Cost of capital Flashcards
3 categories of long-term finance
- Equity
- Preference shares
- Debt (redeemable and irredeemable)
2 determinants of the cost of finance
- Risk-free rate of return or a rate of return that reflects the time value of money.
- Reward for the risk taken by investors in advancing funds to the firm.
2 benefits to shareholders for owning a share
- Future dividends
2. Capital gain
Formula for share price
price of shares now = present value of future dividends + present value of share price on eventual sale.
4 problems with the Gordon growth model / earnings retention model
- Reliance on accounting profits.
- Assumption that the current accounting rate of return and the proportion of profits retained will be constant.
- Inflation can substantially distort the accounting rate of return if assets are valued on an historical cost basis.
- Assumes all new finance comes from equity.
Gordon growth model / earnings retention model formula
g = rb
g is growth in future dividends
r is the current accounting rate of return
b is the proportion of profits retained
Formula for accounting rate of return
r = profit after tax / equity bf
Formula for growth in future dividends (using balance sheet, not Gordon growth model)
g = (dividends cf / dividends bf) - 1
Formula for proportion of profits retained
b = (profit after tax - dividends paid) / profit after tax
2 problems with dividend valuation model
- g must be less than ke. If g equals ke the share price becomes infinitely high, a nonsense result.
- In practice companies are likely to experience periods of varying growth rates.
How to calculate ex-div price using cum-div price
ex-div price per ordinary share = cum-div price per ordinary share less dividend per ordinary share
Define CAPM
A model for measuring the systematic risk of investments.
1 way to measure beta for CAPM calculations
Examining the betas of quoted companies in a similar line of business to the new project.
Formula for cost of preference shares
Kp = constant annual dividend / ex-div market value
Formula for for cost of irredeemable debt
Kd = interest paid on the nominal value of the bond x (1 - T) / current price of the bond
What does £x% mean?
£100 nominal value can be purchased for £x.
3 assumptions made when using WACC to appraise projects
- Historical proportions of debt and equity are not to be changed.
- Systematic business risk of the firm is not to be changed.
- The finance is not project-specific.
4 problems with WACC
- Assumes historical proportions of debt and equity are not to be changed.
- Assumes systematic business risk of the firm is not to be changed.
- Assumes the finance is not project-specific.
- Whether to include short-term finance
- Bank loans don’t have market values
- If a company is unquoted, obtaining a cost of capital is much more difficult.
- Lack of liquidity offered by a small company’s securities tend to make finance more expensive.
When is it appropriate to use WACC as a discount rate for a project?
- If the proportions of debt and equity are not going to change as a result of the project; ie gearing won’t change.
- If the level of risk is not going to change.
- If the finance is not project specific.
Assumptions when using the dividend valuation model
- A perfect market is operating to ensure that the share price is the present value of the future dividends discounted at Ke.
- Dividends are paid only once a year.
- If using historic dividends to predict growth, assuming the past is a good guide to the future.
- If using the earnings retention model to predict growth, assuming both the rate of return and the retention rate will remain constant over time.
When to use APV as a discount rate for a project?
If gearing will change as a result of the project.
Formula for APV
base case NPV + PV of the tax shield
2 formulas for g using ARR
g = return on reinvested funds ARR x retention rate
g = return on reinvested funds ARR x (EPS - D) / EPS
