finance lec 7 - cost of capital Flashcards by Nana Koranteng

what is cost of capital

ROR required by providers of finace

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cost of equty ke=

return required by investors (re

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cost of debt kd =

return required by lenders except for tax implciations

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what si the weihted average cost of capital

avg pf ke and kd

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what terms are used interchangly

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cost of capital is used as a what in investment appraisla calculation

discount rate

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cost of capitla issed as a what rate for investments

hurdle rate

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what would be the right discount rate for company to use for capital IA

wacc

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what do we use when doing IRR nad NPV

wac as hurdle rate for IRR - hurdle rate

wac as DR when doing NPV Calc

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what does comp also use WAC for

internal budgetting purposes

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why is it importnat to minimise cost of capital

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if cash flow is fixed what is the only way for company to maximise value of firmm/shares

minimise discount rate

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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

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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

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if company wants to maximise the value given a cerain set of cf they should eb tryong to minimse

WACC

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what is one way to minimise the WAC

choose capital structure and dividend policy well

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by minimisng the cost of capital what di teh company do

max the mkt value of shares

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how do we max the mkt value of each share

calcualte the cost of each source

combine in the optimal way

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cost of

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when we tlaking about cost of capital we referring to

cost of all capital elements

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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

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when we tallm bout equity -capital structure- we mean

ordinaty shares

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when we talking about debt - CS - we mena

redeemable bonds

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the principle is the same - csot to company for each type of capital is based on

return to investors/providers of each capital

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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

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 -