Lecture 5 Cost of Capital (WACC).pptx

FINANCE 2 (FINC 401) Lecture 5: Cost of Capital (WACC) Muhammad M. Ma’aji, PhD, A C C A , F M VA  Lesson Plan Lesson Topic Cost of equity (Ke), cost of debt (Kd), & weighted average cost of capital (WACC) Learning Outcomes At the end of this lesson, students will...

FINANCE 2 (FINC 401) Lecture 5: Cost of Capital (WACC) Muhammad M. Ma’aji, PhD, A C C A , F M VA  Lesson Plan Lesson Topic Cost of equity (Ke), cost of debt (Kd), & weighted average cost of capital (WACC) Learning Outcomes At the end of this lesson, students will be able to: Calculate cost of equity using the capital asset pricing model Calculate the cost of equity using the dividend growth model Calculate the after tax cost of debt Calculate the cost of preference shares Calculate weighted average cost of capital De-gear and re-gear beta Activities/Methods Lecture, discussion, and group exercise, case study Reading and References Textbook Reading: Financial Management, 2021, BPP, Chapters 15, 16 Practice: Financial Management Revision Kit, 2021, BPP, Questions 64.1-64.10, 76, 77, 78, 79, 80, 82, 83, 85, 86, 87, 88, 90, 91 Additional reading: Watson, D. and Head, A. (2019) Corporate Finance Principles and Practice, 8th Edition, Pearson.  Overview Maximisation of shareholder wealth Investment Financing Dividend decision decision decision Cost of Cost of capital preference share Cost of debt Cost of equity Agenda Introduction cost of capital Cost of equity (Ke) Cost of preference shares (Kp) Cost of debt (Kd) Weighted average cost of capital (WACC) Case study Why cost of capital? Since financial resources are finite, there is a hurdle that projects have to cross before being deemed acceptable. The benchmark for this hurdle that capital project should achieve is the cost of capital. Cost of capital is the minimum required rate of return that the suppliers of capital—debtholders and shareholders—require as compensation for their contribution of capital to the company. The cost of capital should reflect the risk of the investment and opportunity cost. Why cost of capital?  The relative costs and risks of different types of capital are: Lowest risk and lowest cost (1) Secured creditors with a fixed interest (2) Secured creditors with a variable interest (3) Unsecured creditors (4) Preference shareholders Highest risk and highest cost (5) Ordinary shareholders  The most common way to estimate the cost of capital is to calculate the marginal cost of each of the various sources of capital and then calculate a weighted average of these costs, known as WACC. Agenda Introduction cost of capital Cost of equity (Ke) Cost of preference shares (Kp) Cost of debt (Kd) Weighted average cost of capital (WACC) Case study Cost of equity capital Cost of equity (Ke) is the minimum required rate of return by the company’s shareholders. A company may increase common equity through the reinvestment of earnings—that is, retained earnings—or through the issuance of new shares. Commonly used approaches for estimating Ke include the dividend discount model, capital asset pricing model, Multi factor model and bond arbitrage pricing model etc. Cost of equity capital Dividend Discount Model (DDM) The DDM is a quantitative method of valuing a company’s stock price based on the assumption that the current fair price of a stock equals the sum of all of the company’s future dividends discounted back to their present value. Methods to find the growth rate: 1. Gordon Growth Rate or sustainable growth rate = % Profits Retained x ROE 2. Average (Geometric) Growth Rate = (Dividend in Final Year/Dividend in First Year)1/n -1  Practice 1  A share has a current market value of 96c, and a dividend of 12c is about to be paid. If the expected annual growth rate of dividends is 4%, calculate the cost of equity capital.  JSTOR Co. Ltd. has declared a dividend of $0.2. The share price is trading cum-div at $5. JSTOR is expected to pay dividends at a growing rate of 10% per year. What is the cost of equity for JSTOR? Solution  Practice 2  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 capitalisation (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?  