Finance - Cost of Capital

Question 1

What is the cost of capital and how is it is determined

Answer 1

• Cost of capital is the overall rate of return required to compensate all its debtholder and shareholder
• It is determined by: 1. The Entity is looking to assess investment and require a discounted rate
  2. Understand the impact on the entity goals’ overall cost of capital
• The risk level should be compared to the current line of business, if less risky, lower discount rate
  -The maximum value to shareholder, cost of capital must be low as possible

Question 2

What type of cost of capital is usually used to determine the investment of risk

Answer 2

The weighted average cost of capital - average of after-tax financing cost of all sources (debt & equity) for the proportion of capital structure
- It reflects the current market required return and current market value

Question 3

What is needed in calculating cost of capital

Answer 3

Cost of capital is calculated at a specific point in time
What is needed: -Entity’s current cost of debt, –Entity’s current cost of equity
weighted of each source of debt and equity in the entity’s current capital structure
- Entity income tax rate

Change in capital structure - An important financial policy decision is to determine whether there is an optimal weighting of debt and equity that will minimum and entity cost of capital

Question 4

What is the formula to calculate the Weighted average cost of capital

Answer 4

WACC = (Weighted of debt * after tax cost of debt) + (weighted of equity *cost of equity)

• If the company has three sources of debt and two sources of equity, all five sources are required for financial used
• The cost of each type of financing will increase as the risk for the investor increase
• Since cost is deductible for tax purposes, higher an entity’s income tax rate the lower after-tax cost of debt

Question 5

What is the difference between internal and external equity

Answer 5

Internal equity - profit accumulated and retained in the company
External equity - the company having to issue new equity to raise funds

Question 6

What is the cost of debt and the formula to calculate variable base rate

Answer 6

Cost of debt - for bondholders to borrow from financial institutions. *This only includes long term, short-term is excluded
- Need to determine the fixed and variable rate

Cost of borrowing - interest rate company pays on borrowed amount

Variable based rate = Current based rate + premium rate
Prime rate 1.75% + 2% Premium = 3.75% cost of debt

After-tax cost of capital - current debt yield *(1- tax rate)

Question 7

How is the cost of preferred shares calculated and provide the formula that is used

Answer 7

• It is the annual dividends that are generally paid in perpetuity until preferred shares are redeemed
• FV of the preferred share is the annual dividend payment divided by the FMV of the shares

Preferred shares = Total annual preferred dividend paid on preferred share / Total market value of all preferred shares outstanding

Per share basis - Total annual dividend paid per preferred share / current market price per preferred shares

Question 8

Explain how the cost of equity is used and the formula to calculate the cost of common equity

Answer 8

-Cost of equity - is a more complex calculation because common equity does not pay a set return to its investor. BOD declares the distribution of dividend or share repurchase

Cost of equity ‘
Risk free return (rf) + beta (B) * (expected market return (Rm) - Risk-free return Ri))

Risk-free return - rate that is expected on an investment assumes no risk
Market risk premium - Long-term average of the difference between the total return on market & risk-free investment
Beta - Measure the amount of volatility, systematic risk

Question 9

How is the capital asset pricing model used (CAPM)

Answer 9

CAPM - is for an investor who needs to be compensated for both the time value of money and the risk
- Arises from the idea that a dollar today is worth more than a dollar received in the future
- Risk premium is calculated using a multiplier that represents the amount of risk related to a particular investment and market risk premium

Question 10

Once the cost of debt and equity instruments are determined. What is the formula for WACC

Answer 10

WACC =
D/V *(Rd) (1-T) + P/V * (Rp) + E/V * (Re)

D= market value of debt
V= Total market value of debt, preferred shares, and equity
Rd = Current cost of debt
P= Market value of preferred share outstanding
Rp= Current cost of preferred shares
E = Market value of common share outstanding
Re = Current cost of equity

Question 11

Explain the cost of equity for private equity

Answer 11

• Cost of capital for private companies is different because the equity is illiquid for irregular buying and selling shares and these companies have higher operating risk

CAPM
E(ri) = Rf + B(RPm)+ RPs + RPu
E(ri) = required return on security
Rf - risk-free rate
RPm - general market risk premium
RPs - Risk premium for small companies
RPu - Risk premium for company-specific risk factors

Question 12

Explain what project risk consideration is and how pure play is referred to

Answer 12

• It is which WACC is used in assessing the viability of an investment for a company
  Pure play - refers to the fact that this is the company’s only line of business