Week 8 Everything

Question 1

Capital

Answer 1

Capital represents the funds used to finance a firm’s assets and operations. Capital constitutes all items on the right hand side of balance sheet, i.e., liabilities and common equity.

Question 2

Main sources of capital

Answer 2

Debt, Preferred stock, Retained earnings and Common Stock

Question 3

Opportunity cost of capital

Answer 3

The firms cost of capital is also referred to as the firms opportunity cost of capital.

Question 4

Investor’s Required Rate of Return

Answer 4

the minimum rate of return necessary to attract an investor to purchase or hold a security. Investor’s required rate of return is not the same as cost of capital due to taxes and transaction costs.

Question 5

Impact of taxes

Answer 5

For example, a firm may pay 8% interest on debt but due to tax benefit on interest expense, the net cost to the firm will be lower than 8%

Question 6

Impact of transaction costs on cost of capital

Answer 6

For example, If a firm sells new stock for $50.00 a share and incurs $5 in flotation costs, and the investors have a required rate of return of 15%, what is the cost of capital?

The firm has only $45.00 to invest after transaction cost.0.15 x $50.00 = $7.5k = $7.5/($45.00) = 0.1667 or 16.67% (rather than 15%)

Question 7

Financial Policy

Answer 7

A firm’s financial policy indicates the desired sources of financing and the particular mix in which it will be used. For example, a firm may choose to raise capital by issuing stocks and bonds in the ratio of 6:4 (60% stocks and 40% bonds). The choice of mix will impact the cost of capital.

Question 8

The Cost of Debt

Bond market price

Answer 8

The bondholder’s required rate of return on debt is the return that bondholders demand. This can be estimated using the bond price equation:

2/4/19

Question 9

The Cost of Debt

Net proceeds per bond

Answer 9

Since firms must pay flotation costs when they sell bonds, the net proceeds per bond received by firm is less than the market price of the bond. Hence, the cost of debt capital (Kd) will be higher than the bondholder’s required rate of return. It can be calculated using the following equation:

2/4/19

Question 10

The cost of preferred stock

Answer 10

If flotation costs are incurred, preferred stockholder’s required rate of return will be less than the cost of preferred capital to the firm. Thus, in order to determine the cost of preferred stock, we adjust the price of preferred stock for flotation cost to give us the net proceeds.

Net proceeds = issue price – flotation cost

Question 11

The cost of preferred stock

formula

Answer 11

2/4/19

Question 12

The Cost of Common Equity

Answer 12

Cost of equity is more challenging to estimate than the cost of debt or the cost of preferred stock because common stockholder’s rate of return is not fixed as there is no stated coupon rate or dividend. Furthermore, the costs will vary for two sources of equity (i.e., retained earnings and new issue). There are no flotation costs on retained earnings but the firm incurs costs when it sells new common stock. Note that retained earnings are not a free source of capital. There is an opportunity cost.

Question 13

Cost Estimation Techniques

Answer 13

Two commonly used methods for estimating common stockholder’s required rate of return are:

The Dividend Growth Model

The Capital Asset Pricing Model

Question 14

Dividend growth model formula

Answer 14

2/4/19

Question 15

Dividend growth model is simple to use but suffers from the following drawbacks:

Answer 15

It assumes a constant growth rate

It is not easy to forecast the growth rate

Question 16

Capital Asset Pricing Model

Answer 16

2/4/19

Question 17

Capital Asset Pricing Model Variable Estimates

Answer 17

CAPM is easy to apply. Also, the estimates for model variables are generally available from public sources.

Question 18

Risk-Free Rate

Answer 18

Wide range of government securities on which to base risk-free rate

Question 19

Beta

Answer 19

Estimates of beta are available from a wide range of services, or can be estimated using regression analysis of historical data. Beta is a measure of thevolatility, orsystematic risk, of a security or aportfolioin comparison to the market as a whole. Beta is also known as the beta coefficient.

Question 20

Market Risk Premium

Answer 20

It can be estimated by looking at history of stock returns and premium earned over risk-free rate.

Question 21

How to work out the discount rate (r) a firm should use in undertaking a NPV analysis

Answer 21

Use the average rate of return on the firm’s capital (finance) items, weighted according to the percentage of the total capital (finance) of the firm each capital item makes up, i.e. use the weighted average cost of capital (WACC).

Question 22

Capital Items Used By The Firm

Answer 22

Equity Items: ordinary shares, preference shares.

Debt Items: mortgages, overdrafts, debentures/bonds, term loans.

Question 23

What Exactly Is Capital?

Answer 23

Firm’s stock of funds. Represented in balance sheet on the right-hand side as the financial assets of the firm. Capital can be viewed as one of the inputs or factors of production of the firm’s operations in the same way as salaries and wages, raw materials, rent, fuel and power. Just like other inputs capital has a cost and must be paid for.

Question 24

Cost of Capital

Answer 24

Cost of funds used to finance the activities of the firm.

Compensation for providers of capital.

Opportunity cost foregone by providers of capital for investing funds in the real assets of the firm.

