another similar firm

Question 12

Define cost of debt

Answer 12

Return lenders require on debt - interest rate they must pay on new borrowing

Question 13

Define YTM

Answer 13

Yield to maturity is market required rate (cost of debt)

Question 14

What is cost of preference shares

Answer 14

Rp = D/P0 where P0 is current share price

Question 15

What does WACC stand for and explain it

Answer 15

Weighted average cost of capital - average of cost of equity and after tax cost of debt.
Its the overall return a firm must earn on existing asset to maintain its value of equity.
Required return on an any investments by firm that have essentially same risks as existing operations

Question 16

Define E and how to find it (market value of …)

Answer 16

Number of shares outstanding multiplies by share price = E (market value of equity

Question 17

Define D and how to find it (market value of …)

Answer 17

Market price of single bond multipled by number of bonds outstanding (Done for each issue and added) = D (Market value of debt)

Question 18

What is formula for combined market value?

Answer 18

V = E +D

Question 19

What are the capital structure weights in %?

Answer 19

100% = E/v + D/v

Question 20

What is there to note about tax and discount rate

Answer 20

if determining discount rate it needs to be expressed on after tax basis. Interest is tax deductible for firm - not included in taxable income

Question 21

With no preference shares what is the formula for WACC?

Answer 21

(E/V x Re) + (D/V x Rd) x (1-Tc)

Question 22

With preference shares what is the formula for WACC?

Answer 22

(E/V x Re) + ( P/V x Rp) + (D/V x Rd) x (1-Tc)