Calculate The Cost Of Long Term Finance

Question 1

What is the cost of debt:

Answer 1

It’s the interest rate a company pays on debt, adjusted for tax to show the true cost of the bond debt.

Question 2

What is YTM:

Answer 2

The Yield to Maturity on a bond.

This calculates the return the investor will receive from the bonds. This is based on the interest received and the final redemption amount.

The YTM allows investors to compare bonds with different maturities and coupon payments.

For a company the YTM is not the same as the cost to the company. The cost to the company is lower, because interest is an allowable expense for tax purposes.

Question 3

What is the cost of capital:

Answer 3

This is the cost of debt combined with the cost of equity.

It represents a hurdle rate that a company must overcome before it can generate value.

It is used extensively in the capital budgeting process to determine whether a company should proceed with a project.

Question 4

Downside of an irredeemable bond:

Answer 4

Because the bond will never be redeemed, the company will need to keep on paying the coupon, even when it no longer needs the debt finance.

Question 5

Formula to calculate the cost of an irredeemable bond:

Answer 5

Kd = i (1-T) / P0

Kd = Cost of the bond to the issuer
i = annual interest rate (coupon rate)
T = marginal rate of tax
Pzero = the ex-interest market price of the bonds

Ex-interest = the market price excl interest payments.

Question 6

How to calculate the cost of an Redeemable bond:

Answer 6

1. Identify the cashflows (typically, the bond price at issuance, interest payments, bond redemption amount
2. Discount the cashflows at 2 different rates (one lower, one higher), so that 2 NPVs are calculated
3. Calculate the IRR (internal rate of return - this is an approximation, it’s not exact)

Question 7

How to calculate the IRR of a bond:

Answer 7

IRR = L + (((NPV L) / (NPV L - NPV H)) * (H - L))

L = the lower rate of interest selected
H = the higher rate of interest selected
NPV L = NPV at lower rate
NPV H = NPV at higher rate

Question 8

Features of the IRR:

Answer 8

Internal Rate of Return of a Redeemable Bond:

• when NPV H is negative and NPV L is positive, the IRR lies between the two of them.
• IRR is approximate. When you use different interest rates, the result can be very different.

Question 9

How to calculate the interest payment on a bond:

Answer 9

This is the percentage of interest x the price of the bond at par.

The cost to the company is this interest cost x (1- tax rate)

Question 10

How to calculate the NPV of each of the cashflows:

Answer 10

The NPV of the cost of issuance is 1, as its being paid now. This is represented as a negative number.

2. To calculate the NPV of the interest rates, we need the Cumulative Discount Rate for the number of years to maturity of the bond and for a lower and higher interest rate. One of them being the actual coupon rate.

If this means NPV L is positive and NPV H is negative, then the IRR lies in between.

Question 11

How to calculate the cashflow on the redemption amount:

Answer 11

This is the discount value for the maturity of the bond at L and at H. So you will have two NPV.

Question 12

How to work out the cost of Convertible Bonds:

Answer 12

• it is similar to calculating the cost of Redeemable Bonds
• it is assumed that all investors make the same repayment decision
• instead of the cashflow at redemption, we use the highest conversion option to work out this cashflow.

Question 13

How to work out the IRR on a Convertible Bond:

Answer 13

One needs to predict the value of the shares on conversion:

1) Find out which option is most likely to be exercised at maturity: cash or shares
2) Calculate the cost of capital

Question 14

Formula to Calculate the YTM for an Irredeemable Bond:

Answer 14

Yield to Maturity in % = i / Pzero

i = annual interest received over the nominal value in $
Pzero = the ex interest market price of the bond (usually quoted per $100 nominal value)

Question 15

YTM for a Redeemable Bonds:

Answer 15

For this we use the IRR calculation following the same steps as the cost of debt calculation.

Use pre-tax cashflows in this case:

Question 16

YTM for a Redeemable Bonds:

Answer 16

For this we use the IRR calculation following the same steps as the cost of debt calculation.

Use pre-tax cashflows in this case:

Question 17

What is WACC:

Answer 17

Weighted Average Cost of Capital.

This is the cost of debt combined with the cost of equity, which is used to work out the cost of capital.

Question 18

What is DVM:

Answer 18

Dividend Valuation Model:
This is a quantitative method of valuing a company’s shares that assumes the value of a share is equal to the present value of future dividends, discounted at the shareholders’ required rate of return.

2 Variations of the model:
1) Assumes future dividends are constant
2) Assumes dividends grow at a constant rate

Question 19

DVM formula, assuming dividends are constant:

Answer 19

Ke = D / Pzero

Ke = Cost of Equity (Shareholders required rate of return)
D = Constant annual dividend payable from today to the foreseeable future
Pzero = the ex dividend share price

Question 20

DVM formula, assuming dividends grow at a constant rate:

Answer 20

Ke = (Dzero (1+g) / Pzero) + g

Dzero = current dividend
g = constant rate of growth in dividends for the foreseeable future

Question 21

What is the cum-div price of a share:

Answer 21

This is when a company has announced that it is going to pay dividend. The share price then rises by the amount of the dividend declared, because investors are entitled to receive the upcoming dividend payment.

