Topic 13: The Cost of Capital (Sem 2) Flashcards
The cost of equity
Companies can raise long term capital by issuing two main types of security:
Equity
Debt e.g. Corporate bonds
These both have costs for the company.
Note: The return an investor receives on a security is the cost of that security for the company.
Key distinguishing features of equity
It is an ownership interest in a company
Provides partial involvement in corporate decision making (Voting Rights)
Not usually repayable
Gives Dividends rights to company directors
Provides an opportunity for capital gain (or loss) depending on the vlue of the company.
Cost of Equity Capital
The return that investors require on their equity investment in the firm.
Can be calculates in two ways:
1) The dividend growth model
2) Capital Asset Pricing Model (CAPM)
The dividend Growth Model (Formula)
P0 = [D0 * (1 + g)] / [Re - g]
Where:
P0 = Current share price
D0 = Dividend just paid
D1 = Next periods projected dividend
g = Constant dividend growth rate (This model assumes growth is constant)
Re = Required return on equity
Note: Formula can be rearranged to solve for Re:
Re = D1 / (P0 + g) This can be interpreted as the company’s cost of equity capital.
NOTE: CHECK EXAMPLE IN NOTES
The dividend growth model advantages and disadvantages
Advantages:
It is simple to understand and apply
Disadvantages:
It can only be used for companies that pay dividends
The simple version of the model assumes a constant dividend growth rate which may not be applicable;
The model is very sensitive to the rate of dividend growth
It relies on the past to predict the future
The model does not explicitly consider risk
Capital Asset Pricing Model (CAPM) (Formula)
Under CAPM Re can be written as:
Re = Rf + Be * (Rm - Rf)
Where:
Re = Required return on equity
Rf = Risk free rate
Rm - Rf = Difference between the expected return on the market portfolio and the risk-less rate. This difference is often called the market risk premium.
Be = Beta is provided in question usually
NOTE: CHECK EXAMPLE IN NOTES
CAPM Advantages and disadvantages
Advantages:
It explicitly adjust for systematic risk
It can be applied to companies that do not pay dividends
Disadvantages:
It requires estimates for the market risk premium and beta both of which can be difficult
The model relies on the past to predict the future
The Cost of Debt (Corporate Bonds)
Debt is the second source of financing after equity. It comes in two forms:
Corporate Bonds
Preference shares
The cost of debt for these two securities is: The return that lenders require on the firm’s debt.
Note: Cost of Debt is the market return on the bond I.e. the yield to maturity. It is NOT the coupon rate.
NOTE: CHECK EXAMPLE IN NOTES
Distinguishing features of corporate bonds
It is a loan to company
Provides an involvement in corporate decision making
Typically repayable
Gives contractual right to interest, typically a fixed amount
Provides an opportunity for gain or loss depending on the risk of the company.
The cost of debt (Preference Shares)
A type of equity but has a fixed dividend payment every period forever.
A single preferance share is essentially a perpetuity
The cost of Preference shares (Formula)
Rp = D / P0
Where:
Rp = Cost of preference shares
D = Fixed dividend
P0 = Current preference share price
NOTE: CHECK EXAMPLE IN NOTES
The weighted average cost of equity (WACC)
The weighted average of the cot of equity and the after tax cost of debt.
Capital Structure
The mixture of long term debt and equity through which a company finances its operations
Proportion of equity (calculation)
Calculated by: Number of outstanding shares * Market price per share
Use symbol S for share or E for equity
Proportion of Debt (calculation)
Calculated by: Market price of a single bond * The number of outstanding bonds
Use Symbol B for bond or D for debt.
