finance lec 7 - cost of capital Flashcards
what is cost of capital
ROR required by providers of finace
cost of equty ke=
return required by investors (re
cost of debt kd =
return required by lenders except for tax implciations
what si the weihted average cost of capital
avg pf ke and kd
what terms are used interchangly
ke
re
cost of capital is used as a what in investment appraisla calculation
discount rate
cost of capitla issed as a what rate for investments
hurdle rate
what would be the right discount rate for company to use for capital IA
wacc
what do we use when doing IRR nad NPV
wac as hurdle rate for IRR - hurdle rate
wac as DR when doing NPV Calc
what does comp also use WAC for
internal budgetting purposes
why is it importnat to minimise cost of capital
if cash flow is fixed what is the only way for company to maximise value of firmm/shares
minimise discount rate
if the cash flow is fixed and we need to use a DR to work out PV of asset the lower teh DR used
the higher the PV
If cash flow is fixed the lower the WACC the company uses to value the firm the higher
higher the value of firm will be
if company wants to maximise the value given a cerain set of cf they should eb tryong to minimse
WACC
what is one way to minimise the WAC
choose capital structure and dividend policy well
by minimisng the cost of capital what di teh company do
max the mkt value of shares
how do we max the mkt value of each share
calcualte the cost of each source
combine in the optimal way
cost of
when we tlaking about cost of capital we referring to
cost of all capital elements
when we tlakm bout cost of cpaitla we refererig to cost of all capital elements therefore we need to work out
cost of each constituent of capital
when we tallm bout equity -capital structure- we mean
ordinaty shares
when we talking about debt - CS - we mena
redeemable bonds
the principle is the same - csot to company for each type of capital is based on
return to investors/providers of each capital
ordinary shares equity - cost of equity ke based on
reutn on equity - re
ordinary shares equity - where do we find r from
ordniary shares/valuation formula
d0(1+g)/r-g
D1/r-g
r =
re = ke
once r worked out its the same as
cost of equity
there isno waht efect on r=re=ke
tax effect
cost of redeemable debt based on
return on redeemable debt - rrd
how do we find the YTM
using IRR method
YTM =
rrd = pretax krd ( need to adjust for tax)
what is r/rd closely related to
and why
cost of rd
gives us pretax but company needs after tax
irredemable debt is a standard
perpetuity
irredemable debt is a standard perpetuity therfore vale based on
future cf/PV of fututre cf
cost of irredemable d kid baseed on
return on irredeemable debt rid
where do we find r for irredemable debt
irredemable bond valuation formula
what is irredemable bond valuation formula
coupon payment/r = PV
in irredemable r =
rid = pretax kid ( need to adjust for tax)
prefernece shares - we know it is equiyt therfore ROR by preference SH =
cost of prefernce shares kp
where do we find r in preference shres from
prfernce shares valuation formula
what is preference shares value formula
pv = dividend/r
(preference share) r =
rp=kp
when talm bout bank loan we particualry speaking about
ammortised bank loan
bank loans have a x element
debt
bank loans have a debt element therefore x implications have to be taken into account
tax
cost of loan kl is based on
return on loan rl
where do we find interest rate for bank loan
on bank loan
in bank loan what is interest rate
interest = r1 = pretax k1 (need to adjust for tax
when a company incurs debt the actual cost to the company is not
the interest payment i.e waht the debt holders recieve
the interest the company paus o debt is …. but its not
the return the investors get
but its not -
actual cost the company bares
why does a company that has debt in ints captial struture pay less than a 100% equity company
casue they pay debt before the profit before tax
the debt reduces th amoutn fo profit
the amount the y are taxed on is less than teh equity firm
the cost of debt is x x
tax deductible
dividends dont get a liablity t/f
t
we pay tax based onx and before you pay x you pay x
profit before tax and before you pay tax you got to pay interest
interest payments change gtax what is the societal impact
debt subsidised by tax payers
casue if comp got debt in capital stucture pay less tax
we will always use what for cost of capital calculation
after tax cost
how do we calcualte tax shield/deductablity of interest
interest * (1- tax rate)
because of tax shield element what is the difference between post tax cost and pretax cost and so
post tax lower than pretax
the post tac is less than the return to debt holders which is the same as pretax cost to company
cost of debt
what is the return to debt holders
interest/coupon payment
what is the effect of interest payment/coupon payment being tax deductible
cost to company is lower than the return they paid to debt holders
interest /coupon payment =
and what does this change
tax deductible for comp
cost to company
why wont 100 to debt holders cost the copnay 100
tax shield
if the tax rate = 30% what is cost to company of 100
and hence
100 x (1-0.3) = 70
rd = interest/coupon rate
kd = interest/coupon rate x (1- tax rate)
65 is s aslight simlification that applies to
MV of debt = principal to be repaid
the lacualtion emthod deends on whether debt is
irr/redeemable
whenever ther is a coupon/interst payment what do we do
tax deduction
whenever teher is a coupon paument how do we reduce coupon by tax shield amount
multiply payment by 1 - tax rat
reedemable debt method - what is required and what do we use
irr calc require usin after tax coupon payment
coupon x 1 - tax rate
irredemable debt method
do perpetuity formula - but coupon payment we used in the formula must be after tax coupon payment so we get post tax cost of debt
post tax cost required
check this on slides
what is redeemable debt method when fot coupon and principal repayment
mao cashflows from det
coupon - annual after tac cu[on (FV each year)
prinicipal - repaid at end ( FV in final year)
market price of bond ( PV at time t=0)
calc IRR using IRR estimation from table 2 - bruh mi nuh know
only adjustmnt you di s in respect to coupon payment
irredemable debt calc ? bruh how many we gonna do
return on ird = coupon payment/ MV of bond / PV of future cf of the bond)
MV = coupon repayment /rid
oonly cf needs to be adjusted for the tax shield
post tax cost of debt = kid = coupon payment x 1-t/MV
kid = post tax cost of debt
t = tax rate
MV = market value of the iredeemable (perpetual bond)
sont adjust price/principal cause we dont have any principlar repayment
do practice qs
tax shield
why is det cheaper than equity
tax shield
percieved to e les risky than equity
tax shield is importnat in making debt cheaper than equity but can onnly be applied if
company is profitable
tax shield can be applied only if copmany is proitable casue
if company ont profitale wont make tax
if the company is loss making at operating progit level/ deliberatley targetting 0 profit what will happen and what is the result
wont get tax relief so lost to company
= return to bondholder
risk and cost of capital
equity is riskiest so shoudl ave
highest cost
equity is greater than
post tax cost of debt
one reason debit is cheaper is because of the tax shield what is the main reason
debt consdiered less risky
investments demand a lower return
so debt is cheaper casue of assumption of risk aversion
investors require a lower return
why does equity ahve such a high return
equity gets paid already after everyone else been paid
o no guarantee gonna get paid so compensated bya higher so ke is high for company
preference sahhre get paid after waht and before waht so arent as risky
after debt been paid
ebfore ordinary share holders
why debt perceived to be less isky thn shares
- has preferential rights on liquidation in terms of payment
always got to be paid first - companies got debt payment obligation
may be secured - against assets/valauble - so some element of assurance they gt at least some money back
and get priority on sale of assets
-
