江西财经大学会计学院 Topic F Cost of capital

江西财经大学会计学院 PART F-15 The cost of capital

江西财经大学会计学院 Topic list

江西财经大学会计学院 Study guide

江西财经大学会计学院 Exam guide In the exam you may be asked to calculate the weighted average cost of capital and its component costs, either as a separate sub- question, or as part of a larger question, most likely an investment appraisal. Remember that questions won't just involve calculations; you may be asked to discuss the problems with the methods of calculation you've used or the relevance of the costs of capital to investment decisions.

江西财经大学会计学院 The cost of capital The dividend growth model The capital asset pricing model (CAPM) The cost of debt The weighted average cost of capital

江西财经大学会计学院 The cost of capital Fast forward The cost of capital is the rate of return that the enterprise must pay to satisfy the providers of funds, and it reflects the riskiness of providing funds.

江西财经大学会计学院 Aspects of the cost of capital The cost of capital has two aspects to it. (a) The cost of funds that a company raises and uses, and the return that investors expect to be paid for putting funds into the company. (b) It is therefore the minimum return that a company should make on its own investments, to earn the cash flows out of which investors can be paid their return.

江西财经大学会计学院 The cost of capital as an opportunity cost of finance (a) If a bank offers to lend money to a company, the interest rate it charges is the yield that the bank wants to receive from investing in the company, because it can get just as good a return from lending the money to someone else. In other words, the interest rate is the opportunity cost of lending for the bank. (b) When shareholders invest in a company, the returns that they can expect must be sufficient to persuade them not to sell some or all of their shares and invest the money somewhere else. The yield on the shares is therefore the opportunity cost to the shareholders of not investing somewhere else.

江西财经大学会计学院 The cost of capital and risk

江西财经大学会计学院 Explain (a) Risk-free rate of return (b) Premium for business risk (c) Premium for financial risk

江西财经大学会计学院 The relative costs of sources of finance Text book ： P255

江西财经大学会计学院 The creditor hierarchy

江西财经大学会计学院 The dividend growth model Fast forward The dividend growth model can be used to estimate a cost of equity, on the assumption that the market value of share is directly related to the expected future dividends from the shares.

江西财经大学会计学院 The cost of ordinary share capital (a) Shareholders will not be prepared to provide funds for a new issue of shares unless the return on their investment is sufficiently attractive. (b) Retained earnings also have a cost. This is an opportunity cost, the dividend forgone by shareholders.

江西财经大学会计学院 Formula

江西财经大学会计学院 Example: Dividend valuation model Cygnus has a dividend cover ratio of 4.0 times and expects zero growth in dividends. The company has one million $1 ordinary shares in issue and the market capitalization (value) of the company is $50 million. After-tax profits for next year are expected to be $20 million. What is the cost of equity capital?

江西财经大学会计学院 The dividend growth model

江西财经大学会计学院 Exam focus point

江西财经大学会计学院 Question A share has a current market value of 96c, and the last dividend was 12c. If the expected annual growth rate of dividends is 4%, calculate the cost of equity capital.

江西财经大学会计学院 Estimating the growth rate

江西财经大学会计学院 Estimating the growth rate

江西财经大学会计学院 Exam focus point

江西财经大学会计学院 Weaknesses of the dividend growth model Text book : P259

江西财经大学会计学院 The capital asset pricing model (CAPM) Fast forward The capital asset pricing model can be used to calculate a cost of equity and incorporates risk. The CAPM is based on a comparison of the systematic risk of individual investments with the risks of all shares in the market.

江西财经大学会计学院 Systematic risk and unsystematic risk Fast forward The risk involved in holding securities (shares) divides into risk specific to the company (unsystematic) and risk due to variations in market activity (systematic). Unsystematic or business risk can be diversified away, while systematic or market risk cannot. Investors may mix a diversified market portfolio with risk-free assets to achieve a preferred mix of risk and return.

江西财经大学会计学院 Systematic risk and unsystematic risk Exam focus point Market or systematic risk is risk that cannot be diversified away. Non- systematic or unsystematic risk applies to a single investment or class of investments, and can be reduced or eliminated by diversification.

