Cost of Long term Funds Flashcards
What is the order of payment in a liquidation?
1.) Creditors with a fixed charge
2.) Creditors with a floating charge
3.) Unsecured creditors
4.) Preference shareholders
5.) Ordinary shareholders
What is Risk-Return Relationship?
Risk is the main driving force behind the return that is expected by investors, the higher risk faced by the investor, the higher the return they will expect.
What is Cost of Capital?
Minimum acceptable return on investment, generally computed as a discount rate of use in investment appraisal exercises.
What is Cost of Debt?
The effective rate a company pays on its current debt. The cost of debt is expressed as Kd.
What is Cost of Equity?
Rate of return required by a shareholder for investing in the business. The cost of equity is expressed Ke.
When a company declares a dividend, which 2 potential share prices should be considered?
1.) Cum div share price = ‘Cum div’ means with dividend. This is the price the share trades at when a dividend has been declared but not paid. Means that share purchases include rights to the next dividend payment.
2.) Ex div share price = ‘Ex div’ means ‘without dividend’.This is the price that the share trades at when the company has confirmed list of shareholders to receive the dividend. Means that shares purchases do not include the right to the next dividend payment.
What is the cost of debt for irredeemable bonds?
-The company does not have to repay the principal to the bond-holder. Therefore the annual return to the investor (debt-holder who purchases the bonds) will be the fixed interest only.
- Investor calculates their percentage return by comparing the interest received to the market value of the irredeemable bond= interest yield/yield to maturity.
What is Yield to maturity for irredeemable bonds?
The effective average annual percentage return to the investor, relative to the current market value of the bond.
Cost of Debt- Redeemable bonds:
Are more complex than irredeemable bonds. From investor’s perspective, the return on redeemable bonds is based on the interest earned plus the difference between the amount paid for the bond (Po) and redemption value of the bond(what is paid back to investor at the end of the bond’s life).
Return to investor = yield to maturity
Define Internal Rate of Return (IRR)?
Annual percentage return achieved by a project, at which sum of discounted cash flows over life of project is equal to the sum of the discounted outflows.
Yield to maturity for redeemable bonds:
Internal rate of return on market value of the bond, annual interest received and final redemption amount.
What are convertible bonds (cost of debt)?
Offer the investor (bond-holder) a choice of cash or shares on the redemption date.
With an IRR approach we will need to identify the cost of the bond how?
Replace the redemption value of the bond with the HIGHER of Cash value on redemption, Estimated future value of the shares on conversion date.
Define Weighted average cost of capital:
Average cost of entity’s long-term funds (ordinary shares, preference shares, bank loans and bond) weighted according to the proportion each type of long-term fund bears to the total pool of capital based on market values.
