IRC

Sources of finance- WC capital financing

What ??? Why? How?

Advantages Disadvantages

Comparison

Islamic finance

Dividend policy

Cost of capital -debt equity others bank preference shares

 Raising equity finance
NEW
RI
Cheaper because
1.

2.
 generally Will fall
More number
shares issued and
Issue the RI disocunted
price ...discounted price

TERP
Cum or Ex rights
price VALUE of RIGHT
VALUE od RIGHT
per EXISTING
SHARE
Cost of preference
Kp= D/Po

Dividend/Market value of pref share

Cost of bank loan if given info

K bank loan = Int (1- ……………….)

If not given or stated as VARIABLE
STATE AND USE ASSUMPTION that it is t
existing debt SO can use K d for loan her
state and write your explanation.
( refer to CORFE q) Also acceptable use a
rate for bond. Cth co has redeemable bo
So K bank loan = 8( 1-tax rate)
Usually based on $100 loan note thus in
Creditor
hierarchy

Debt

Debt

Preference

Equity
0 Market price DO two PV @ 5% and 10%

1-n Int( 1-tax)

n Redemption value or
Conversion value

IRR
Column A B C D E F
Row 2 -120 5.25 5.25 5.25 5.25 135.25

=IRR(A2:f2)
COST OF CAPITAL

COST OF EQUITY

DIVIDEND
CONSTANT
GROWTH
DIV model ?
model ? g

CAPM ?
beta β
 i. Dividend growth model (DVM) for Ke

Weaknesses of the dividend growth model

(a) The dividend model does not incorporate risk.
(b) Dividend does not grow smoothly in reality so g is only an approximation.
(c) The model fails to take capital gains into account, however it is argued that a
change of share ownership does not affect the present value of the dividend stream.
(d) No allowance is made for the effects of taxation although the model can be
modified to incorporate tax.
(e) It assumes there are no issue costs for new shares.

ii. CAPM

Systematic and unsystematic risk

The risk a shareholder faces is in large part due to the volatility of the company’s earnings. This
volatility can occur because of:
(a) Systematic (or market) risk – it is the risk of market wide factors such as the state of
economy. It will affect all companies in the same way (although to varying degrees), and
it cannot be diversified away.

(b) Non-systematic (or unsystematic or business or unique) risk – it is the risk factors
will impact each firm differently, depending on their circumstances. Diversification can
almost eliminate unsystematic risk.

Beta Factor

The CAPM is mainly concerned with how systematic risk is measured, and how systematic
risk affects required return and share prices. Systematic risk is measured using beta
factors.

(b) Beta factor is the measure of the systematic risk of a security relative to the market
portfolio (e.g. Heng Seng Index). If a share price were to rise or fall at double the market
rate, it would have a beta factor of 2.0. Conversely, if the share price moved at half the
market rate, the beta factor would be 0.5.

(c) Beta = 1, a 1% change in the market index return generally leads to a 1% change in the
return on a specific share.

0 < Beta < 1, a 1% change in the market index return generally leads to a less than a 1%
change in the returns on a specific share.Beta > 1, a 1% change in the market index
return generally leads to a greater than 1% on a specific company’s share.

Assumptions of CAPM

Well-diversified investors

(b) Perfect capital market

(c) Unrestricted borrowing or lending at the risk-free rate of interest

(d) Uniformity of investor expectations

(e) All forecasts are made in the context of one time period only.

Problems with CAPM

Problems of CAPM include unrealistic assumptions and the required estimates being
difficult to make.

(a) The need to determine the excess return (Rm - Rf). Expected, rather than
historical, returns should be used, although historical returns are often used in practice.

(b) The need to determine the risk-free rate. A risk-free investment might be a
government security. However, interest rates vary with the term of the lending.
 (c) Errors in the statistical analysis used to calculate beta values. Betas may also
change over time.

(d) The CAPM is also unable to forecast accurately returns for companies with
low price/earnings ratios and to take account of seasonal “month-of-the-
year” effects and “day-of-the-week” effects that appear to influence returns on
shares.

COMPARE DVM AND CAPM

a) For DVM:

(i) Estimate the future dividend and growth rate are difficult to do.

(ii) Assume the business risk, and hence business operations and the cost of equity,
are constant in future periods.

(iii) Do not consider risk – it should be noted that share price fall as risk increases,
indicating that increasing risk will lead to an increasing cost of equity.

(b) For CAPM:

(i) Consider the company’s level of systematic risk.

(ii) Give rise to a much smaller degree of uncertainty than the future dividend
growth in the DVM.