Revision Course Note [Revision 5]
ACCA F9
Financial Management
Revision Class 4
Session 4
Patrick Lui
Revision 5
Revision 5 – Cost of Capital
Topic List
1. / Cost of Capital / Exam Question Referencea. Meaning
2. / Estimating the Cost of Equity
a. Dividend valuation model (DVM)
l Calculation / Pilot
Dec 09
Jun 11
Jun 13
Dec 13 / Q1a
Q2c
Q2a
Q2a
Q2a
l Weaknesses
b. Estimating the growth rate
l Simple average
l Geometric growth / Dec 12
Jun 13
Dec 13 / Q4a(iv)
Q2a
Q2a
l Earnings retention model / Dec 12 / Q4a(iv)
c. CAPM
l Calculation / Dec 08
Jun 09
Dec 09
Jun 10
Jun 12
Dec 12
Jun 14 / Q1c
Q1a
Q2c
Q4a(i)
Q4b
Q3a
Q3a
l Systematic risk and unsystematic risk / Jun 12
Jun 13
Jun 14 / Q4d(iii)
Q2b
Q3c
l Assumptions
l Limitations / Dec 08 / Q3c
d. Comparison between DVM and CAPM / Jun 08
Dec 13 / Q1c
Q2b
3. / Cost of Debt and Other Capital Instruments
a. Irredeemable debt
b. Redeemable debt (e.g. bonds) / Jun 09
Dec 09
Jun 10
Dec 10
Jun 11
Dec 11
Jun 13
Dec 13
Jun 14 / Q1a
Q2a
Q2a
Q4b
Q2a
Q3c
Q2a
Q2c
Q3a
c. Convertible debt / Dec 07
Dec 12 / Q1b
Q3a
d. Preference shares / Pilot
Dec 10
Dec 12
Jun 13 / Q1a
Q4c
Q3a
Q2a
e. Bank debt / Jun 12
Jun 13 / Q4c
Q2a
f. Comparison between cost of equity and cost of debt / Jun 13 / Q2c
4. / WACC
a. Computation by book value
b. Computation by market value / Pilot
Jun 08
Dec 08
Jun 09
Dec 09
Jun 10
Dec 10
Jun 11
Dec 11
Jun 12
Dec 12
Jun 13
Dec 13
Jun 14 / Q1a
Q1a
Q3a
Q1a
Q2c
Q2b
Q4c
Q2a
Q3c
Q4c
Q3a,b
Q2a
Q2c
Q3a
c. When is suitable for using in investment appraisal / Jun 08
Dec 11 / Q1b
Q3d
5. / Marginal Cost of Capital
6. / Traditional View of Capital Structure
a. Concept / Pilot
Jun 09
Jun 11
Dec 13 / Q1b
Q1c
Q2c
Q2e
b. Assumptions
7. / M&M Views on Capital Structure
a. Without tax (1958) / Pilot
Jun 09
Jun 11
Dec 13 / Q1b
Q1c
Q2c
Q2e
b. With tax (1963) / Pilot
Jun 09
Jun 11
Dec 13 / Q1b
Q1c
Q2c
Q2e
c. Their assumptions
8. / Market Imperfections / Jun 09
Jun 11
Dec 13 / Q1c
Q2c
Q2e
9. / Pecking Order Theory / Jun 09
Jun 11 / Q1c
Q2c
10. / CAPM and M&M Combined – Project-specific Discount Rate
a. When to use?
b. Steps for calculating a project-specific discount rate / Dec 08
Jun 10
Dec 10
Jun 13
Dec 13
Jun 14 / Q3c
Q3c(iii)
Q1c
Q2b
Q2d
Q3b
Chapter 15 The Cost of Capital
I. The Cost of Capital
1. Consider the following two statements concerning investor attitudes towards risk:
1. A risk-averse investor will only be prepared to invest in a project with the prospect of high returns if there are no risks involved.
2. A risk-seeking investor will readily invest in a project with prospects of high returns, even if it means carrying substantially high risk.
Which one of the following combinations relating to the above statements is correct?
