WACC Specifics

Question 1

How do you calculate the cost of equity using the gordon’s growth model?

Answer 1

g = r x b

r = accounting rate of return
Earnings in the year/(ordinary share capital + opening capital)
Opening capital = Retained earnings in SOFP - Retained earnings this year
- This year = (earnings - dividend paid or PAT)
b = retained earnings from the year / total earnings from the year

Then plug into the cost of equity formula:

(d1)/MV + g

D1 = the current dividend multiplied by the growth rate to give next years dividend

Question 2

How do you calculate the cost of preference shares?

Answer 2

dividend/market value

e.g. 6% £1 preference shares with an MV of £1.33 ex-div =

£0.06/1.33 = 4.51%

Question 3

How do you calculate the cost of irredeemable shares?

Answer 3

(interest-tax)/MV

Question 4

How do you approach calculating a risk adjusted WACC?

Answer 4

Co A is considering a project with a different risk profile to its usual activities.
Co B is a company engaged in similar activities to the new project
1 Degear the Be of company B (using B’s D:E ratio) to find Ba
2 Regear this Ba for company A (using A’s D :E ratio)
3 Use this Be in the CAPM formula to find the ke for company A
4 Calculate kd and then WACC as usual for company A

Question 5

What happens as gearing increases?