Unit 9 - Capital Structure, COC, WACC

• Why is the cost of capital important in financial decision making?

  It helps design optimal capital structure
• What does capital structure represent?

  Composition of equity and liabilities
• What is the key objective of a company regarding capital structure?

  Maximise the value of the company
• What is the weighted average cost of capital (WACC)?

  Company's overall cost of capital
• What does the cost of equity represent?

  Return expected by equity investors
• What are the two methods to determine the cost of equity?

  CAPM and dividend valuation model
• Who developed the capital asset pricing model (CAPM)?

  Sharpe and Lintner
• What does the risk-adjusted discount rate (RADR) represent?

  Required returns for risky investments
• What is the formula for calculating RADR?

  RADR = RFR + risk premium
• What are unsystematic risks?

  Company-specific risks that can be diversified
• What are systematic risks?

  Market risks that cannot be diversified
• How does the CAPM suggest investors manage unsystematic risk?

  By diversifying their investment portfolio
• What does beta (ß) represent in CAPM?

  Systematic risk of a share
• What does a beta (ß) greater than 1 indicate?

  Higher systematic risk than the market
• What does a beta (ß) less than 1 indicate?

  Lower systematic risk than the market
• What is the security market line (SML)?

  Graphical representation of risk-adjusted returns
• What does the risk-free rate (RFR) represent in CAPM?

  Return on risk-free investments
• What does the return on stock market portfolio (RM) represent?

  Average return of the stock market
• How is the cost of equity calculated using CAPM?

  RADR = RFR + ß (RM – RFR)
• What does a positive alpha coefficient indicate?

  Abnormal returns due to unsystematic risk
• What happens to the alpha coefficient over time?

  It should become zero
• What is used to work out the value of any share?

  Security market line (SML)
• What does the SML plot graphically?

  Risk-adjusted return for systematic risk
• What is the ß of risk-free capital?

  Zero
• What is the ß for the stock market as a whole?

  One
• What does a share with a ß greater than zero indicate?

  It has a risk premium attached
• What happens when ß is less than 1?

  RADR is lower than market return
• What does a ß higher than 1 indicate?

  RADR is higher than market return
• How can the SML be used?

  To calculate return for systematic risk
• What does RADR stand for?

  Risk-adjusted discount rate
• What does RFR represent?

  Risk-free rate
• What does RM stand for?

  Return on stock market portfolio
• What is the market risk premium?

  RM minus RFR
• How do you calculate the cost of equity using CAPM?

  RADR = RFR + Beta (RM – RFR)
• What are the assumptions of CAPM?

  • Investors are rational and fully informed
  • Greater returns expected for greater risks
  • Unsystematic risk can be diversified
  • Borrowing and lending rates are equal
  • No transaction costs exist
  • Markets are perfect and self-correcting
  • RFR equals government bond returns
  • No taxation or inflation
• What are the criticisms of CAPM?

  • Linearity of SML may change
  • Other factors affect excess returns
  • Difficulty in deriving systematic risk
  • Different divisions may have different risks
  • CAPM is a one-year model only
• What does the dividend valuation model state?

  • Value of a share is present value of future dividends
  • Discounted at shareholders’ required rate of return
  • Assumes constant growth rate in dividends
• How do you calculate the cost of equity using the dividend valuation model?

  Ke = [D0(1 + g) ÷ P0] + g
• What is the cost of debt?

  • Effective interest rate paid on debt
  • Usually expressed as after-tax rate
  • Interest is tax-deductible expense
• What is irredeemable debt?

  Perpetual debt never repaid