Question 22

What is the ex-div price of a share?

Answer 22

This is the first day that a share trades without its dividend included in the share price.
Investors buying shares on or after the ex dividend date are not entitled to the dividend.
This makes the share price cheaper.

Question 23

When does the ex dividend included date occur:

Answer 23

Shortly before the date of record, which is the date on which a company determines its current roster of shareholders for purposes of identifying those shareholders eligible to receive dividend.

Question 24

How to calculate the ex dividend payable price for the DVM:

Answer 24

Ex div price = cum div price -/- upcoming dividend

Question 25

2 methods to calculate dividend growth:

Answer 25

1) The averaging method (to use when dividend growth rate is fairly stable) 2) the profit retention rate method (to use when a company regularly invests a set percentage of its profits, and when that reinvestment generates a fairly constant rate of return.

Question 26

Averaging method to calculate future dividend growth:

Answer 26

Also called the Averaging past method: Formula to calculate the Past Average Growth Rate: g = n square root dzero / dn -/- 1 g = growth rate d = latest dividend dn = dividend paid n number of years ago n = the number of years between dzero and dn

Question 27

Profit retention rate method:

Answer 27

Also called earnings retention rate method: g = r x b r = percentage return the company receives when profits are reinvested b = proportion of profits retained and reinvested The higher b, the higher the growth.

Question 28

Assumptions made in the profit retention rate method:

Answer 28

- that there is a constant rate of return from reinvestment - that there is only equity finance - that retained profits are the only source of reinvestment - that there is a constant amount of retained profits reinvested In real life it is unlikely this will all happen. The model gives us a useful tool though to work out an approximation.

Question 29

Formula to calculate the cost of debt for bank borrowings:

Answer 29

kd = r (1-t) kd = post-tax cost of borrowing r = annual interest payable in percentage terms t = the corporate tax rate

Question 30

What is the pre-tax cost of bank borrowing:

Answer 30

This is the amount that the company needs to pay to the bank.

Question 31

What is the post-tax cost of bank borrowing:

Answer 31

This is the cost of borrowing after taking into account the amount of interest that is tax deductible. The post tax cost of borrowing is lower than the pre-tax cost. Companies should use the post tax cost of borrowing to determine how the debt will affect the overall budget.

Question 32

What value to use to calculate the WACC:

Answer 32

For each source of finance we use the market value, rather than the book value, because this better reflects the current amount invested by each of the providers of finance.

Question 33

What can de WACC be used for by directors of a business:

Answer 33

- To make decisions about new investments. If the returns from a new investment exceeds the WACC, then the investment is worthwhile. - To make decisions about financing the business. It may be possible for directors to reduce the WACC by changing the proportions of equity and debt capital. A reductions of the WACC is beneficial, because it lowers the overall cost of an entitiy’s finance.

Question 34

How to calculate the WACC: (5 steps)

Answer 34

1. Estimate the cost of each type of finance 2. Calculate the total market value of each type of finance 3. Calculate what proportion of total finance each different finance type represents 4. Multiply the proportion of finance by the cost of each finance type (Step 3 x Step 1) 5. Sum the individual weightings from step 4 to give the WACC

Question 35

Formula for the WACC:

Answer 35

WACC = Ke [Ve / (Ve+Vd)] + Kd [Vd / (Ve+Vd)] Ve = market value of equity Vd = market value of debt The cost of debt should be included on a post-tax basis.

Question 36

Limitations of using WACC:

Answer 36

- The assumptions underlying the calculation of the costs of the individual forms of finance may not be correct - Calculating the cost of capital for an unlisted company can be more difficult. - WACC is normally used to calculate long-term finance. If a company uses short-term finance (for example a rolling bank overdraft), then the WACC should also include this type of finance. - The WACC represents the minimum return that is required for the new investment or project to make it worthwhile. - Assumptions include that the long-term capital structure of the company won’t change, that there is no change to financial risk. - It assumes there is no change in business risk - It assumes the new investment is relatively small compared to the whole of the business and hence will not significantly change Ke, Kd or WACC

Question 37

Steps to Calculating WACC:

Answer 37

1. Identify the different sources of finance: - ordinary shares - preference shares - bank loan - Redeemable bonds 2) identify the cost of each type of finance. (For bonds and bank loans this is the post-tax cost) 3) Work out the market value of each type finance: - Ordinary and Preference shares = number of shares x share price - bank loans is the book value - Bonds 4) Add all of them to get the total finance 5) Work out the percentage proportion for each of them out of total finance 6) Multiply the proportion x cost of capital for each of them and add up costs of capital.