The cost of capital and capital structure

Question 1

What is cost of capital 3

Answer 1

1. All providers of finance require returns.
2. The required return will reflect the risk of the investment and the returns of alternatives.
3. Companies need information about the cost of different sources of finance in order to find the overall cost of finance and to make investment and financing decisions.

Question 2

Cost of Debt

Answer 2

is the required rate of return on investment of the lenders of a company. ki = kd ( 1 - T )

Question 3

Cost of Preferred Stock

Answer 3

is the required rate of return on investment of the preferred shareholders of the company. kP = DP / P0

Question 4

cost of equity capital

Answer 4

ke = Rj = Rf + (Rm - Rf )bj

Question 5

Average and marginal cost 4

Answer 5

1. The marginal cost of capital is the cost of the incremental capital raised.
2. Initially, as cheaper debt is added, average cost of capital will fall.
3. After a minimum is reached, the average cost of capital will rise due to increased risk.
4. The marginal cost will initially be lower than average; after the minimum, it will be higher.

Question 6

When to use WACC? 4

Answer 6

1. WACC can be used in investment appraisal in certain restricted circumstances:
2. Business risk of investment project is similar to business risk of existing operations.
3. Incremental finance is raised in proportions that preserve existing capital structure.
4. Required return of existing finance sources is not affected by new investment project.

Question 7

Practical problems with WACC

Answer 7

Security market values may be unavailable

• use substitute security with similar risk, return and maturity
• add risk premium to yield on government bond

Securities may be complex:

• convertible securities
• floating rate notes
• foreign currencies
• currency and interest rate swaps.

Question 8

Problems with calculating WACC 4

Answer 8

Which sources of finance should be included in the WACC calculation?

What about long-term bank debt?

• use book value and average interest rate
• accounts may not provide adequate data
• internal information will be required

Company may have large range of securities.

WACC is not constant.

Question 9

Implications of high gearing 4

Answer 9

What is gearing? The mixture of debt finance relative to equity finance that a company uses to finance its business operations.

1. Increased volatility of equity returns arises with high gearing since interest must be paid before paying returns to shareholders.
2. Increase risk of bankruptcy also occurs.
3. Stock exchange credibility falls as investors learn of company’s financial position.
4. Short-termism moves managers’ focus away from maximisation of shareholder wealth.