Cost of Capital Flashcards
(16 cards)
What creates value?
(3,3,4)
Business Strategy
Focuses on revenue generation and profitability.
Key value drivers:
- Sales growth
- Increasing revenue through market expansion, new products, or higher sales volumes.
- Margin
- Enhancing profitability by controlling costs and improving operational efficiency.
- Planning horizon
- Setting long-term strategic goals for sustainable growth.
This strategy directly influences cash flow from operations, which is a key determinant of shareholder value.
Investment Strategy
Focuses on resource allocation to sustain and grow the business.
Key value drivers:
- Capital investment
- Spending on infrastructure, technology, or expansion to enhance productivity and competitiveness.
- Working capital
- Managing short-term assets and liabilities to ensure liquidity and smooth operations.
- Acquisitions
- Expanding business through mergers and acquisitions to gain market share and capabilities.
These factors also impact cash flow from operations, strengthening the company’s financial performance.
Financing Strategy
Determines how the company funds its operations and investments.
Key value drivers:
- Credit rating
- Maintaining a strong credit profile to access financing at lower costs.
- Tax rate
- Managing tax obligations efficiently to improve profitability.
- Capital structure
- Balancing debt and equity financing to optimize risk and returns.
- Dividend policy
- Deciding how profits are distributed to shareholders versus reinvested for growth.
These factors influence the cost of capital, affecting the overall valuation of the company.
Cost of Capital
What is the definition of Cost of Capital?
What does Cost of Capital involve?
What does Cost of Capital set for companies?
What is the shareholder perspective on Cost of Capital?
What is the firm’s perspective on Cost of Capital?
What is the financial manager’s perspective on Cost of Capital?
What is the definition of Cost of Capital?
- The rates of return that a company must offer finance providers to induce them to buy and hold a financial security.
What does Cost of Capital involve?
- Includes the cost of funds and investor expectations for returns.
What does Cost of Capital set for companies?
- Establishes the minimum return companies should generate on investments to meet investor expectations (sets the hurdle rate).
What is the shareholder perspective on Cost of Capital?
- Ensures returns are appropriate for the level of risk compared to other investment options.
What is the firm’s perspective on Cost of Capital?
- Balances cost versus the return necessary to attract and retain investors.
What is the financial manager’s perspective on Cost of Capital?
- Determines the minimum rate of return required on projects to satisfy shareholders.
What are the key considerations when calculating the cost of capital? (4)
What are the key considerations when calculating the cost of capital?
- Requires subjective assessment, as precise figures depend on various assumptions.
- Good decision-making relies on understanding the limitations of input variables.
- Knowing where informed judgment is applied helps in making value-enhancing decisions.
- A reasonable range is more important than absolute precision.
What is the Gordon Growth Model?
What is the formula for the cost of equity in the Gordon Growth Model?
What does D₀ represent?
What does P₀ represent?
What does g represent?
What is the Gordon Growth Model?
- A method used to calculate the cost of equity.
What is the formula for the cost of equity in the Gordon Growth Model?
What does D₀ represent?
- The current or recent dividend paid.
What does P₀ represent?
- The ex-dividend share price.
What does g represent?
- The expected annual growth in dividends.
ABC’s shares are currently traded at £5.20, having just recently paid a dividend of 50p. ABC’s dividends are expected to grow by a rate of 6% in forthcoming years, Calculate the cost of equity (or cost of capital if the firm is all equity financed)?
What does the CAPM approach consist of? (3)
What does the CAPM approach consist of?
- Risk-Free Rate of Return – Represents the opportunity of investing safely, free of risk (e.g., government securities).
- Premium for Systematic/Non-diversifiable Risk – Additional returns demanded by investors due to uncertainty and future prospects.
- Beta or Systematic Risk – Measures exposure to market-wide risk factors affecting asset returns.
Capital Asset Pricing Model (CAPM)
What does it allow?
Formula?
What each things means
- CAPM allows investors to base their required returns from the return of risk-free investments plus a premium.
GymShark Plc has a beta of 1.2, operates in a market in which the market return is 6% and the risk-free return is 3%.
Calculate the rate of return/ cost of equity?
Calculation of Cost of Debt
What are the different types of debt in cost of debt calculations?
What is an important characteristic of UK bonds?
What are the different types of debt in cost of debt calculations?
- Irredeemable Traded Debt – Interest-only payments, like perpetual bonds or preference shares, with indefinite maturity.
- Redeemable Debt – Interest payments plus repayment of principal at maturity.
- Bank Borrowings – Involve a compound interest rate applied to the principal amount.
What is an important characteristic of UK bonds?
- Bonds in the UK are traded in blocks of £100.
Irredeemable Debt
What is irredeemable debt?
What is a perpetual bond?
What is the formula for the cost of irredeemable debt?
What is the formula for the after-tax cost of debt?
What is irredeemable debt?
- Debt that cannot be redeemed or repaid before its maturity date.
What is a perpetual bond?
- A form of irredeemable debt that pays interest indefinitely without a maturity date.
Redeemable Debt (Corporate Bond)
What is the cost of redeemable debt?
What do we already know? (2)
What do we need to determine?