江西财经大学会计学院 Systematic risk and unsystematic risk Key term Market or systematic risk is risk that cannot be diversified away. Non- systematic or unsystematic risk applies to a single investment or class of investments, and can be reduced or eliminated by diversification.

江西财经大学会计学院 Systematic risk and unsystematic risk Exam focus point Common errors on this topic in exams include: Assuming risk-averse investors wish to eliminate risk. Risk-averse investors are prepared to accept risk, in exchange for higher returns Failing to link the risks of an investment with its returns Mixing up systematic and unsystematic risk

江西财经大学会计学院 Systematic risk and unsystematic risk: implications for investments (a) If an investor wants to avoid risk altogether (b) If an investor holds shares in just a few companies (c) If an investor holds a balanced portfolio of all the stocks and shares on the stock market (d) Shares in individual companies will have different systematic risk characteristics to this market average.

江西财经大学会计学院 Systematic risk and the CAPM Fast forward The beta factor measures a share's volatility in terms of market risk.

江西财经大学会计学院 Systematic risk and the CAPM Exam focus point Beta factor is the measure of the systematic risk of a security relative to the market portfolio. 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.

江西财经大学会计学院 Example: CAPM 1

江西财经大学会计学院 Example: CAPM 2

江西财经大学会计学院 Example: CAPM 3

江西财经大学会计学院 The market risk premium Key term Market risk premium is the difference between the expected rate of return on a market portfolio and the risk-free rate of return over the same period.

江西财经大学会计学院 The CAPM formula

江西财经大学会计学院 Example Shares in Louie and Dewie have a beta of 0.9. The expected returns to the market are 10% and the risk-free rate of return is 4%. What is the cost of equity capital for Louie and Dewie?

江西财经大学会计学院 Question The risk-free rate of return is 7%. The average market return is 11%. (a) What will be the return expected from a share whose β factor is 0.9? (b) What would be the share's expected value if it is expected to earn an annual dividend of 5.3c, with no capital growth?

江西财经大学会计学院 Problems with applying the CAPM in practice Fast forward Problems of CAPM include unrealistic assumptions and the required estimates being difficult to make.

江西财经大学会计学院 Question (a) What does beta measure, and what do betas of 0.5, 1 and 1.5 mean? (b) What factors determine the level of beta which a company may have?

江西财经大学会计学院 Dividend growth model and CAPM The two models will not necessarily give the same cost of equity and you may have to calculate the cost of equity using either, or both, models.

江西财经大学会计学院 Example : Dividend growth model and CAPM

江西财经大学会计学院 The cost of debt Fast forward The cost of debt is the return an enterprise must pay to its lenders. For irredeemable debt, this is the (post-tax) interest as a percentage of the ex interest market value of the loan stock (or preferred shares). For redeemable debt, the cost is given by the internal rate of return of the cash flows involved.

江西财经大学会计学院 The cost of debt Exam focus point Remember that different types of debt have different costs. The cost of a loan note will not be the same as the cost of a bank loan.

江西财经大学会计学院 Irredeemable debt capital

江西财经大学会计学院 Example: cost of capital Lepus has issued loan stock of $100 nominal value with annual interest of 9% per year, based on the nominal value. The current market price of the loan stock is $90. What is the cost of the loan stock?

江西财经大学会计学院 Non-annual interest

江西财经大学会计学院 Redeemable debt capital

江西财经大学会计学院 Example: cost of capital Owen Allot has in issue 10% loan notes of a nominal value of $100. The market price is $90 ex interest. Calculate the cost of this capital if the debenture is: (a) Irredeemable (b) Redeemable at par after 10 years Ignore taxation.

江西财经大学会计学院 Debt capital and taxation

江西财经大学会计学院 Formula

江西财经大学会计学院 Debt capital and taxation Exam focus point Students often don't remember that debt attracts tax relief in most jurisdictions.

