In this series of revision posts, we ask AB Maximus CFA® Program exam trainers to give you quick tips and essential advice for different chapters in the curriculum. Handy for revision or simply for a last minute review to make sure you’re thoroughly prepared – don't miss the chance to brush up on your knowledge and do a little extra prep!
3 must-know concepts are: deriving the cost of capital, capital budgeting techniques, and the difference between dividends and share repurchase®.
1. Deriving the cost of capital
Remember that cost of capital is the cost of funding a company’s business, which relies on the type of financing used, such as cost of equity, cost of debt, or a combination of both.
Cost of capital is the weighted average of the cost of debt and cost of equity, otherwise known as the hurdle rate – the rate the company needs to exceed before it is profitable – and is affected by factors like operating history and credit worthiness. Therefore, established companies have lower costs of capital than new ones as they have a proven track record to show investors and banks, lenders etc., and can use debt financing. In contrast, newer companies lack collateral and assets, and tend to use equity financing.
The cost of capital is derived by working out the required returns of each component.
Cost of debt is interest rate paid. Remember to calculate the after-tax cost of debt, since interest expense is tax-deductible:
Yield to maturity x (1 - the company’s marginal tax rate)
On the other hand, cost of equity is estimated based on the Capital Asset Pricing Model:
Risk-free rate + (company beta x risk premium)
After calculating the weighted average, you can then use cost of capital to discount future cash flows from potential business projects to estimate their Net Present Value and profitability.
2. Different capital budgeting techniques
Capital budgeting is a planning process for projects on assets with cash flows of a period greater than one year. It tells a company if mutual or independent projects, such as new products, market expansion, or replacement decisions that maintain the business, are worth funding.
Capital budgeting is done via three main techniques: payback period, net present value method and the internal rate of return method.
Calculating the payback period is determining number of years needed to earn back the initial investment for a project, and is suitable for small or simple projects:
total cost of project ÷ cash inflow per year
For mutually exclusive projects, take the project with the shorter number of years as the payback period.
Net Present Value obtained by calculating the difference between the project cost and cash flows generated by that project, using discounted cash flow analysis:
cash outflows (in prevent value) - cash inflows (in present value)
Typically, independent projects are accepted when NPV is positive and rejected when NPV is negative. For mutually exclusive projects, the project with the highest NPV is accepted.
Calculating the Internal Rate of Return (IRR) tells investors the rate of return on a project. The IRR is the discount rate for a project to break even (NPV = 0). For independent projects, projects whose IRR is greater than the cost of capital will be profitable.
However, remember that mutually-exclusive projects may have conflicting IRRs and NPVs, where one project may have a higher IRR, but the other may have a higher NPV.
3. Know the difference between dividends and share repurchase
While both methods are ways for a company to distribute cash to its shareholders, they can also provide information about the company’s future prospects. Both methods affect the financial ratios and shareholders’ investment returns differently.
Dividends are declared by the company’s board of directors and may or may not require approval by shareholders. These include regular cash dividends, extra dividends, liquidating dividends, stock dividends, stock splits and reverse stock splits. Dividends are distributed to all shareholders.
Repurchases happen when a company believes its stock is undervalued. They are a distribution in the form of the company buying back its stock from shareholders and hence concern only those shareholders that sell their shares back to the company. These shares can be repurchased by the company by buying them back from the open market.
Students often get confused when it comes to: computing the cost of capital.
When computing the cost of capital, consider the three components: common stock, preferred stock and debt. Students forget that these form the required rate of return for each item, which in turn can be worked out using simple fundamentals.
For instance, the cost of long-term debt is the yield to maturity of the bond. The cash flow components of a bond usually comprise two parts, i.e. the face (or par) value on maturity, and the regular annuity flow of the coupon (i.e. coupon rate face value). The yield to maturity is simply the rate that equates these two parts of cash flow to today's bond price.
2 great study tips are: drawing timeline diagrams and revising calculator skills.
1. Draw timeline diagrams as you do practice questions.
Timeline diagrams display a list of events in chronological order on a horizontal line that represents the flow of time, including information about events and when they occur. They are useful for a quick overview for analysis and planning of timing and to understand the interconnected logic between calculations.
2. Know how to use your financial calculator.
Being familiar with the calculator and the calculations for these topics will help you minimise mistakes.
About the author
Eric Koh, CFA, MBA, PhD is the AB Maximus trainer for Corporate Finance. He had worked as an auditor in an international public accounting firm, in banks and in a global shared service centre. He is a member of CPA Australia and the Malaysian Institute of Accountants, and has served in the Asian Institute of Chartered Bankers.