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No avoiding the cost of capital

Changes to the FM exam mean you need to be able to calculate the weighted average cost of capital

October 2016

The new exam format.
Like other assessments for the professional qualification, the format of the FM exam has changed. It now comprises 30 multiple-choice questions (each worth one mark), three five-mark questions and three 10-mark questions. All questions are compulsory, with a pass rate of 50%.
In the old exam format students could choose questions that suited their preferences (choose four from five 25-mark questions). The new exam format will change this, and a more rounded knowledge of the syllabus will now be required.

Weighted average cost of capital.
This is one of those areas that students could have ignored in the previous format, to a degree – it was likely to come up once or maybe twice across the paper. But with the new compulsory format and multiple-choice questions the specifics of this topic could be tested in a number of ways.
There are four main steps when calculating the cost of capital:
• Calculate the individual costs of capital.
• Calculate the market value of each cost of capital and the total market value of the company.
• Calculate the proportions of the market value that each source of capital represents.
• Finally, calculate the weighted average cost of capital.
Let’s explore step one in more detail, as this could be a short question in itself.

Calculate individual costs of capital.
Here we must first identify which sources of finance we are using: ordinary shares, preference shares, redeemable or irredeemable debentures, or other fixed rate debt. There are a number of formulas used here, many of which can be found on the formula sheet.
For ordinary shares we might need to use the dividend model with growth or without growth, or we might have to use the capital asset pricing model. For preference shares, irredeemable debentures and other fixed rate debt the calculations are straightforward; just watch out for the tax when dealing with debt. Redeem debentures are the toughest calculation, and here we would use the IRR calculation identifying the appropriate cash flows and using suitable discount factors.
In summary, a wider range of cost of capital calculations could be tested and the best way to prepare for this topic is to prepare as many calculations as possible.
• Karl Ballard, Kaplan

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