Cost of capital

Question 1

3 categories of long-term finance

Answer 1

1. Equity
2. Preference shares
3. Debt (redeemable and irredeemable)

Question 2

2 determinants of the cost of finance

Answer 2

1. Risk-free rate of return or a rate of return that reflects the time value of money.
2. Reward for the risk taken by investors in advancing funds to the firm.

Question 3

2 benefits to shareholders for owning a share

Answer 3

1. Future dividends

2. Capital gain

Question 4

Formula for share price

Answer 4

price of shares now = present value of future dividends + present value of share price on eventual sale.

Question 5

4 problems with the Gordon growth model / earnings retention model

Answer 5

1. Reliance on accounting profits.
2. Assumption that the current accounting rate of return and the proportion of profits retained will be constant.
3. Inflation can substantially distort the accounting rate of return if assets are valued on an historical cost basis.
4. Assumes all new finance comes from equity.

Question 6

Gordon growth model / earnings retention model formula

Answer 6

g = rb

g is growth in future dividends
r is the current accounting rate of return
b is the proportion of profits retained

Question 7

Formula for accounting rate of return

Answer 7

r = profit after tax / equity bf

Question 8

Formula for growth in future dividends (using balance sheet, not Gordon growth model)

Answer 8

g = (dividends cf / dividends bf) - 1

Question 9

Formula for proportion of profits retained

Answer 9

b = (profit after tax - dividends paid) / profit after tax

Question 10

2 problems with dividend valuation model

Answer 10

1. g must be less than ke. If g equals ke the share price becomes infinitely high, a nonsense result.
2. In practice companies are likely to experience periods of varying growth rates.

Question 11

How to calculate ex-div price using cum-div price

Answer 11

ex-div price per ordinary share = cum-div price per ordinary share less dividend per ordinary share

Question 12

Define CAPM

Answer 12

A model for measuring the systematic risk of investments.

Question 13

1 way to measure beta for CAPM calculations

Answer 13

Examining the betas of quoted companies in a similar line of business to the new project.

Question 14

Formula for cost of preference shares

Answer 14

Kp = constant annual dividend / ex-div market value

Question 15

Formula for for cost of irredeemable debt

Answer 15

Kd = interest paid on the nominal value of the bond x (1 - T) / current price of the bond

Question 16

What does £x% mean?

Answer 16

£100 nominal value can be purchased for £x.

Question 17

3 assumptions made when using WACC to appraise projects

Answer 17

1. Historical proportions of debt and equity are not to be changed.
2. Systematic business risk of the firm is not to be changed.
3. The finance is not project-specific.

Question 18

4 problems with WACC

Answer 18

1. Assumes historical proportions of debt and equity are not to be changed.
2. Assumes systematic business risk of the firm is not to be changed.
3. Assumes the finance is not project-specific.
4. Whether to include short-term finance
5. Bank loans don’t have market values
6. If a company is unquoted, obtaining a cost of capital is much more difficult.
7. Lack of liquidity offered by a small company’s securities tend to make finance more expensive.

Question 19

When is it appropriate to use WACC as a discount rate for a project?

Answer 19

1. If the proportions of debt and equity are not going to change as a result of the project; ie gearing won’t change.
2. If the level of risk is not going to change.
3. If the finance is not project specific.

Question 20

Assumptions when using the dividend valuation model

Answer 20

1. A perfect market is operating to ensure that the share price is the present value of the future dividends discounted at Ke.
2. Dividends are paid only once a year.
3. If using historic dividends to predict growth, assuming the past is a good guide to the future.
4. If using the earnings retention model to predict growth, assuming both the rate of return and the retention rate will remain constant over time.

Question 21

When to use APV as a discount rate for a project?

Answer 21

If gearing will change as a result of the project.

Question 22

Formula for APV

Answer 22

base case NPV + PV of the tax shield

Question 23

2 formulas for g using ARR

Answer 23

g = return on reinvested funds ARR x retention rate

g = return on reinvested funds ARR x (EPS - D) / EPS