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Year 1 - Accounting and Finance > finance lec 7 - cost of capital > Flashcards

finance lec 7 - cost of capital Flashcards

1
Q

what is cost of capital

A

ROR required by providers of finace

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2
Q

cost of equty ke=

A

return required by investors (re

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3
Q

cost of debt kd =

A

return required by lenders except for tax implciations

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4
Q

what si the weihted average cost of capital

A

avg pf ke and kd

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5
Q

what terms are used interchangly

A

ke

re

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6
Q

cost of capital is used as a what in investment appraisla calculation

A

discount rate

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7
Q

cost of capitla issed as a what rate for investments

A

hurdle rate

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8
Q

what would be the right discount rate for company to use for capital IA

A

wacc

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9
Q

what do we use when doing IRR nad NPV

A

wac as hurdle rate for IRR - hurdle rate

wac as DR when doing NPV Calc

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10
Q

what does comp also use WAC for

A

internal budgetting purposes

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11
Q

why is it importnat to minimise cost of capital

A
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12
Q

if cash flow is fixed what is the only way for company to maximise value of firmm/shares

A

minimise discount rate

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13
Q

if the cash flow is fixed and we need to use a DR to work out PV of asset the lower teh DR used

A

the higher the PV

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14
Q

If cash flow is fixed the lower the WACC the company uses to value the firm the higher

A

higher the value of firm will be

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15
Q

if company wants to maximise the value given a cerain set of cf they should eb tryong to minimse

A

WACC

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16
Q

what is one way to minimise the WAC

A

choose capital structure and dividend policy well

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17
Q

by minimisng the cost of capital what di teh company do

A

max the mkt value of shares

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18
Q

how do we max the mkt value of each share

A

calcualte the cost of each source

combine in the optimal way

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19
Q

cost of

A
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20
Q

when we tlaking about cost of capital we referring to

A

cost of all capital elements

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21
Q

when we tlakm bout cost of cpaitla we refererig to cost of all capital elements therefore we need to work out

A

cost of each constituent of capital

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22
Q

when we tallm bout equity -capital structure- we mean

A

ordinaty shares

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23
Q

when we talking about debt - CS - we mena

A

redeemable bonds

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24
Q

the principle is the same - csot to company for each type of capital is based on

A

return to investors/providers of each capital

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25
Q

ordinary shares equity - cost of equity ke based on

A

reutn on equity - re

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26
Q

ordinary shares equity - where do we find r from

A

ordniary shares/valuation formula

d0(1+g)/r-g

D1/r-g

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27
Q

r =

A

re = ke

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28
Q

once r worked out its the same as

A

cost of equity

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29
Q

there isno waht efect on r=re=ke

A

tax effect

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30
Q

cost of redeemable debt based on

A

return on redeemable debt - rrd

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31
Q

how do we find the YTM

A

using IRR method

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32
Q

YTM =

A

rrd = pretax krd ( need to adjust for tax)

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33
Q

what is r/rd closely related to

and why

A

cost of rd

gives us pretax but company needs after tax

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34
Q

irredemable debt is a standard

A

perpetuity

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35
Q

irredemable debt is a standard perpetuity therfore vale based on

A

future cf/PV of fututre cf

36
Q

cost of irredemable d kid baseed on

A

return on irredeemable debt rid

37
Q

where do we find r for irredemable debt

A

irredemable bond valuation formula

38
Q

what is irredemable bond valuation formula

A

coupon payment/r = PV

39
Q

in irredemable r =

A

rid = pretax kid ( need to adjust for tax)

40
Q

prefernece shares - we know it is equiyt therfore ROR by preference SH =

A

cost of prefernce shares kp

41
Q

where do we find r in preference shres from

A

prfernce shares valuation formula

42
Q

what is preference shares value formula

A

pv = dividend/r

43
Q

(preference share) r =

A

rp=kp

44
Q

when talm bout bank loan we particualry speaking about

A

ammortised bank loan

45
Q

bank loans have a x element

A

debt

46
Q

bank loans have a debt element therefore x implications have to be taken into account

A

tax

47
Q

cost of loan kl is based on

A

return on loan rl

48
Q

where do we find interest rate for bank loan

A

on bank loan

49
Q

in bank loan what is interest rate

A

interest = r1 = pretax k1 (need to adjust for tax

50
Q

when a company incurs debt the actual cost to the company is not

A

the interest payment i.e waht the debt holders recieve

51
Q

the interest the company paus o debt is …. but its not

A

the return the investors get

but its not -
actual cost the company bares

52
Q

why does a company that has debt in ints captial struture pay less than a 100% equity company