IPA Co is about to pay a $0.50 dividend on each ordinary share. Its earnings per share was $1.50, making retained earnings $1.00. Net assets per share is $6. Current share price cum-div is $4.50 per share. What is the cost of equity? Solution  Practice 3 T h e f o llo wing e ar ning s a nd d ivid e nd r e lat e s t o F9 Plc o ve r t h e p as t fi ve y e ar s. Ye a r Divid e nd s Ea r ning s $ $ 20X1 15 0 ,0 0 0 4 0 0 ,0 0 0 20X2 19 2 ,0 0 0 5 10 ,0 0 0 20X3 2 0 6 ,0 0 0 5 5 0 ,0 0 0 20X4 2 4 5 ,0 0 0 6 5 0 ,0 0 0 20X5 2 6 2 ,3 5 0 7 0 0 ,0 0 0 I f t h e c o m p any is fi nanc e d e nt ir e ly b y e q uit y and t h e r e ar e 1,0 0 0 ,0 0 0 s h ar e s in is s ue , e a c h wit h a m a r k e t va lue o f $ 3.3 5 e x d iv, wh at is t h e r at e o f r e t ur n r e q uir e d b y F9 Plc s h a r e h o ld e r s o r t h e c o s t o f e q uit y c a pit al? Solution Capital Asset Pricing Model (CAPM) The CAPM is a model that describes the relationship between the expected return and risk of investing in a security. It is based on the idea of systematic risk that investors need to be compensated for in the form of a risk premium. The CAPM model provides a methodology for quantifying risk and translating that risk into estimates of expected or minimum return on equity. Risk Reduction Is there a way to lower or minimize risk without giving up a return potential? “Don’t put all your eggs in one basket”. Rather diversify your investments. Diversification is the spreading of wealth over a variety of investment opportunities so as to eliminate some risk. Diversification of risk Total risk falls as number of investments rises Risk 0 0 Unsystematic 0 0 0 0 0 0 0 0 Systematic Number of investments 0 8 –12 30 Capital Asset Pricing Model (CAPM) Using CAPM, the minimum required return on a stock, Ke, is the sum of the risk-free rate of interest, RF, and a premium for bearing the stock’s market risk, β(Rm − RF): Assumptions: Investors are diversified Investors are risk averse Capital markets are efficient: All information is public, there are no transaction costs, markets are liquid. Investors can borrow and lend at the risk free rate  Industry Beta Industry Equity Beta Tobacco 0.59 Beverage (Alcoholic) 0.73 Food Wholesalers 0.74 Drugs (Pharmaceutical) 0.80 Transportation 0.83 Banks (Regional) 0.85 Shoe 0.85 Power 0.85 Telecom. Services 0.90 Household Products 1.01 Cable TV 1.03 Restaurant/Dining 1.04 Software (System & Application) 1.08 Healthcare Support Services 1.28 Oil/Gas Distribution 1.33 Software (Internet) 1.34 Advertising 1.49 Source: Domodaran Retail (Building Supply) 1.76 Online, New York Homebuilding 1.78 University, accessed Precious Metals 1.89 January 1, 2022 Practice 4 Suppose the following information is about AMAZON Inc.:  It trades on the NYSE and its operations are based in the United States  Current yield on a U.S. 10-year treasury is 2.5%  The average excess historical annual return for U.S. stocks is 7.5%  The beta of the stock is 1.25 (meaning its average return is 1.25x as volatile as the S&P500 over the last 2 years) What is the cost of equity of AMAZON using the CAPM? Practice 5 Solution  Practice 6 IML Co is an all equity financed listed company. Nearly all its shares are held by financial institutions. IML Co's chairman has been dissatisfied with the company's performance for some time. Some directors were also concerned about the way in which the company is perceived by financial markets. In response, the company recently appointed a new finance director who advocated using the capital asset pricing model as a means of evaluating risk and interpreting the stock market's reaction to the company. The following initial information was put forward by the finance director for two rival companies operating in the same industry: Equity Beta AZT 0. 