江西财经大学会计学院 Example: cost of capital (a) A company has outstanding $660,000 of 8% loan notes on which the interest is payable annually on 31 December. The debt is due for redemption at par on 1 January 20X6. The market price of the loan notes at 28 December 20X2 was $103 cum interest. Ignoring any question of personal taxation, what do you estimate to be the current cost of debt? (b) If a new expectation emerged that the cost of debt would rise to 12% during 20X3 and 20X4 what effect might this have in theory on the market price at 28 December 20X2? (c) If the effective rate of tax was 30% what would be the after-tax cost of debt of the loan notes in (a) above? Tax is paid each 31 December on profits earned in the year ended on the previous 31 December.

江西财经大学会计学院 cost of capital Exam focus point Make sure that you know the difference in methods for calculating the cost of irredeemable and redeemable debt, as this is often a weakness in exams.

江西财经大学会计学院 The cost of floating rate debt If a firm has variable or 'floating rate' debt, then the cost of an equivalent fixed interest debt should be substituted. 'Equivalent' usually means fixed interest debt with a similar term to maturity in a firm of similar standing, although if the cost of capital is to be used for project appraisal purposes, there is an argument for using debt of the same duration as the project under consideration.

江西财经大学会计学院 The cost of convertible debt (a) If conversion is not expected, the conversion value is ignored and the bond is treated as redeemable debt, using the IRR method described in section 4.6. (b) If conversion is expected, the IRR method for calculating the cost of redeemable debt is used, but the number of years to redemption is replaced by the number of years to conversion and the redemption value is replaced by the conversion value i.e. the market value of the shares into which the debt is to be converted.

江西财经大学会计学院 The cost of preference shares

江西财经大学会计学院 Formula

江西财经大学会计学院 The cost of preference shares Exam focus point Don't forget however that tax relief is not given for preference share dividends. When calculating the weighted average cost of capital (see section 5), the cost of preference shares is a separate component and should not be combined with the cost of debt or the cost of equity.

江西财经大学会计学院 The weighted average cost of capital Fast forward The weighted average cost of capital is calculated by weighting the costs of the individual sources of finance according to their relative importance as sources of finance.

江西财经大学会计学院 Computing a discount rate Key term Weighted average cost of capital is the average cost of the company's finance (equity, debentures, bank loans) weighted according to the proportion each element bears to the total pool of capital.

江西财经大学会计学院 General formula for the WACC

江西财经大学会计学院 Example: weighted average cost of capital

江西财经大学会计学院 Weighting

江西财经大学会计学院 Marginal cost of capital approach (a) Establishing rates of return for each component of capital structure, except retained earnings, based on its value if it were to be raised under current market conditions. (b) Relating dividends or interest to these values to obtain a marginal cost for each component. (c) Applying the marginal cost to each component depending on its proportionate weight within the capital structure and adding the resultant costs to give a weighted average.

江西财经大学会计学院 Example: Marginal cost of capital

江西财经大学会计学院 Chapter Roundup Text book : P272

江西财经大学会计学院 Quick Quiz 1

江西财经大学会计学院 Quick Quiz 2

江西财经大学会计学院 Answers to Quick Quiz

江西财经大学会计学院 PART F-16 Capital structure

江西财经大学会计学院 Topic list

江西财经大学会计学院 Study guide

江西财经大学会计学院 Exam guide The theories covered in this chapter could be needed in a discussion part of a question. Pilot Paper question 1 (b) is an example of such a discussion. Gearing and ungearing a beta is an essential technique to master using the formula which will be given to you in the exam.

江西财经大学会计学院 Capital structure Capital structure theories Impact of cost of capital on investments

江西财经大学会计学院 Capital structure theories Fast forward Some commentators believe that an optimal mix of finance exists at which the company's cost of capital will be minimized.

江西财经大学会计学院 The traditional view Fast forward Under the traditional theory of cost of capital, the cost declines initially and then rises as gearing increases. The optimal capital structure will be the point at which WACC is lowest.

