Revision Flashcards
What is the WACC Formula ?
WACC = (E/(D+E))Ke + (D/(D+E)KD(1-t)
Kd= Cost of debt
Ke = Cost of ordinary equity
t= Marginal tax rate
D = Market Value of Debt
E = Market value of ordinary equity
V= Market value of the firm
What are the 3 main advantages of debt over equity :
- Leverage concept.
Ie, then the company is earning more than the interest charged - the profits are levered so that the return on shareholders funds is higher than the return on assets.
Converse is also true.
- Tax deducibility of the interest
- Cost of debt is usually less than the cost of equity
Capital structure.
1. What are the three components of capital structure
- Enterprise risk
- Business risk
- Financial risk
Steps to consider when choosing a capital structure :
- What is the capital structure based on the current market values of debt and equity ?
- What are the capital structures of firms in the same industry ?
- What is management’s target capital structure ?
- IF no specific target, what is implied by their financing activities ? What is implied by potential financial restructuring ?
Cost of debt calculation:
Interest rate (1 - tax rate)
- Non-redeemable debt instruments and Redeemable debt instruments
When a debenture is in perpetuity, how would you calculate that?
(Coupon rate of debenture/market rate on date of issue) x Rand value of debenture at inception
What is the cost of redeemable debentures?
The cost is the yield to maturity
What are the 2 types of cost of debt :
- Non- Redeemable debt instruments
- Redeemable debt instruments
What are the three types of preference share?
- Not redeemable
- Redeemable
- Convertible preference shares
Formula for value of preference shares :
Vpf = Expected dividend rate/required rate x issue price
What are the methods of calculating the cost of equity :
- Dividend growth model
- Capital asset pricing model
- Bond yield plus risk premium
- Divisional cost of equity
What is the formula for sustainable growth models :
SGR = ROE x b(retention ratio)
What is the formula for Gordons growth model?
What is the formula for Gordons growth model?
Po = Do(1+g)/ r-g
= D1/ r-g
What makes up D1?
(EPS x Dividend payout ratio) x Expected growth rate
What is the CAPM Formula ?
What is the market risk premium ?
What is the risk free rate ?
Ke = Rf + (Rm - Rf) x B
(Rm + Rf)
Risk free rate used is the long term government bond rate
Advantage of Gordons’s Dividend Growth Model ?
Easy to understand and use
Disadvantage of Gordons Dividend growth model?
- Only applicable to companies currently paying dividends
- Not applicable if dividends are not growing at a constant rate
- Extremely sensitive to the estimated growth rate - and increase in g of 1% increases the cost of equity by 1 %
Definition of a beta ?
Beta is a measure of the volatility or systematic risk, of a share in comparison to the market as a whole.
Advantages of the CAPM Model ?
- Explicitly adjusts for systematic risk
- applicable to all companies as long as we can compute the beta
Disadvantages of CAPM?
- Have to estimate the expected market risk premium, which does vary over time
- We have to estimate beta, which also varies over time
We are relying on the past to predict the future, which is not always reliable
Bond Yield Formula :
Cost of equity = Bond Yield (AKA Borrowing cost) + risk premium
Other points to consider in WACC :
Leases
- May increase the debt/ equity of an entity
- If already not factored into the Beta, then we need to reflect it by using a higher beta and we can do this by levering and releveling the firm’s beta. This will increase risk and thereby increase WACC.
- Lower cost of debt financing is mainly offset by increase in the cost of equity
Break points in the WACC
General WACC points to remember :
- Focus on target capital structure -otherwise use market values as a guide
- Only use book values if this reflects the target capital structure.