Rate of return the firm must generate from investment in real assets to compensate suppliers of capital.

Cost of debt capital – interest expense.

Cost of equity capital – dividends.

Question 25

The cost of capital is determined by the use to which it is put:

Answer 25

Capital is used to finance investment in real assets. These real assets in turn generate the cash-flows used to service the capital. The risk of the cash-flows/real assets used to service the capital will be determined by the nature of the real assets. The higher the risk of the cash-flows/real assets, the higher will be the return required by the suppliers of the capital. It is the nature of the investments/real assets that determines the cost of capital.

Question 26

Weighted Average Cost of Capital (WACC)

Answer 26

As a company draws finance (capital) from several sources, the firm’s cost of capital is the sum of the weighted average cost of each source of capital, i.e. the WACC. WACC is one cost representative of the cost of all sources of finance, where each cost is weighted by its relative importance to the total finance of the firm.

Question 27

The simple WACC formula (with no taxation) is :

Answer 27

WACC = r = Σ ri wi

where:

r = the weighted average cost of capital

ri = the cost if the ith source of funds

wi= the weighting of the ith source of funds in the firm’s capital structure

Question 28

Cost of Capital Before Tax

Answer 28

Total Revenue

less

Operating costs

equals

Net Operating Income (NOI)

less

Interest expense ( cost of debt )

less

Tax ( cost of government )

equals

Net Income (NI) ( cost of equity (dividends))

Question 29

WACC assuming two sources of finance (debt & equity) and no tax:

Answer 29

WACC = r = re E/V + rd D/V

where:

re = the cost of equity capital

E / V = the proportion of equity in the capital structure

rd = the cost of debt capital

D / V = the proportion of debt in the capital structure

E = market value of equity

D = market value of debt

V = total market value of the firm (i.e. D + E)

Question 30

Cost of Capital After Tax

Answer 30

WACC after tax is the rate of return that the firm needs to earn on its assets/projects in order to compensate debt and equity holders given the government has already been compensated.

Question 31

Cost of Capital After Tax

Assuming only two sources of capital (debt & equity)

Answer 31

WACC after-tax = cost of debt + cost of equity

Question 32

Cost of Capital After-Tax

Interest Payments And Tax

Answer 32

Interest payments on debt are tax deductible, while dividend payments on equity are not. When calculating the WACC the after-tax cost of debt is (1-t) of the interest payments (where t = tax rate). Therefore, the firm’s assets gets some “help” from the government in covering the cost of debt which reduces the return that needs to be earned.

Question 33

WACC After Tax

Answer 33

The cost of servicing the debt is rd(D)(1-t) (where D = total debt). The cost of servicing equity is re(E) (where E = total equity). Therefore, the firm’s assets/capital have to generate a return sufficient to satisfy both debt and equity holders. Let r be the after-tax rate of return the firm can earn on its assets/capital, i.e. r = WACC.

WACC = r = re(E/V) + rd(1-t)(D/V)

Question 34

Market Value of The Firm

Answer 34

In order to calculate the WACC we need to find the market value of the firm. A firm is a collection of real assets that generate cash-flows.

Question 35

How to Value The Firm When Calculating WACC?

Answer 35

Value the income claims of those having provided the finance to purchase the real assets of the firm i.e. value the debt and equity of the firm.

Question 36

Real Assets & Financial assets

Answer 36

2/4/19

Question 37

The Cost of Ordinary Shares - CAPM

Answer 37

2/4/19

Question 38

The Cost of Preference Shares – Dividend Yield

Answer 38

2/4/19

Question 39

Cost of Debt

Answer 39

The cost of debt, rd, is the interest rate on new borrowings.

The historic cost of debt (book value) is not used – we must use the current cost of debt (i.e. the current interest rate in the market or the yield to maturity). Book values represent historical values and, consequently, fail to recognize the concept of the cost of capital as an opportunity cost i.e. the price of using capital as a factor of production

Question 40

rd is observable:

Answer 40

yields on currently outstanding debt

yields on newly-issued similarly-rated bonds

Question 41

Cost of Debt - The Effective Interest Rate

Answer 41

2/4/19

Question 42

The WACC should only be used when:

Answer 42

The risk of the project the firm is undertaking is similar in nature and risk to projects the firm normally takes on

The way the project is financed is similar to the way in which the firm is financed. This will be the case if the firm currently has the optimal capital structure.

Question 43

Calculating WACC

The 7 Step Process:

Answer 43

Identify the relevant components of the Capital Base

Calculate the Market Value of each component

Determine the Weighting of each component

Determine the Before-Tax Cost of each component

Determine the After-Tax Cost of each component

Calculate the Weighted Cost of each component

Sum the weighted costs to obtain the WACC

Question 44

In calculating the WACC of a company you will only have to include the following six items:

Answer 44

Equity: 1. ordinary shares & 2. preference shares;

Debt: 3. mortgage, 4. overdraft 5. debentures/bonds & 6. term loans

Items such as trade credit, provisions for bad and doubtful debts, provisions for taxation & provisions for dividends should be ignored.