A

casue they pay debt before the profit before tax

the debt reduces th amoutn fo profit

the amount the y are taxed on is less than teh equity firm

53
Q

the cost of debt is x x

A

tax deductible

54
Q

dividends dont get a liablity t/f

A

t

55
Q

we pay tax based onx and before you pay x you pay x

A

profit before tax and before you pay tax you got to pay interest

56
Q

interest payments change gtax what is the societal impact

A

debt subsidised by tax payers

casue if comp got debt in capital stucture pay less tax

57
Q

we will always use what for cost of capital calculation

A

after tax cost

58
Q

how do we calcualte tax shield/deductablity of interest

A

interest * (1- tax rate)

59
Q

because of tax shield element what is the difference between post tax cost and pretax cost and so

A

post tax lower than pretax

the post tac is less than the return to debt holders which is the same as pretax cost to company

60
Q

cost of debt

A
61
Q

what is the return to debt holders

A

interest/coupon payment

62
Q

what is the effect of interest payment/coupon payment being tax deductible

A

cost to company is lower than the return they paid to debt holders

63
Q

interest /coupon payment =

and what does this change

A

tax deductible for comp

cost to company

64
Q

why wont 100 to debt holders cost the copnay 100

A

tax shield

65
Q

if the tax rate = 30% what is cost to company of 100

and hence

A

100 x (1-0.3) = 70

rd = interest/coupon rate
kd = interest/coupon rate x (1- tax rate)

66
Q

65 is s aslight simlification that applies to

A

MV of debt = principal to be repaid

67
Q

the lacualtion emthod deends on whether debt is

A

irr/redeemable

68
Q

whenever ther is a coupon/interst payment what do we do

A

tax deduction

69
Q

whenever teher is a coupon paument how do we reduce coupon by tax shield amount

A

multiply payment by 1 - tax rat

70
Q

reedemable debt method - what is required and what do we use

A

irr calc require usin after tax coupon payment

coupon x 1 - tax rate

71
Q

irredemable debt method

A

do perpetuity formula - but coupon payment we used in the formula must be after tax coupon payment so we get post tax cost of debt

post tax cost required

check this on slides

72
Q

what is redeemable debt method when fot coupon and principal repayment

A

mao cashflows from det

coupon - annual after tac cu[on (FV each year)

prinicipal - repaid at end ( FV in final year)

market price of bond ( PV at time t=0)

calc IRR using IRR estimation from table 2 - bruh mi nuh know

only adjustmnt you di s in respect to coupon payment

73
Q

irredemable debt calc ? bruh how many we gonna do

A

return on ird = coupon payment/ MV of bond / PV of future cf of the bond)

MV = coupon repayment /rid

oonly cf needs to be adjusted for the tax shield

post tax cost of debt = kid = coupon payment x 1-t/MV

kid = post tax cost of debt

t = tax rate

MV = market value of the iredeemable (perpetual bond)

sont adjust price/principal cause we dont have any principlar repayment
do practice qs

74
Q

tax shield

A
75
Q

why is det cheaper than equity

A

tax shield

percieved to e les risky than equity

76
Q

tax shield is importnat in making debt cheaper than equity but can onnly be applied if

A

company is profitable

77
Q

tax shield can be applied only if copmany is proitable casue

A

if company ont profitale wont make tax

78
Q

if the company is loss making at operating progit level/ deliberatley targetting 0 profit what will happen and what is the result

A

wont get tax relief so lost to company
= return to bondholder

79
Q

risk and cost of capital

A
80
Q

equity is riskiest so shoudl ave

A

highest cost

81
Q

equity is greater than

A

post tax cost of debt

82
Q

one reason debit is cheaper is because of the tax shield what is the main reason

A

debt consdiered less risky

investments demand a lower return

so debt is cheaper casue of assumption of risk aversion

investors require a lower return

83
Q

why does equity ahve such a high return

A

equity gets paid already after everyone else been paid

o no guarantee gonna get paid so compensated bya higher so ke is high for company

84
Q

preference sahhre get paid after waht and before waht so arent as risky

A

after debt been paid

ebfore ordinary share holders

85
Q

why debt perceived to be less isky thn shares

A
  • has preferential rights on liquidation in terms of payment
    always got to be paid first - companies got debt payment obligation

may be secured - against assets/valauble - so some element of assurance they gt at least some money back
and get priority on sale of assets

-

Year 1 - Accounting and Finance (49 decks)

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