Transcript Document
2BUS0197 – Financial Management
Cost of Capital and
Returns to Providers
of Finance
Lecture 7
Dr Francesca Gagliardi
Learning outcomes
By the end of the session students should be able to:
Calculate the costs of different sources of finance used
by a company
Calculate the weighted average cost of capital
Understand how to apply the cost of capital in
investment appraisal
Appreciate the reasons for preferring market values to
book values
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Knowledge development
In the past weeks we have looked at short- and longterm financing sources that are available to companies
We have analysed how investment appraisal methods
can be applied to make capital investment decisions
We have also discussed the risk-return trade-off faced
by investors
Today we go a step further and discuss how the level of
risk of different financing sources affects their required
rate of return, hence a company’s cost of capital
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Why focus on cost of capital?
The cost of capital is the rate of return required on
invested funds
Companies should seek to raise capital by the cheapest
and most efficient methods
Minimisation of the average cost of capital will increase
the net present value of a company’s projects, hence its
market value
To minimise the cost of capital:
Information on the costs associated to the available different
sources of finance is needed
Knowledge of how to combine different sources of finance to
reach an optimal capital structure is required
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Calculating the cost of capital
A company’s cost of capital can be used as:
A discount rate in investment appraisal
A benchmark for company performance
Calculating a company’s cost of capital can be difficult
and time consuming
To calculate the weighted average cost of capital, need
first to find the cost of capital of each source of long-term
finance used by a company
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Ordinary shares
In previous lectures we have seen that equity finance
can be raised either by issuing new ordinary shares or
by using retained earnings
The cost of equity can be calculated using the dividend
growth model as:
where:
Ke D0(1 g) g
P0
Ke = cost of equity
D0 = current dividend
g = the expected growth rate of dividends
P0 = the current ex-dividend share price
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Ordinary shares
The cost of equity can also be found from the CAPM:
Rj = Rf + βj (Rm - Rf)
where:
Rm = return of the market
Rf = risk-free rate of return
(Rm – Rf) = equity risk premium
βj = beta value of ordinary share
CAPM allows shareholders to determine their required
rate of return, based on the risk-free rate of return plus
an equity risk premium
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Retained earnings
It is a mistake to consider retained earnings as a free
source of finance
Retained earnings have an opportunity cost, which is
equal to the cost of equity
If retained earnings were returned to shareholders they could
have achieved a return equal to the cost of equity through
personal reinvestment
The cost of retained earnings can be found in the same
way as the cost of equity
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Preference shares
Dividend paid on preference shares is usually constant
The cost of preference shares is found by dividing the
preference dividend by the ex dividend market price:
D
Kps
P
p
0
where:
Kps = cost of preference shares
P0 = current ex dividend preference share price
Dp = preference dividend
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Irredeemable bonds
Like preference shares, bonds involve a constant annual
payment in perpetuity
I
Kid
P0
Kid = cost of irredeemable bonds
I = annual interest payment
P0 = current ex interest market price
Interest is tax-deductible. The after-tax cost of debt is:
Kid(after-tax) = Kid(1 – CT)
CT = corporation taxation rate
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Example
10% irredeemable bonds
Ex interest market price: £72
Corporation tax: 30%
Kid (before tax) = 10/72 = 13.9%
Kid (after tax) = 13.9 x (1 - 0.3) = 9.7%
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Redeemable bonds
Redeemable bonds involve several fixed interest payments plus
redemption value. The after-tax cost of debt is:
P0
I(1 CT) I(1 CT) I(1 CT)
I(1 CT) RV
2
3
n
(1 Kd) (1 Kd) (1 Kd)
(1 Kd)
I = interest payment
RV = redemption value
Kd = cost of debt capital
n = number of years to maturity
CT = corporation tax rate
The before-tax cost of debt is found by using I instead of I(1-CT)
Kd estimated through linear interpolation or Hawanini-Vora (1992)
model
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Convertible bonds
To calculate the cost of debt need first to determine
whether conversion is likely to occur
Conversion not expected: bond treated as redeemable debt
Conversion expected: cost of capital found by linear
interpolation and a modified version on the redeemable
bond valuation model
Use number of years to conversion (not to redemption)
Use future conversion value (CV) instead of redemption value
P0
I(1 CT) I(1 CT) I(1 CT)
I(1 CT) CV
2
3
n
(1 Kd) (1 Kd) (1 Kd)
(1 Kd)
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Bank borrowings
Bank borrowings are not traded and have no market
value that interest can be related to
The cost of bank borrowings can be proxied by the
average interest paid: interest paid in a period divided by
average borrowings for that period
Alternatively, the cost of traded debt issued by a
company may be used as a best approximation
Appropriate adjustments to allow for tax-deducibility of
interest payments are needed
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The relationship between the costs of
different sources of finance
The cost of each finance source is linked to the risk faced by each
supplier of finance
Equity finance: highest level of risk faced by investors, hence most
expensive source of finance
The cost of preference shares is less than the cost of ordinary shares as
the former are less risky and rank higher in the creditor hierarchy
Debt finance: generally no uncertainty on interest payments. Debt
further up the creditor hierarchy. Hence, the cost of debt less is than
the cost of equity
Whether bank debts are cheaper than bonds depends on the
relative costs of obtaining a bank loan and issuing bonds, the
amount of debt and the length of period over which debt is raised
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Calculating the weighted average cost of
capital (WACC)
The costs of individual sources of finance are weighted
according to their relative importance as sources of finance
KeE Kd(1 CT)D
WACC
( D E)
(D E )
E = value of equity D = value of debt
Ke = cost of equity
Kd = cost of debt
E/(E+D) is the proportion of equity
D/(E+D) is the proportion of debt
CT = taxation rate
The equation will expand in proportion to the number of
different sources of finance used by a company
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Market value or book value weighting?