7 Co 1. BOR The finance director notes that the risk-free rate is 4 5% each year and the expected rate of return on the market portfolio is 15% each year. Co (a)Calculate, using the capital asset pricing model, the required rate of return on equity of: (i) AZT Co, (ii) BOR Co (4 marks) (b)Calculate the equity beta of IML Co, assuming its required annual rate of return on equity is 17% and the stock market uses the capital asset pricing model to calculate the equity beta, and explain the significance of the beta factor. (5 marks) (c) Explain the assumptions and limitations of the capital asset pricing model. (6 marks) Solution  Cost of Equity in Cambodia E(r) = Rf + β x (Rm-Rf) or E(r) = Rf + CRP + Beta (Mature ERP) Country Risk Premium Source: Domodaran Online, New York University, accessed July 11, 2021 http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/ctryprem.html http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/Betas.html Agenda Introduction cost of capital Cost of equity (Ke) Cost of preference shares (Kp) Cost of debt (Kd) Weighted average cost of capital (WACC) Case study Cost of Preference Shares The cost of preference shares is the required rate of return by the company’s preference investors. The cost of preference shares can be found by dividing the preference dividend by the ex dividend market price: Kp = D p Kp = cost of preference shares P 0 P0 = current ex dividend preference share price Dp = preference dividend.  Practice 7  Alcoa has one class of preference shares outstanding for which there are 546,024 shares outstanding, with a $3.75 cumulative dividend. If the price of this stock is $72, what is the estimate of Alcoa’s cost of preference shares?  ELW Co has a 15% preference share of 1,000,000 shares outstanding. The current market price of the preference share is $1.75. What is the estimate of ELW’s cost of preference shares? Solution Agenda Introduction cost of capital Cost of equity (Ke) Cost of preference shares (Kp) Cost of debt (Kd) Weighted average cost of capital (WACC) Case study Cost of debt capital The cost of debt is the return that a company provides to its debtholders and creditors. Not only does the cost of debt reflect the default risk of a company, but it also reflects the level of interest rates in the market. Commonly used approaches for estimating Kd include the yield-to-maturity (YTM) approach and debt- rating approach. Irredeemable bonds Like preference shares, bonds involve a constant annual payment in perpetuity Kd = I ◦ Kd = cost of debt P 0 ◦ I = annual interest payment ◦ P0 = current ex-interest market price ◦ note that interest is tax-deductible.  Practice 8 A company has irredeemable bonds in issue at a nominal value of $100,000, paying a coupon of 10%. The market value of the bonds is $100,000 cum- interest. The company has a tax rate of 30%.What is the after-tax cost of debt? After Tax Cost of Debt Solution  Practice 9 Jay Co. Ltd. has $50,000,000 in loan notes with an ex-interest market value of $55,000,000. The loan notes pay nominal interest of 12%. The Tax rate for the company is 20%. What is the after-tax cost of debt? Solution Cost of Redeemable Bond  The cost of redeemable Bond is the IRR of the payments made by the bond or loan. In the case of floating debt, use the cost of debt of a fixed rate instrument with the same maturity. Example Silly Putty Co. has issued 6% 10-year bonds, each with a face value of $1,000. The market price at issue was $920. What is the cost of debt for the company? PV at 6% = ($60 x 7.36) + ($1,000 x 0.558) = $1,000 NPV at 6% = $1000 - $920 = 80 PV at 10% = ($60 x 6.145) + ($1,000 x 0.386) = 754.7 NPV at 10% = $754.70 - $920 = - 165.30 IRR = 6% + [80/(80+165.30)] x (10% - 6%) = 7.3%  Practice 10 A company has outstanding $660,000 of 8% bonds on which the interest is payable annually on 31 December. The debt is due for redemption at par ($1,000) on 1 January 20X6. The market price of the bonds at 28 December 20X2 was $950. If the tax rate is 30% what would be the after-tax cost of debt of the bonds? Solution Cost of Convertible Bond  The cost of convertible Bond is the IRR of the payments of the convertible debt. However, in calculating the IRR, the redemption value at maturity will be the higher of the principle of the debt and the value of equity on conversion.  