The Cost Of Capital

Question 1

What is the formula for weighted average cost of capital?(WACC)

Answer 1

WACC = Kd (1-t)(D/V)+Ke(E/V)
Kd= cost of debt
t= tax rate
Ke= cost of ordinary equity
D= market value of debt
E= market value of ordinary equity
V= market value of the firm

Question 2

Formula for cost of debt

Answer 2

Kd = I(1-t)
I = the interest rate payable
T = tax rate

Question 3

Formula for value of debenture

Answer 3

Vd = ( coupon rate / required rate ) x nominal rate
Net receipt = Vd (1-F)
F = floatation costs
Therefore cost of debenture (debts) = I (1-t)

Question 4

What is cost of capital?

Answer 4

It’s an indication of risk of a company and it helps to determine the required return for capital budgeting projects

Question 5

What is the required return and what is it for?

Answer 5

The required return is the same as the appropriate discount rate and is based in the risk of the cash flows. The required return for an investment is needed before we can compute the NPV and make a decision about whether or not to take the investment. We need to earn at least the required return to compensate our investors for their financing

Question 6

What is the cost of equity?

Answer 6

Cost of equity is the return required by the equity investors given the risk of cash flows from the firm.

Question 7

Name the two methods used to determine the cost of equity

Answer 7

The dividend growth model and CAPM

Question 8

The formula for dividend growth model

Answer 8

Re = ( D1 / P(1-f) ) + g
D1 = D0 ( 1 + g )
D1 = the next dividend
P0 = current market price
g = growth

Question 9

How do you estimate the growth rate?

Answer 9

Using historical average

Question 10

What is the advantage of dividend growth model?

Answer 10

Easy to understand and use

Question 11

What are the disadvantages of the dividend growth model?

Answer 11

1. It is only applicable to companies currently paying dividends
2. It is not applicable if dividends aren’t growing at a reasonably constant rate
3. It is extremely sensitive to the estimated growth rate
4. It does not explicitly consider risk

Question 12

What is the formula for CAPM

Answer 12

Re = Rf + B ( Rm - Rf )
Rf = risk free rate
B = beta
Rm = risk of market
( Rm - Rf ) = risk premium

Question 13

List the advantages of CAPM

Answer 13

1. It explicitly adjusts for risk

2. It is applicable to all companies, as long as we can compute beta

Question 14

What are the disadvantages of CAPM

Answer 14

1. The expected market risk will have to be estimated
2. Beta has to be estimated as it varies over time,
3. Past is used to predict future, which is not always reliable

Question 15

Preference share is an annuity, so what is the formula for an annuity?

Answer 15

Rp = D / P0
D = dividend
P0 = current price

Question 16

What’s the weighted average cost of capital?

Answer 16

The individual cost of capital that has been computed together forms an average cost of capital of the for and this average is the required return on the assets, based on the market’s perception of the risk of those assets. The weighting are determined by how much of each type of financing that is used.

Question 17

How do you work out capital structure weight?

Answer 17

E = market value of equity = number of outstanding shares x price per share
D = market value of debt = number of outstanding bonds x bond price
V = market value of the firm = D + E
Therefore,
We = E/V = percent financed with equity
Wd = D/V = percent financed with debt
Interest expense reduces tax liability therefore the formula for WACC is as followed:
WACC = WeRe + WdRd(1- t )

Question 18

What are some reasons for calculating a company’s cost of capital?

Answer 18

1. The evaluation of capital projects
2. The valuation of companies
3. The determination of a company’s EVA or economic profit

Question 19

What are some underlying principles for calculating cost of capital?

Answer 19

1. Use weighted average of the costs of the different sources of finance
2. Use marginal costs, cost of new financing, data that refers to the future.
3. Include the effect of tax - after tax discount rate
4. Use nominal rates for nominal cash flows and real rate for real cash flows
5. Use market values or a target capital structure