Cost of Capital

Question 1

What is the company cost of capital?

Answer 1

this is the opportunity cost of capital for an investment in all the firms assets and it is the correct discount rate for its average risk projects.
Rate of return required by providers of finance is the basis for the cost of capital for the company.

Question 2

What is cost of equity (Ke) the same as?

Answer 2

return required by investors (Re)

Question 3

What is the cost of debt (Kd) the same as?

Answer 3

return required by lenders (Rd) - this has tax implications and adjustments

Question 4

What is the weighted average cost of capital (WACC)?

Answer 4

is an average of Ke and Kd, it is used as a discount rate in investment appraisal calculations and used as a hurdle for investment.

Question 5

What happens when we minimise the cost of capital/ decrease discount rate?

Answer 5

The company maximises the market value of the shares, it calculates the cost of each source and combines them in an optimal way.
In practice, it can be difficult to achieve - academic debate about relevance of capital structure to value

Question 6

Where does ordinary shares/equity value come from?

Answer 6

value comes from dividend payments. Cost of equity (Ke) is based on return on equity (Re)

Question 7

What is the calculation for return on ordinary shares?

Answer 7

Re = D1/MVe + g

Question 8

What is the calculation for cost of ordinary shares?

Answer 8

Ke = D1/MVe +g

Question 9

How do you find r from the ordinary shares valuation formula?

Answer 9

PV = D0(1 + g)/(r-g) = D1/(r-g)
r = Re = Ke -> no tax effect
the capital assest model is used to find Ke.

Question 10

What is the cost of redeemable debt (Krd) based on?

Answer 10

Return on redeemable debt (Rrd)

Question 11

What is the MV based on for redeemable debt?

Answer 11

MV is based on the discount rate that gives NPV of zero (i.e. IRR)
Return on redeemable debt: Rrd = IRR (using standard CF)
Cost of redeemable debt: Krd = IRR (using after tax coupon payment)

Question 12

How do you find YTM for redeemable debt?

Answer 12

Find YTM of the bond using IRR method.
YTM = Rrd = pre tax Krd -> need to adjust for tax, we want the value after tax has been deducted.

Question 13

What is the cost of irredeemable debt (Kid) based on?

Answer 13

Return on irredeemable debt (Rid)

Question 14

How do you find r from the irredeemable bond valuation formula?

Answer 14

PV = coupon payment/r
r = Rid = pre tax Kid -> need to adjust for tax

Question 15

What is cost of preference shares (Kp) the same as?

Answer 15

Return on preference shares (Rp)

Question 16

How do you find r from the preference shares valuation formula?

Answer 16

PV = dividend/r
r - Rp = Kp -> no tax effect

Question 17

What is the valuation formula for preference shares?

Answer 17

MVp = preference dividend/r

Question 18

What is the return of preference share calculation?

Answer 18

Rp = preference dividend/MVp

Question 19

What is the cost of preference share calculation?

Answer 19

Kp = preference dividend/MVp

Question 20

What is the cost of loan (Kl) based on?

Answer 20

return on loan (Rl)

Question 21

What is the calculation for the interest rate on a bank loan?

Answer 21

interest rate = Rl = pre tax Kl -> need to adjust for tax
return on loan: Rl = interest rate
cost of loan: Kl = interest x (1-tax rate)

Question 22

What is the return to debtholder?

Answer 22

this is the interest/coupon rate - this is tax deductible for the company. This changes cost to company. £100 paid to the debtholder will not cost the company £100 due to tax relief (tax shield). If tax rate is 30% the cost to the company of £100 of interest will be x (1-0.3) = £70.

Question 23

What is the calculation for return on debt?

Answer 23

Rd = interest/coupon rate

Question 24

What is the calculation for cost of debt?

Answer 24

Kd = interest/coupon rate x (1 - tax rate)
this is applied when market value of debt = principal to be repaid.

Question 25

What is the calculation for coupon payment?

Answer 25

= coupon rate x principal

Question 26

Why is tax shield important?

Answer 26

It is important in making debt cheaper than equity. However, it can only be applied, if the company is profitable. If the company is not profitable it will be not paying any tax so cannot get tax relief on the interest payments. If a company is loss making it will not get the tax relief and so the cost to the company will equal the return to the bond holder.

Question 27

What is riskiest?

Answer 27

equity is riskiest so should have the highest cost as higher risk but higher rate of return if it pays off. preference shares in dividend and on liquidation, lower cost than equity, riskier than debt, only paid if company makes profit but get payed before ordinary shareholders.

Question 28

Why is debt less risky then shares?

Answer 28

Has preferential rights on liquidation (get paid first), may be secured (collateral) has tax shield, cost of debt will be lower than cost of preference or ordinary shares as a lower rate of return. Longer term debt will cost more than short term debt.

Question 29

What is weighted average cost of capital used for?

Answer 29

As a discount rate in investment appraisal. It is based on an average of the cost of equity and the cost of debt. It is weighted to reflect the proportions of equity and debt in the capital structure. Weighting is usually based on market value of equity and debt.

Question 30

What is the simplified formula for WACC?

Answer 30

WACC = Ke x (E/E+D) + Kd x (D/E+D) Ke = cost of equity Kd = cost of debt (calculated after adjusting for tax shield, sometimes estimated as being equal to rd x (1-t). E = market value of equity D = market value of debt

Question 31

What are the 2 scenarios where you can get cost of debt straight from return on debt?

Answer 31

1. where your bond is traded at a par value (YTM or return on debt is x 1 - tax rate = cost of debt) 2. if you have a bank loans (YTM or return on debt/return on bank loan which is the interest rate, can be x 1 - tax rate = cost of bank loan)

Question 32

What can the WACC for a company be?

Answer 32

for a company with only debt and equity the WACC cannot be greater than 15% or less than 5% - it is somewhere in between, if equity had a bigger weight it would be closer to 15% and if debt had a bigger weight it would be closer to 5%

Question 33

What are the practical problems of WACC?

Answer 33

- Can only use market value to calculate cost of capital if the market has a market value i.e. is regularly traded -> problematic for shares in private companies which are not traded e.g. Twitter don't know their market value so need to find another way to come up with a market valuation of their equity. - Should we include leasing? - this is a source of long term finance - Should we include a persistent overdraft? This is a short term obligation that is paid of within 12 months -Difficult to predict a dividends growth - how reliable is this measure?

Question 34

WACC for a company should only be used as a project discount rate?

Answer 34

- business risk is the same - same industry, no difference between the nature of the project and the company's core operations - financial risk is the same - same capital structure (gearing) same amount of debt and equity in that project as well. - project is marginal to company e.g. different business ops, Uber trying to acquire Shell (cant use own cost of capital to conduct an investment appraisal for the cash flows of that potential investment) - if these conditions are not met: estimate WACC for project based on the specific projects risk profile.