What is the formula?
What is the cost of redeemable debt?
- The cost of redeemable debt is found by determining the rate of return on debt, known as Kd, using the internal rate of return method.
What do we already know?
- A marketed price for the bond—the price the investor is willing to pay.
- The various payments made by the company, including coupon payments and principal.
What do we need to determine?
- if a person is willing to pay £X for a certain bond and receive £I payments in interest and £P payments in principal for that, what rate of interest does that represent?
WACC
WACC: Further Considerations
__________ _________ (3)
What about short-term debt (2)
What about financial leases (capital leases - long term) and operating leases (renting office space, equipment - short term)? (2)
Classic error:
- managers are sometimes tempted to use the cost of the latest capital raised to discount projects, special business units.
- Each project or unit may have a different risk profile, requiring a different discount rate.
- Using the latest cost of capital assumes all projects have the same risk, which can lead to poor investment decisions.
What about short-term debt?
- Should be included if pervasive.
- May be excluded if temporary or offset by cash and marketable securities.
What about financing leases (capital leases – long term) and operating leases (renting office space, equipment – short term)?
- Financing lease payments are considered part of operating expenses, not debt financing.
- If a company relies heavily on financing leases instead of traditional debt, they should be included in the cost of capital.
Negative Yielding Debt & Risk-free rate of return (2020)
What is negative yielding debt? (2)
How did LVMH use negative yielding debt? (2)
What does a negative coupon rate mean for investors? (2)
What is negative yielding debt?
- Debt where investors pay the issuer for holding the bond instead of receiving interest.
- Common in government gilts but also used by some corporations.
How did LVMH use negative yielding debt?
- Issued €300 million in negative-rate corporate bonds in March 2019.
- Fund managers placed orders six times the bond’s size.
What does a negative coupon rate mean for investors?
- Investors pay the company for the right to receive a payment at the bond’s redemption date.
- Instead of earning interest, they accept lower returns in exchange for security.
Cost of Capital and ESG – Does it pay to be Good?
What is the main topic of the slide?
- The relationship between the cost of capital and ESG (Environmental, Social, and Governance) credentials.
- Whether strong ESG credentials result in a lower cost of capital, referred to as “green-ium.”
What does the Bank of America report say about ESG-labelled bonds? (2)
What do analysts say about the “green-ium”?
What is the conclusion about academic studies on this topic? (2)
What is the main topic of the slide?
- The relationship between the cost of capital and ESG (Environmental, Social, and Governance) credentials.
- Whether strong ESG credentials result in a lower cost of capital, referred to as “green-ium.”
What does the Bank of America report say about ESG-labelled bonds?
- Compared European senior unsecured ESG-labelled bonds with similar conventional bonds from the same issuers.
- Found a difference of around 10 basis points, equating to a tenth of 1% off projects aligned with ESG rules.
What do analysts say about the "green-ium"?
- Consider the small “green-ium” to be within the margin of error for a company’s return estimates.
What is the conclusion about academic studies on this topic?
- Conceptual benefits of ESG-labelled bonds are well established.
- Empirical evidence on their impact is diverse and mixed.
1.
Sleeprough Ltd, an UK extreme outdoor bed-maker for climbers, is considering obtaining a £10m loan to finance a new bed line which is a contract they won in Chile for the Chilian Government to create a new type of roll-bed for the army. The company has never traded outside of the UK before and has never had a government contract before. It has been suggested that due to political risk and the unknowns that the Directors may want to consider “project finance”. Though at this point none of the Directors of the company understand really what that may entail.
The Directors are also concerned about the direction of current variable interest rates. The company’s current capital structure of £10m currently has a weighted average cost of capital (WACC) of 12% and is 50% financed through Equity and 50% financed through Debt. The Equity is all held by a single Director and Investor called Micky Ashbly, who has stated to the board clearly that he has no expectations of equity returns in the short or medium term. Due to this the Directors have an assumed 0% return on Equity. The debt is all held on a variable interest rate via various bank loans. The company has had in recent times had trouble getting loans with banks and has found itself often paying over-the-odds in interest rates. The discussions with banks have often centred around the assumption in Sleeprough Ltd’s calculations that the return on Equity will remain zero.
You are to recalculate the WACC of Sleeprough Ltd if the Cost of Equity were to rise to: (i) 5%, (ii) 10% or (iii) 15%. Assume no taxes. Comment on your assumptions. (6 Marks)
If the current WACC is 12% yet the Ke is 0% that means that the Kd is effectively 24% (24% x 0.5 = 12% WACC) (1 Mark)
WACC
At 5% = 5% x 0.5 + 24% x 0.5 = 14.5% (1 Mark)
At 10% = 10% x 0.5 + 24% x 0.5 = 17% (1 Mark)
At 15% = 15% x 0.5 + 24% x 0.5 = 19.5% (1 Mark)
Assumptions (2 Marks)
The clearest assumption made is that the variable rate of interest for the debt will stay the same as the Ke rises. The case already alludes to the fact that banks are concerned of the company’s expectations that Ke is zero. It seems unlikely given that information that they wouldn’t risk adjust their lending rates if that were to change.
