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B294 - Unit 3 - Coggle Diagram
B294 - Unit 3
Session 2
The cost of capital
Debt and equity
Have costs
Investor
Between investment options
Expected return in light of
Inflation
Greater than
Risk
Reflect those taken
Risk return trade-off
Company
Different projects
Overall financing
Allows project completion
Opportunity cost
Risk free rate of return
Safe investments
Gilts
Unlikely government won't pay
Savings account
The cost of equity
E(Rh) = Rf + Rp
E(Rh) = expected rate of return on share h
Rf = risk free rate
Compensates opportunity cost
Rp = Risk premium
Excess return for higher risk investments
Reducing risk
Portfolio diversification
Markovitz (1952)
Risk reduced via spread of assets
Different companies in different markets
Specific risk can be eliminated
Theoretically
Simplified assumptions
Investor behaviour
Functionality of markets
Capital asset pricing model (CAPM)
Determine trade-off between expected return and risk
Dividend valuation model (DVM)
The cost of debt
Investment carries risk
Interest/capital may not be repaid
Require higher returns
In exchange for risk
Credit risk premium
Historical cost of debt
Tax-shield
Interest payments deducted from taxable profits
Dividends non-tax deductible
Capital structure
Debt / equity mix
Weight of costed capital (WACC)
Provides base discount rate for investment appraisal
Cost of investment
Return must be higher than WACC to generate profit
Combines all finance sources
Mathematical concepts and statistical tools
Variance
Range
Standard deviation
Square root of variance
Same units as data set
Variance
Square data set
Difficult to relate to data set
Covariance and correlation
Covariance
Relationship between two variables
Negative
Move in opposite directions
Positive
move in same direction
Coefficient correlation
0
No correlation
-1
Perfect negative correlation
As one increases the other decreases
+1
Perfect positive correlation
As one increases, other decreases
Average
Mean
Add data together
Divide by data set number
Weighted
Data x weights
Divide by weights
Session 1
Time value of money
Three factors
Inflation
Increase in cost over time
Opportunity cost
Can money be spent elsewhere?
Risk
Future
Cash flows
May not happen
Benefits
Greater for greater return
Greater for loss
Smaller for smaller reward
Smaller loss
Cost of capital
Interest
Simple
% per year
Compound
% applies to new balance
Future value formula
Future value (FV) = Present value(1 + annual interest rate) squared by number of years
Discounted cash flows
Reverse of compounding
PV = FV / (1+r) squared by number of years