Week 5 - Cost Of Capital Flashcards
What is the ‘cost of capital’? (2)
• Cost of capital is the actual return a firm is currently is currently making to its investors
• is the amount investors want in order to compensate them for their (perceived) risk
Define cost of equity (2)
• Cost of equity is the theoretical cost that the market demands in exchange for a “share” in a firm
• higher for high risk investments (or firms) than for lower risk ones
Define cost of debt (2)
• The effective cost of servicing a firm’s debts (eg. interest payments).
• A firm gets tax relief on interest payments so the cost of debt is calculated POST TAX
Define weighted average cost of capital
• Is the weighted average cost paid to service a firms debts
How can the weighted average cost of capital (WACC) be used when recommending an investment?
• It represents a useful way of setting a hurdle rate for new investment (providing the new investment is typical of historic investments) where a new project should yield an IRR which is greater
than a firms WACC
What is the formula for tax shield/savings in tax/true interest rate? (2)
• interest charge x tax rate
• actual interest rate x (1 - tax rate)
What is the formula for the cost of bank debt?
What is the formula for the cost paid to bondholders
Formula for the cost of equity
How do you answer a weighted average cost of capital question? (4)
1 - Workout the value of the firm
2 - Calculate the weight (%) of the firms’ bank debt, bonds and equity to the total value
3 - Calculate the cost of bank debt, bonds and equity
4 - Use the weight figures and cost figures and put them into the WACC equation
How do you calculate the value of a firm in a WACC question? (4)
• Value (firm) = Value (bonds) + Value (bank debt) + Value (equity)
Where:
- Value (bonds) = Market value of the bonds x number of bonds in circulation
- Value (equity) = number of shares x share price
- Value (banks) = the amount of the bank loan
How do you calculate the weight (%) of the firm’s bank debt, bonds and equity
• V (equity) / total value of the firm x 100
• V (bonds) / total value of the firm x 100
• V (banks) / total value of the firm x 100
What is the formula for the weighted average cost of capital (WACC)?
What are the uses of WACC? (4)
• WACC can be used as a hurdle rate for investment decisions where it can be used as the minimum required return for new investment and if a projects return is greater than the WACC it’s financially viable
• WACC reflects the weighted cost of equity and debt helping to understand how much firms needs to generate to satisfy investors and creditors
• WACC is helpful in capital budgeting decision which can be used in NPV and IRR calculations ensuring the projects are evaluated consistently with the company’s cost of capital
• Can be used a measure of a project’s performance - if a company’s returns are greater than the WACC it’s financially creates shareholder value (but if it doesn’t it can destroy shareholder value)
What are the limitations of WACC? (4)
- WACC assumes a constant capital structure - assuming the debt to equity ratio remains constant is not guaranteed
- Does not take into the account the risk profile of a firm - if a firm enters a new industry with different risks, WACC may not be an appropriate discount rate
- WACC depends on interest rates, tax rates and investor expectations, all of which can change making it unstable over time and sometimes inaccurate
- Difficulty in calculating the true cost of equity which is estimated through the ‘dividend growth model’ or CAPM which can be inaccurate. Future dividends and growth rates are based on assumptions which can lead to errors in the calculations
