S2 - cost of capital Flashcards
what is cost of capital
the rates of return that a company has to offer finance providers to induce them to buy and hold a financial security
Involves the cost of funds and investors expectations of returns
Sets the minimum return companies should make on its own investments to earn these for investors - sets the hurdle rate
what is warning
behind any final number generated lies an enormous amount of subjective assessment
Good decision making comes from knowing the limitations of the input variables to the decision
Knowing where informed judgement has been employed in the cost of capital calculation is required to make value enhancing decisions and thus assist the art of management
Precision is less important than knowledge of what is a reasonable range
how to calculate cost of equity
gordon growth model
Capital asset pricing model
what is the gordon growth model
issuing new shares or utilisation of retained earnings - both have costs
Ke = D0(1+g)/p + P0
what is the capita; asset pricing model
3 main elements
risk free rate of return
Opportunity of investing safely
Free of risk investments - government securities
premium for business risk
Additional returns demanded by investors due to uncertainty and future prospects
premium for financial risk
Additional returns demanded due to concerns of debt levels
links to constituents of cost capital and allows investors to base their required returns from the return of risk free investments plus a premium
K = Rf + Bi x (Rm-Rf)
what is calculation of cost of debt
irredeemable traded debt
Traded debt
Non traded debt - bank borrowings
what is irredeemable debt
Kid found in much the same way as preference shares
Perpetual bond is a form of this debt
what is redeemable debt bond
the cost of redeemable debt is found by finding out the Kd through the internal rate of return method
We know a marketed price for the bond and the various payments which will be made by the company
We need to work backwards and say if a person is willing to pay £X for a certain bond and receive £1 payments for that, what rate of interest does that represent
what is the weighted average cost of capital
Company may use a mix of debt & equity to finance its activities. Investors will expect a return on funds invested in debt or equity. Returns paid to investors represent the cost of capital to the company of funds invested by the investors.
For a company to grow, cash generated by the business ventures must exceed returns paid to investors. I.e. the companies cost of capital.
WACC is one way of estimating a company’s cost of capital:
WACC = [We x Ke] + [Wd x Kd]
For a company financed by only debt and equity
WACC = [We x Ke] + [Wd x Kd] + [Wpre x Kpre]
what is evidence of corporate practice - recent international studies
Extraordinary consistency across time and geo-location in surveyed usage.
Andor et. al. (2015) surveyed 400 executives in ten countries in Central and Eastern Europe (CEE) on their capital budgeting practices.
Found 61% of companies surveyed frequently used Discounted Cashflow (DCF) Techniques to appraise large investment projects, with the majority calculating the WACC using the CAPM.
Batra & Verma (2017) examine Indian corporate capital budgeting practices of a sample of 77 Indian companies listed on the Bombay Stock Exchange.
The survey results reveal that a majority of 61% of the companies used weighted average cost of capital (WACC) to calculate cost of capital
what is evidence of corporate practice - hurdle rates
In finance generally many investment appraisal approaches theorists espouse that companies should apply the WACC as the discount rate to projects and invest in +NPV. In practice Duke University/CFO Global Business Outlook Survey (2017) found that a fifth insist on a higher rate.
The average US WACC reported is 9.2% (across the entire survey sample), but the average hurdle rate used is 13.5%. Similarly European companies average hurdle rate 12.67%, but WACC average 8.67%. Set higher because of the shortage of management time or expertise in 63.7% of firms
One explanation given was that a shortage of management time or expertise prevented firms from doing so.
This survey data gels well with Jagannathan et al.’s (2016) more academic examination which found that “operational constraints” often had firms using discount rates of twice the WACC.
