Topic 8: Estimating the cost of capital Flashcards
What is the risk/return relationship?
Investor provides a finance to a company and the company compensates the investor for the return they could have had in a risk free investment and the risk the investor took by investing in the company.
What are the differences between debt and equity finance for the investor?
Annual Return - Equity is variable as it relies on dividend amount and capital gain and debt is more fixed only variance is variable interest.
Traded - Equity is tradeable but market value is volitile, debt can be through bonds and loan notes but not very volitile.
Repayments - Equity is not repaid, debt is paid in full.
Sercurity - Equity is unsecure, debt is mostly secure but defaults can happen (rarely).
Winding up (Liquidation) - Equity is last paid, debt is first paid.
What is the growth model? and what are the terms?
On the formula sheet.
First formula:
Re = The investors required rate of return.
Do = The dividends now e.g just paid or just about to be paid
G = The expected future growth rate in dividends
Po = The market value of shares now (Ex-div)
Second formula:
Re = The cost of equity to the company (Required rate of return)
Po = Valuing equity.
What are the two ways to estimate the growth rate?
Historic method
Gordon’s growth model
What is the weakness of the growth model?
Share price - They can be volitile and affected by general economic and political factors.
Constant growth - assumes growth is nil or constant forever, which is not realistic.
Ignores earnings - earnings could be being retained for future growth opportunities so it is not an absolute measure as it can be manipulated and dividends is just one aspect.
Not linked to risk.
How to calculate the cost of preference shares? Explain the terms?
Kpref = D/Po
Kpref = Cost of preference share
D = Preference dividends per share
Po = Current preference share price.
What are the difference types of debt?
Irredeemable debt
redeemable debt
convertible debt
How to calculate the cost of irredeemable debt? Explain the terms.
Kd = (I x (1-T))/Po
Kd = Cost of irredeemable debt
I = Annual interest in $
Po = Current market value of debt (ex-int) per nominal value
How to calculate the cost of redeemable debt?
Step 1 - Determine cashflows per £100 nominal value e.g Market value, interest, redemption.
Step 2 - Calculate NPV of the cashflows at two different discount rates 5%, 10%, 20%.
Step 3 - Calculate IRR using the interpolation formula.
What is the formula for IRR?
IRR = L+(NPVL/(NPVL-NPVH) x (H-L)
L = Lower discount rate
NPVL = NPV using lower discount rate.
NPVH = NPV using higher discount rate.
H = Higher discount rate.
What is the cost of convertible debt and how to calculate?
Calculate Conversion balance which is Market value of shares at the start multiplied by the growth rate. (If conversion balance is higher than redemption balance we take it)
Workout Cashflows and then the NPV of the converted debt.
Then using two different discount rates to calculate using IRR
IRR = L + (NPVL/(NPVL-NPVH) x (H-L)
How to calculate cost of bank debt?
Interest x (1-Taxation)
What is weighted average cost of capital? Explain terms.
Ve = Value of equity
Vd= Value of Debt
Ke = Cost of equity
Kd = Cost of debt
T = Taxation
When can WACC be used in investment appraisal?
It can be used as the discount rate.
