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Dear Sir,
In the Bpp practice kit,they have given formulas that you need to learn because they are not provided for in the exam.the two I need help with are;
Ke=D1/P0 +1
Kd=i(1-t)/P0I know kd= cost of equity and Kd=cost of debt.
What do the rest of the signs = ? and under what circumstances do you use them.
And what is debt beta ? When do you use it?
Hi Flexi,
Sorry for jumping in, but wanted to privde you a quick answer. The two formulas you referred to are:Ke (Cost of Equity) = D1/P0+g . (D1): D stands for divideds, 1 is representing the growth in divided. (P0) stands for price of share today (g) at the end is the growth rate. This formula could also be written as D0 x (1+g) /P0 + g. In this case the D0 represents dividend today and you multiply it be growth rate.
Kd (Cost of Debt) = i x (1-T)/P0 : (i) stands for interest rate, (T) is the tax rate. say a company tax rate is 30%, to use that in the formula than you enter (1- 0.30) and you will get 0.70 as a result that needs to be multiplied interest rate (i) divided by the current market price of shares.
When do you use them? You use to mostly in calculating the WACC or weighted average cost of capital, but there are other instances where you will need to use them. Important thing is to learn them and rest will be putting numbers in right place.
Beta is an index or a measurement of a company or projects systematic risk compared to it is industry. you use it mainly with CAPM or capital asset pricing model. To understand it better you will have to do some reading on related topic in the book.
Hope I did not confuse you further 🙂
J
Thank you very much Jay…i was just wondering when you will need them given that most of the time you can find ke and Kd using formula given in the exam.
And yes I know about beta but only equity beta and it’s relationship with the asset beta..
My question was what DEBT beta is.
Flexi:
What jay_azizi has written is correct.
In addition however:
First, the formula you have written for Kd is only relevant for irredeemable debt. For redeemable debt (which is what you normally have in the exam) you have to calculate the IRR to get Kd.
Second, just as an equity beta measures the riskiness of equity, a debt beta measures the riskiness of debt borrowing. In a perfect world debt is risk free and therefore the debt beta is zero.
It is extremely unlikely that you will ever be given a debt beta in the exam, and the only place you ever see it is in the asset beta formula on the formula sheet. When using that formula we always assume the debt beta to be zero and so the whole of the second term in the formula becomes irrelevant.
All of the above is dealt with in detail in the free lectures.
Thank you Sir..
And that answers my question.The formula for kd in this case is for irredeemable debt.. That was were my confusing was because i know the IRR approach.
I saw a mock exam question where they had given the equity beta and debt beta.
They used CAPM to get Ke using the equity beta (which I was ok with ) but then they again used CAPM to get kd (by using the debt beta this time).
Please help me! F9
When we calculate cost of debt after tax, Bpp shows that we have to deduct interest first (interest x (1-T)) then we can work out cost cost of debt after tax (yield to maturity). But in a lot of other textbooks such CFA we can work out kd first and then multiplied by (1-t) to get cost of debt after tax. Who is right? Thanks in advance.If it is irredeemable debt, then it makes no difference – both approaches give the same answer.
If it is redeemable debt, then you take the after-tax interest and then calculate the IRR of the flows (and this will not be the same as Kd(1-t) ).
I do suggest that you go watch the lectures on calculating the cost of capital where I stress this point (and if necessary the F9 lectures on it, because P4 is quick revision of F9 for this topic.)
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