Statement 1 / Statement 2A / True / True
B / True / False
C / False / True
D / False / False
II. Cost of Equity – Dividend Valuation Model
2. Lydford Electronics plc has issued nominal share capital of $10 million, made up of $0·25 ordinary shares, and a market capitalisation of $20 million. The company expects post-tax profits for the forthcoming year to be $8 million and wishes to maintain a constant dividend payout ratio of 25%. Dividends are expected to increase by 3% per year for the foreseeable future.
What is the expected rate of return from the ordinary shares?
A 7%
B 13%
C 17%
D 23%
3. The current market value of shares in Segontium Co is $2·50 and the most recent dividend was $0·20 per share. The annual growth rate in dividends is expected to be 5%.
What is the cost of the company’s equity share capital?
A 3·4%
B 7·6%
C 13·0%
D 13·4%
4. Teal plc has a market capitalisation of $30 million and forecast post-tax profits for the forthcoming year of $10 million. The company has an issued share capital of $1 million, which is made up of $0·50 ordinary shares. The policy of Teal plc is to maintain a constant dividend cover of 2·5 times. Dividends are expected to increase by 5% per annum for the foreseeable future.
Which of the following is the expected rate of return from the ordinary shares?
A 8·3%
B 18·3%
C 21·7%
D 31·7%.
5. Gypsum plc has 20 million $0·25 ordinary shares in issue. The company has a market capitalisation of $60 million and has reported post-tax profits of $15 million for the year that has just ended. The company expects profits to rise by 20% and the dividend payout ratio is expected to be 30% in the forthcoming year. The company is committed to increasing the dividend by 4% per annum for the foreseeable future.
Which one of the following is the expected rate of return from the ordinary shares?
A 4·1%
B 11·5%
C 13·0%
D 15·1%
6. Cygnus plc has a dividend cover ratio of 4·0 times and dividends are expected to increase by 4% per year for the foreseeable future. The company has one million $1 ordinary shares in issue and the market capitalisation (value) of the company is $50 million. After-tax profits for next year are expected to be $20 million.
What is the expected rate of return from the ordinary shares?
A 6·0%
B 10·0%
C 14·0%
D 25·0%
7. Linacre plc has twenty million $0·50 ordinary shares in issue and the company has a market capitalisation (value) of $60 million. The company has a constant dividend cover ratio of 2·0 times and has a price earnings ratio of 10 times. Dividends per share and profits are expected to remain constant for the foreseeable future.
What is the expected rate of return from the ordinary shares?
A 0·8%
B 5·0%
C 20·0%
D 30·0%
8. Cassini plc has 40 million $0·50 ordinary shares in issue and has a market capitalisation of $160 million after announcing the following information concerning profits, dividends and projected growth. The company has reported post-tax profits of $20 million for the year that has just ended and expects profits to rise by 40% in the forthcoming year. The dividend cover ratio will be 2·5 times in the forthcoming year. After this, the company wishes to increase the dividend by a compound rate of 6% per year for the foreseeable future.
What is the expected rate of return from an ordinary share?
A 16·07%
B 11·00%
C 13·00%
D 19·50%
9. IPA Co is about to pay a $0.50 dividend on each ordinary share. Its earnings per share was $1.50. Net assets per share is $6. Current share price is $4.50 per share.
What is the cost of equity?
A 31%
B 30%
C 22%
D 21%
III. CAPM
A. Systematic risk and unsystematic risk
10. Risk that cannot be diversified away can be describe as
A Systematic risk
B Financial risk
C Unsystematic risk
D Business risk
11. Which of the following statements about systematic and unsystematic risk is correct?
A Neither systematic nor unsystematic risk can be diversified away
B Only systematic risk can be diversified away
C Only unsystematic risk can be diversified away
D Both systematic and unsystematic risk can be diversified away.
12. Which of the following best describes systematic risk?
A The chance that automated processes may fail
B The risk associated with investing in equity
C The diversifiable risk associated with investing in equity
D The residual risk associated with investing in a well-diversified portfolio.
13. Beta factors (β) measure the systematic risk of a portfolio relative to the market portfolio.
Which of the following statements is true?
(1) If β < 1 the security is less sensitive to systematic risk than the market average
(2) If β > 1 the security is less sensitive to systematic risk than the market average
(3) If β = 1 the security's exposure to systematic risk exactly matches the market average
(4) If β = 0 the security is risk free
A (1) and (4) only
B (2) and (3) only
C (1), (3) and (4) only
D (2), (3) and (4) only
14. Consider the following statements:
1. Investors can only expect to receive a return for incurring unsystematic risk.
2. Systematic risk can be eliminated by holding a well-diversified portfolio of shares.
Which one of the following combinations relating to the above statements is correct?