江西财经大学会计学院 The traditional view The traditional view is as follows: (a) As the level of gearing increases, the cost of debt remains unchanged up to a certain level of gearing. Beyond this level, the cost of debt will increase. (b) The cost of equity rises as the level of gearing increases and financial risk increases. There is a non-linear relationship between the cost of equity and gearing. (c) The weighted average cost of capital does not remain constant, but rather falls initially as the proportion of debt capital increases, and then begins to increase as the rising cost of equity (and possibly of debt) becomes more significant. (d) The optimum level of gearing is where the company's weighted average cost of capital is minimized.

江西财经大学会计学院 The traditional view

江西财经大学会计学院 Explain

江西财经大学会计学院 The net operating income (Modigliani- Miller (MM)) view of WACC Fast forward Modigliani and Miller stated that, in the absence of tax, a company's capital structure would have no impact upon its WACC.

江西财经大学会计学院 Assumptions of net operating income approach Key term Arbitrage is when a purchase and sale of a security takes place simultaneously in different markets, with the aim of making a risk-free profit through the exploitation of any price difference between the markets.

江西财经大学会计学院 Assumptions of net operating income approach Exam focus point The proof of Modigliani and Miller's theory by arbitrage is not examinable.

江西财经大学会计学院 Explain If Modigliani and Miller's theory holds, it implies: (a) The cost of debt remains unchanged as the level of gearing increases. (b) The cost of equity rises in such a way as to keep the weighted average cost of capital constant.

江西财经大学会计学院 Explain

江西财经大学会计学院 Example: net operating income approach

江西财经大学会计学院 Market imperfections

江西财经大学会计学院 Pecking order theory Retained earnings Straight debt Convertible debt Preference shares Equity shares

江西财经大学会计学院 Reasons for following pecking order use retained earnings no issue costs safer securities signalling effect

江西财经大学会计学院 Consequences of pecking order theory Text book : P280

江西财经大学会计学院 Impact of cost of capital on investments Fast forward The lower a company’s WACC, the higher the NPV of its future cash flows and the higher its market value.

江西财经大学会计学院 Limitations of pecking order theory (a) It fails to take into account taxation, financial distress, agency costs or how the investment opportunities that are available may influence the choice of finance. (b) Pecking order theory is an explanation of what businesses actually do, rather than what they should do.

江西财经大学会计学院 Limitations of using CAPM in investment decisions (a) It is hard to estimate returns on projects under different economic environments, market returns under different economic environments and the probabilities of the various environments. (b) The CAPM is really just a single period model. (c) It may be hard to determine the risk-free rate of return. Government securities are usually taken to be risk-free, but the return on these securities varies according to their term to maturity. (d) Some experts have argued that betas calculated using complicated statistical techniques often overestimate high betas, and underestimate low betas, particularly for small companies.

江西财经大学会计学院 CAPM and MM combined – geared betas Fast forward When an investment has differing business and finance risks from the existing business, geared betas may be used to obtain an appropriate required return. Geared betas are calculated by: Ungearing industry betas Converting ungeared betas back into a geared beta that reflects the company's own gearing ratio

江西财经大学会计学院 Beta values and the effect of gearing Text book : P283

江西财经大学会计学院 Geared betas and ungeared betas

江西财经大学会计学院 Explain

江西财经大学会计学院 Example: CAPM and geared betas

江西财经大学会计学院 Using the geared and ungeared beta formula to estimate a beta factor Text book : P284

江西财经大学会计学院 Example: Gearing and ungearing betas

江西财经大学会计学院 Question Two companies are identical in every respect except for their capital structure. XY has a debt: equity ratio of 1:3, and its equity has a β value of PQ has a debt: equity ratio of 2:3. Corporation tax is at 30%. Estimate a β value for PQ's equity.

江西财经大学会计学院 Weaknesses in the formula difficult to identify other firms with identical operating characteristics estimates of beta values from share price information are not wholly accurate differences in beta values

江西财经大学会计学院 Question 1

江西财经大学会计学院 Question 2

江西财经大学会计学院 Chapter Roundup Text book : P289

江西财经大学会计学院 Quick Quiz

江西财经大学会计学院 Answers to Quick Quiz

江西财经大学会计学院 Revision P37-44 Cost of capital 36-44