KCB WEEK 9 - Cost of Capital Flashcards
1.Equity finance – ordinary shares and other reserves
2.Preference share capital – legally share capital but is categorised with debt finance
3.Long-term debenture capital/long-term debt finance
What is systematic risk?
Common will affect all / all will be exposed to systematic risk (some more, some less) – political and economic factors
Largely caused by macroeconomic factors/affects all shares in the market
Unavoidable so, cannot be diversified
Ex. – economic recession affecting both the markets and the economy of the country
Level to which each share affected will differ, although known that all shares will be affected
What is unsystematic risk?
Unique – specific to each co/industry – not merely because it is part of the ‘system’
Not impacted by political or economic factors
Examples – weak labour relations/adverse press / strikes
Different for different companies – might cancel out in some circumstances
oNegative correlation
Studies – if portfolio consists of 15-20 shares – most of the unsystematic risk tends to be diversified (away) - fluctuation in two separate cash flows cancel out when combined (aprox 70% of risk)
Not possible to totally eliminate unsystematic risk – assumption in CAPM
CAPM - calculating cost of equity
RADR = RFR + B (RM-RFR)
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RADR = RFR + B (RM – RFR) (risk adjusted discount rate)
RE = RF + B (RM - RF)
RFR (0 risk) = risk (free rate of interest, free risk) – (ex. base rate of interest)
B = Beta coefficient of the stock (risk of the ordinary share) – (1)
RM (1 risk) = overall average return on stock market portfolio
(RM-RF) = Equity (or market) risk premium
Risk free investment 0 RFR = 3.5
Stock market investment 1 RM = 12.5
Premium RM – RF = 9 (equity/market risk premium)
Analysis points on Beta of CAPM method
SLOPE HIGH – BETA HIGH
SLOPE LOW – BETA LOW
Where gradient of regression line > 45o – indicates share systematic risk of the share exceeds systematic risks of the stock markets thus excess returns on share is greater than excess return on stock market – B will be greater than 1 –
Where gradient of regression line < 45o – systematic risk of the shares lower than systematic risk of stock market, thus excess return on the share is less than excess return on stock market. B will be less than 1 (market beta is 1)
Vertical intercept point (value on Y axis line crosses) –alpha (a) – ideally alpha coefficient should be 0
Regression line should go through the graph’s origin
If > 0 – implies share is generating abnormal return due to an element of unsystematic risk
Over time abnormal returns should cancel out and alpha coefficient become 0
B of any share can estimated if RM known
Security market line use – capital asset pricing model equation
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Where 1 About the same as risk of market
>1 - more risky investment
<1 - safe investment
Assumptions of CAPM
Investors are rational and have full knowledge about market
Expect greater returns for greater risks
Possible for investor to diversify unsystematic risks by actively managing portfolio
Borrowing and lending rates are equal
There are no transaction costs
Markets are perfect and any imperfections tend to correct themselves in the long run
RFR is the same as the returns on government bonds
No taxation and no inflation
Drawbacks of CAPM
SML is not always linear
CAPM only considers changes in beat – not other factors (ex. co size/market value)
CAPM assumes markets are perfect markets
Companies with more than 1 division = each division may have different systematic risks yet B is derived on the basis of a single share price
CAPM is a one-year only model – only event for a year – cost of equity from CAPM should not be used for a model that goes on longer than 1 year
Overview dividend growth method (non sophisticated companies, no listing)
Will need to use the old dividend growth rate model to get value of B
Ke = [Do ( 1 + g) / Po] + g
Po: current share price
Do: current dividend level
g: growth rate dividend (estimated)
Calculating cost of debt (irreedemable debentures)
Kd = I ( ( 1 – t ) / Sd )
Kd Cost of debt capital I Annual interest t CT rate (decimal value) Sd Market price of the debt
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Redeemable debts key notes
Interest payable over period of X yrs
Years after which company will buy the debenture back and cancel
IRR = cost of redeemable debt
Impact of debt on capital
Even if not making profit - need to pay interest to debenture holders – creates issue for shareholders, company is not generating sufficient profits so shareholders are not receiving return
oNeed to sell some assets and pay debenture holders
oEquity investors see payment to debenture holders from their subscription not profits
oRisk for equity holders will go up – will demand higher returns from the company – causes the cost of equity to go up – firm’s WACC will go up
Calculating WACC
WACC= [ (E/E+D) * re ] + [ (D/E+D) * rd * 1 - T
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E / (E + D) - rate of equity in long term capital of the company
D / (E + D) - rate of debt capital in the long term capital of the company
Re – cost of equity (Ke)
Rd – cost of debt (Kd
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Cost of equity X weight of equity) + (cost of debt after tax X weight of debt)