Book values are historical and are obtained from a
company’s accounts
Book values rarely reflect the current required rate of
return of providers of finance
Example: an ordinary share with a nominal value of 25p has
a market value of £1.76
Book values will underestimate the impact of the cost of
equity on the average cost of capital, hence unprofitable
projects will be accepted
Market values reflect current requirements and can be
obtained from financial press and databases
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Class activity
Source of finance
Equity
Preference shares
Irredeemable debt
Redeemable debt
Bank loans
Cost
Market value (£000)
Ke = 16.9%
633.6
Kp = 13.4%
33.5
Kid = 9.7%
68.4
Krd = 8.7%
76.0
Kbl = 8.8%
60.0
871.5
Note: the relative costs of the different sources reflect
their relative risks, i.e. the risk-return hierarchy of
financial securities
Required: in groups of four calculate the WACC
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Solution
WACC
(16.9%633.6) (13.4%33.5) (9.7%68.4) (8.7%76.0) (8.8%60.0)
WACC
871.5
13009.42
871.5
14.9%
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Average and marginal cost of capital
So far we have looked at how to calculate the cost
of capital on an average basis by using book values
or market values
The cost of capital can also be calculated on a
marginal basis, as the cost of the next increment of
capital raised
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Average and marginal cost of capital
Cost (%)
MC
0
AC
Quantity of capital
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Average or marginal cost of capital?
The marginal cost of capital should be preferred but it is
difficult to allocate particular funding to a specific project
WACC can be used if the following are satisfied:
The business risk of an investment project is similar to the
business risk of a company’s current operations
Incremental finance is raised in proportions that preserve
the existing capital structure
The required return of existing finance sources is not
affected by a new investment project
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Practical problems with WACC
Calculating the cost of particular sources of finance may
not be straightforward
Ordinary shares of private companies
Market value of bonds
Solution: use the cost of equity for a listed company, with
similar characteristics and add a premium to reflect the
higher risk of the private company
Solution: find the market value of a bond issued by another
company, with similar maturity, risk and interest rate, and use
this market value as a proxy
The accuracy of the calculated cost of capital depends
on the reliability of the models used
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Practical problems with WACC
Which sources of finance should be included in the WACC
calculation?
Finance sources used to fund the long-term investments of a
company should be included in the calculation of WACC
What about a bank overdraft used on an ongoing basis?
The difficulty of finding the market value of securities impacts
on the weightings applied
Both market and book values are used in practice
Debt finance raised in foreign currencies needs to be
converted
WACC is not constant: changes in the market value of
securities and in macroeconomic conditions affect a
company’s average cost of capital
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WACC in the real world
Companies pay attention to the value of WACC
In recent years WACC received attention also from
national regulatory bodies to determine what is
considered to be a ‘fair’ level of profit
Several companies claimed that the cost of capital calculated by
the regulatory body underestimated their true cost of capital
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Gearing
The term refers to the amount of debt finance a company
uses relative to its equity finance
Gearing ratios assess financial risk:
Debt/equity ratio: long-term debt / shareholders’ funds
Capital gearing: long-term debt / capital employed (i.e. D+E)
Market values preferred to book values
The nature of the industry in which a company operates
is a major factor in determining what the market
considers to be an appropriate level of gearing
Typically, the lower the business risk the higher the
gearing
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Implications of high gearing
Increased volatility of equity returns arises with high
gearing since interest must be paid before paying returns
to shareholders
Increased risk of bankruptcy also occurs
Stock exchange credibility falls as investors learn about
company’s financial position
Short-termism moves managers’ focus away from
maximisation of shareholder wealth
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Summary
Today we looked at:
How to calculate the cost of different sources of finance
How to calculate the WACC
Average vs. marginal cost of capital
Main issues arising from WACC
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Readings
Textbook
Watson, D., Head, A. (2009). Corporate Finance. Principles & Practice, 5th
Ed., FT Prentice Hall – Chapter 9
Research papers
Miller, R. A. (2009), The Weighted Average Cost of Capital is not Quite
Right, The Quarterly Review of Economics and Finance, Vol. 49, 3, pp. 128138
Bade, B. (2009), Comment on “The Weighted Average Cost of Capital is not
Quite Right”, The Quarterly Review of Economics and Finance, Vol. 49, 4,
pp. 1476-1480
McGowan, C.B., Tessema, A., Collier, H.W. (2004), A Comparison of the
Weighted Average Cost of Capital for Multinational Corporations: The Case
of the Automobile Industry Versus the Soft Drink Industry, The Journal of
Current Research in Global Business, Vol. 6, 9, pp.82-88
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Your tutorial activity for next week
During the seminar you will be expected to work on:
Q1 p.298; Q3 p.299 (5th ed)
Q1 p.278; Q3 p.279 (4th ed)
To prepare for the seminar you should answer the following
practice questions:
Q3,4,5,9 p.295-6 (5th ed)
Q3,4,5,10 p.274-5 (4th ed)
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