F2A - Chapter 2: Cost of capital Flashcards
What is the cost of equity?
Rate of return that ordinary shareholders expect to receive on their investment.
What is the main method of calculating the cost of equity?
Dividend valuation model
How do we calculate the cost of equity using the dividend valuation model?
Ex div market price of the share = constant dividend / cost of equity
What is the ex dividend value of a share?
Value just after a dividend has been paid
How do you calculate cost of equity with constant growth using the dividend valuation model?
(dividend to be paid in one year’s time / ex div market price of the share) + constant rate of growth in one years time
What are the two main methods to calculate dividend growth?
The averaging method
The growth model based upon the profit retention rate
How do you calculate dividend growth using the averaging method?
g = (n^√(current dividend/dividend n years ago)) - 1
g = dividend growth rate
How do you calculate dividend growth using the growth model based upon the profit retention rate?
g = r x b
r = percentage rate of return the company receives on its investment
b = proportion of funds retained
What are the assumptions of the growth model based on retention rate?
Entity must be fully financed by equity
Retained profits are the only source of additional investment
Constant proportion of each year’s earnings is retained for reinvestment
Projects financed from retained earnings earn a constant rate of return
What is the cost of debt?
Rate of return that debt providers require on the funds that they provide.
Value of debt is assumed to be the present value of its future cash flows
What are the features of debt?
Interest on debt is tax deductible and hence interest payments are always considered net of tax
Debt is always quoted in £100 nominal units or blocks
Interest paid on the debt is stated as a percentage of nominal value
Debt is redeemable at par or at a premium or discount
Interest can be either fixed or floating on borrowings, but bonds normally pay fixed-rate interest
How do we calculate the cost of debt for bank borrowings?
Cost of debt = r(1-T)
r = annual interest rate in percentage terms
T = corporate tax rate
How do you calculate the cost of debt for irredeemable, or undated, bonds?
Cost of debt = i(1-T)/P0
i = interest paid each year
T = marginal rate of tax
P0 = ex interest market price of the bonds
What is the weighted average cost of capital?
Average cost of the entity’ finance weighted according to the proportion each element bears to the total pool of funds.
What is the procedure for calculating the WACC?
- Calculate weights/proportions for each source of capital based upon market values
- Estimate the cost of each source of capital
- Multiply the weight/proportion of each source of capital by the cost of that source of capital (Step 1 x Step 2)
- Sum the results of step 3 to give the WACC`