Example: A company has issued 8% convertible bonds which are due to be redeemed in five years’ time. They are currently quoted at $82 per $100 nominal value. The bonds can be converted into 25 shares in five years’ time. The share price is currently $3.50 and is expected to grow at a rate of 3% per year. Assume a 30% rate of tax. Value of Shares on Conversion = $3.50 x 1.03 5 x 25 shares = $101.44 Solution Estimating Synthetic Ratings The rating for a firm can be estimated using the financial characteristics of the firm. In its simplest form, the rating can be estimated from the interest coverage ratio. Interest Coverage Ratio = EBIT / Interest Expenses Once a synthetic rating is assessed, it can be used to estimate a default spread which when added to the risk free rate yields a pre-tax cost of debt for the firm. Cost of debt = Risk free rate + *Company default + **(Country default spread) * The company default is based on the synthetic rating lookup table after estimating the interest coverage ratio ** The country default spread is only added in the case for developing countries firms with a country rating of less than AAA Sources: http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/ratings.html  Estimating Synthetic Ratings Interest coverage ratio Rating is Spread is > 12.5 AAA 0.75% 9.5 - 12.5 AA 1.00% 7.5 - 9.5 A+ 1.50% 6 - 7.5 A 1.80% 4.5 – 6 A- 2.00% 3.5 - 4.5 BBB 2.25% 3 - 3.5 BB 3.50% 2.5 – 3 B+ 4.75% 2 - 2.5 B 6.50% 1.5 – 2 B- 8.00% 1.25 -1.5 CCC 10.00% 0.8 - 1.25 CC 11.50% 0.5 - 0.8 C 12.70% < 0.5 D 14.00% Sources: http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/ratings.html Bank Loans Bank borrowings are not traded and have no market value that interest can be related to. Cost of bank loans can be found multiplying the before-tax interest rate by (1 – CT) Appropriate adjustment for taxation is needed. Agenda Introduction cost of capital Cost of equity (Ke) Cost of preference shares (Kp) Cost of debt (Kd) Weighted average cost of capital (WACC) Case study Weighted average cost of capita (WACC) WACC is the current overall minimum required rate of return by all the providers of capital to the company Market values or book values? ◦ book values are historical, reflect past activities ◦ market values reflect current requirements WACC  Practice 11  Current financial information on Droxfol Co is as follows. Statement of financial position for the last $’000 $’000 year Non-Current Assets 20,000 Current assets 20,000 Total assets 40,000 Equity and Liabilities Ordinary shares, nominal value $1 5,000 Retained earnings 22,500 Total equity 27,500 10% loan notes 5,000 9% preference shares 2,500 Current liabilities 7,500 Total equity and Liabilities 40,000  Practice 11  The current ex div ordinary share price is $4.50 per share. An ordinary dividend of 35 cents per share has just been paid and dividends are expected to increase by 4% per year for the foreseeable future. The current ex div preference share price is 76.2 cents. The loan notes are secured on the existing non-current assets of Droxfol Co and are redeemable at nominal value in eight years' time. They have a current ex interest market price of $105 per $100 loan note. Droxfol Co pays tax on profits at an annual rate of 30%. Required (a) Calculate the current weighted average cost of capital of Droxfol Co. (12 marks) Solution Solution Using WACC in Investment Appraisal  WACC can be used in an investment appraisal if: 1. The project is small relative to the company 2. The existing capital structure will be maintained (same financial risk) 3. The project has the same business risk as the company  If the above do not hold, then a project-specific or risk adjusted cost of capital should be used. Risk adjusted cost of capital To find a Project specific WACC which reflect the risk of an investment project: 1. Find appropriate proxy company equity betas. 2. Un-gear/De-gear proxy equity betas to remove proxy company financial risk to give Asset Beta. 3. Re-gear average asset beta to reflect the investing company’s financial risk. 4. Apply CAPM to give project-specific Ke. 5. Use new cost of equity to find new WACC. Industry Asset Beta Equity Beta Tobacco 0.57 0.59 Beverage (Alcoholic) 0.70 0.73 Food Wholesalers 0.43 0.74 Drugs (Pharmaceutical) 0.75 0.80 Transportation 0.55 0.83 Banks (Regional) 0.38 0.85 Shoe 0.74 0.85 Power 0.49 0.85 Telecom. Services 0.69 0.90 Household Products 0.93 1.01 Cable TV 0.94 1.03 Restaurant/Dining 0.90 1.04 Software (System & Application) 1.05 1.08 Healthcare Support Services 1.09 1.28 Oil/Gas