Ch.5 - Cost of capital

Question 1

How is cost of equity calculated?

Answer 1

Ke = [D0*(1+g)/P0] + g

P0 = ex-div price

Question 2

What are methods for estimating dividend growth?

Answer 2

Historic method:
g = [(D0/Dn yrs ago)^(1/n)] - 1

Earnings retention model (Gordon growth model):
g = r*b

r = accounting rate of return on investment
b = earnings retention rate (careful if given dividend retention rate)

Question 3

How is cost of preference shares calculated?

Answer 3

Kp = D/P0

P0 = ex-div price

Question 4

How is cost of irredeemable debentures calculated?

Answer 4

r = i/P0
Kd = r*(1-T)

r = yield 
P0 = ex-interest price

Question 5

How is cost of redeemable debentures calculated?

Answer 5

• calculate IRR

- adjust for tax @ (1-T)

Question 6

How is cost of convertible debentures calculated?

Answer 6

• compare the redemption value with the value of conversion option = select HIGHER
• calculate IRR
• adjust for tax @ (1-T)

Question 7

How is cost of non-tradable debt (loan) calculated?

Answer 7

Kd = i*(1-T)

Question 8

When is it appropriate to use WACC as a discount rate for the project?

Answer 8

• gearing level of the company is not going to change over the life of the project (use APV)
• level of risk is not going to change (use CAPM)
• finance is not project-specific

Question 9

What are the assumptions behind dividend valuation model?

Answer 9

• perfect market is operating to ensure that the share price is the present value of the future dividends discounted at Ke
• dividends are paid only once a year and either have just been or are just about to be paid
• dividend growth is expected to be reasonably constant and predictable
  => if using historic dividends to predict the growth, then we assume that the past is a good guide to the future
  => if using earnings retention model to predict growth, we assume that both rate of return and retention rate will remain constant over time

Question 10

What are problems with WACC?

Answer 10

• ideally we should be using permanent long-term sources of finance in the calculation, however some companies use overdrafts, leasing and even trade creditors for finance over long-term which could affect cost of capital
• calculating WACC for small, unquoted company is very difficult as there are no market values to obtain accurate returns and small size usually results in more expensive finance