Statement 1 / Statement 2A / True / True
B / True / False
C / False / True
D / False / False
15. A share that has a beta of 1·0 will have which one of the following properties?
A An expected return that is equal to the risk-free rate
B An expected return that is equal to the expected returns from the market
C An expected return that is above the expected returns from the market
D No non-diversifiable risk.
16. The following two statements concern the propositions which underpin the capital asset pricing model (CAPM).
1. Investors in shares require a return in excess of the risk-free rate to compensate for systematic risk.
2. Investors will require higher returns from shares in companies where the level of systematic risk is higher.
Which one of the following combinations (true/false) is correct?
Statement 1 / Statement 2A / True / True
B / True / False
C / False / True
D / False / False
17. Consider the following statements:
1. The amount of systematic risk varies between different forms of investment
2. Systematic risk can be diversified away by holding a suitably wide portfolio of investments
Which one of the following combinations (true/false) relating to the above statements is correct?
Statement 1 / Statement 2A / True / True
B / True / False
C / False / True
D / False / False
18. Four companies are identical in all respects, except for their capital structures, which are as follows:
% / % / % / %
Equity as a proportion of total market capitalization / 70 / 20 / 65 / 40
Debt as a proportion of total market capitalization / 30 / 80 / 35 / 60
The equity beta of A plc is 0.89 and the equity beta of D is 1.22.
Within which ranges will the equity betas of B plc and C plc lie?
A The beta of B plc and the beta of C plc are both higher than 1.22
B The beta of B plc is below 0.89 and the beta of C plc is in the range of 0.89 to 1.22
C The beta of B plc is above 1.22 and the beta of C plc is in the range of 0.89 to 1.22
D The beta of B plc is in the range 0.89 to 1.22 and the beta of C plc is higher than 1.22
19. Which of the following assumptions is not required when using the capital asset pricing model to estimate the cost of equity for project appraisal?
A Efficient capital markets
B Well diversified investors
C Future periods are consistent with the present
D Companies are well diversified
Question 1 – Business risk, financial risk and systematic riskDiscuss how the shareholders of Corhig Co can assess the extent to which they face the following risks, explaining in each case the nature of the risk being assessed:
(a) Business risk;
(b) Financial risk;
(c) Systematic risk. (9 marks)
(ACCA F9 Financial Management June 2012 Q4(d))
B. Calculation of expected rate of return
20. Shares in Alborz Co have an expected rate of return of 9% and a beta of 0·8. Shares in Ural Co have a beta of 1·2. The expected market rate of return is 10%.
Using the Capital Asset Pricing Model (CAPM), what is the expected rate of return for shareholders in Ural Co?
A 8·7%
B 11·0%
C 13·0%
D 13·5%
21. The shares of Danae plc have a beta of 0·5 and the shares of Alcmene plc have a beta of 2·0. Investors have an expected rate of return of 4% from shares in Danae plc and the expected returns to the market are 6%.
Using the Capital Asset Pricing Model, what will be the expected rate of return for investors in Alcmene plc?
A 8%
B 10%
C 12%
D 16%.
22. Investors have an expected rate of return of 8% from ordinary shares in Algol plc, which have a beta of 1·2. The expected returns to the market are 7%.
What will be the expected rate of return from ordinary shares in Rigel plc, which have a beta of 1.8?
A 9·0%
B 10·5%
C 11·0%
D 12·6%
23. The shares of Lincoln plc have a beta of 0·4 and an expected rate of return of 5%. The expected market rate of return is 8%. The shares of Wadham plc have a beta of 1·5.
Using the Capital Asset Pricing Model, what will be the expected rate of return for investors in Wadham plc?
A 10·5%
B 11·3%
C 15·0%
D 18·8%
24. A share in MS Co has an equity beta of 1.3. MS Co’s debt beta is 0.1. It has a gearing ratio of 20% (debt:equity). The market premium is 8% and the risk free rate is 3%. MS Co pays 30% corporation tax.