Distribution 0.75 1.33 Software (Internet) 1.28 1.34 Advertising 1.41 1.49 Source: Domodaran Retail (Building Supply) 1.39 1.76 Online, New York Homebuilding 0.81 1.78 University, accessed Precious Metals 1.43 1.89 January 1, 2022  Beta and Gearing Ba, Asset Beta: The beta of a company without debt Be, Equity Beta: The beta of a company with debt Bd, Debt Beta: The beta of a company’s debt Ve: The total market value of equity Vd: The total market value of debt T: Tax rate Assuming the debt beta of a company is zero: De-gear, Ba = Be x Ve (Ve + Vd(1-T)) Assuming the debt beta of a company is zero: Re-gear, Be = Ba x Ve + Vd(1-T)) Ve  Practice 12  Galaxy Co. Ltd. has a debt of $70m and equity of $30m and has a beta of 2.8. Deep Co. Ltd. is in the same business as Galaxy but has a debt of $15m and equity of $85m. The return on government bonds is 2.75%. The tax rate for both companies is 30%. The market is expected to return 14% per year. What is the cost of equity for Deep Co.?  Practice 13 Backwoods is a major international company with its head office in the UK, wanting to raise $150 million to establish a new production plant in the eastern region of Germany. Backwoods evaluates its investments using NPV, but is not sure what cost of capital to use in the discounting process for this project evaluation. The company is also proposing to increase its equity finance in the near future for UK expansion, resulting overall in little change in the company's market-weighted capital gearing. The summarised financial data for the company before the expansion are shown below. S t a t e m e nt o f pr o fi t o r lo s s ( e x t r a c t s ) f o r t h e y e a r e nd e d 3 1 De c e m b e r 2 0 x 1 $m Re ve nue 1,9 8 4 Gr o s s p r o fi t 432 Pr o fi t af t e r t a x 81 Divid e nd s 37 Re t a ine d e ar ning s 44 S t a t e m e nt o f fi na nc ia l p o s it io n ( e x t r a c t s ) a s at 3 1 De c e m b e r 2 0 x 1 $m N o n- c ur r e nt a s s e t s 846 Cur r e nt as s e t s 350 T o t al as s e t s 1,19 6 I s s ue d o r d ina r y s h ar e s o f $ 0.5 0 e a c h no m ina l va lue 225 Re s e r ve s 761 986 Me d ium - t e r m a nd lo ng - t e r m lo a ns ( s e e no t e b e lo w) 2 10 T o t a l e q uit y a nd liab ilit ie s 1,19 6 Note on borrowings These include $75m 14% fixed rate bonds due to mature in five years' time and redeemable at par. The current market price of these bonds is $120 and they have an after-tax cost of debt of 9%. Other medium- and long-term bank loans, with an after-tax cost of debt of 7%. Company rate of tax may be assumed to be at the rate of 30%. The company's ordinary shares are currently trading at 376c. The equity beta of Backwoods is estimated to be 1.18. The systematic risk of debt may be assumed to be zero. The risk-free rate is 7.75% and market return is 14.5%. The estimated equity beta of the main German competitor in the same industry as the new proposed plant in the eastern region of Germany is 1.5, and the competitor's capital gearing is 35% equity and 65% debt by book values, and 60% equity and 40% debt by market values. Required: Estimate the cost of capital that the company should use as the discount rate for its proposed investment in eastern Germany. State clearly any assumptions that you make Solution Solution Agenda Introduction cost of capital Cost of equity (Ke) Cost of preference shares (Kp) Cost of debt (Kd) Weighted average cost of capital (WACC) Case Study Analysis Overview – Cost of capital (WACC) Maximisation of shareholder wealth Investment Financing Dividend decision decision decision Cost of Cost of capital preference share Cost of debt Cost of equity  Chapter Recap The cost of capital is the rate of return that the enterprise must pay to satisfy the providers of funds. The dividend growth model can be used to estimate a Ke with the assumption that market value share based on expected future dividend. The CAPM can be used to calculate Ke and incorporate systematic risk measured by Beta. The Kd is the return an enterprise must pay to its lenders. The WACC is the average cost of capital for all the company’s long- term sources of finance. Chapter Recap Questions Using Kahoot Click icon to add picture Thank you for listening Q&A