cost of capital Flashcards
what is cost of capital
unique cost of each business that we use to evaluate (present value) the cash flows of future projects
for each project the internal rate of return is calculated
what do we do if the projects overall internal rate of return exceeds our cost of capital
we accept the project as we believe that it will add value to the firm
what do we do if we dont know the internal return rate?
we present value all the cash flows using our cost of capital and if the overall result is positive we accept the project and if its negative we reject the project
what is included in liabilities/debt?
any long term liability that bears interest such as long term loans or bonds or debentures. Bank overdrafts and short term debt are general short term financing as they fund net working capital
what is the cost of debt (rd)
would be the market rate of the debt after tax
the South African tax rate is 28% and because a business can deduct interest for tax purposes the actual cost would be 72% of the market rate. We say that we multiply the market cost of debts by (1- tax rate). So if debt has a market rate of say 9% the after tax cost of debt for the business would be 9% (1 - 0.28) = 9% x 0.72 = 6.48%
what is included in equity?
For a sole proprietor or partnership it will be the capital account. For companies it is the share capital, any reserves and the retained income (accumulated profits). Equity has a cost but this is not reflected anywhere in the annual financial statements.
Preference shares are also form of equity funding.
If we wish to calculate the effective rate of the preference shares we rearrange the formula (and you must be able to do this) …
rps = Dps/Pps
what are flotation costs
when a company issues new pref shares there is a cost called flotation costs
formula to calculate the effective rate of the preference share, accounting for flotation costs
rps = Dps/Pps(1-F)
capm formula
Expected Return or cost of equity = Risk-Free Rate + Beta (Market Return – Risk-Free Rate)
average beta = 1
more risk = more than 1
less risk = less than 1
what is the market premium
market rate - risk free rate
what is the risk free rate
- The rate for along‐term government debt security because the equity claim is a long‐term claim on the firm’s cash flows.
note: a long term risk free rate better reflects the long term inflation expectations and the cost of getting investors to part with with their money for a long time period than a short term rate
using the constant growth dividend model
Rs = (D1/P0) +growth
the cost of issuing new shares
Rs = (D1/P0(1-F)) +growth
