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Chapter 1 5

Chapter 1 5. The cost of capital. Contents. The cost of capital. 1. The dividend growth model. 2. The capital asset pricing model(CAPM). 3. The cost of debt. 4. The weighted average cost of capital. 5. Syllabus Guide Detailed Outcomes.

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Chapter 1 5

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  1. Chapter 15 The cost of capital

  2. Contents The cost of capital 1 The dividend growth model 2 The capital asset pricing model(CAPM) 3 The cost of debt 4 The weighted average cost of capital 5

  3. SyllabusGuide Detailed Outcomes • Describe the relative risk-return relationship and describe costs of equity and debt. • Apply the dividend growth model and discuss its weaknesses. • Describe and explain the assumptions and components of the CAPM.

  4. Syllabus Guide Detailed Outcomes – cont’d • irredeemable debt • redeemable debt • convertible debt • preference shares • baDistinguish between average and marginal costs of capital • nk debt • Calculate the weighted average cost of capital (WACC) using book value and market value weightings. • Calculate the cost of capital on a wide range of capital instruments, including:

  5. Overview – cost of capital Maximisation of shareholder wealth Investment decision Investment decision Financing decision Dividend decision Cost of capital Cost of debt Cost of equity

  6. The cost of capital • The creditor hierarchy • The cost of capital and risk

  7. The dividend valuation model If the future dividend per share is expected to be constant in amount, then the ex dividend share price will be calculated by the formula: d d d …… P0= (1+Ke) (1+Ke)2 Ke d So Ke= P0

  8. The dividend growth model The fundamental theory of share values states that the market price of a share is the present value of the discounted future cash flows of revenues from the shares, so the market value given an expected constant annual growth in dividends would be: d0(1+g)2 d0(1+g) …… P0= (1+Ke) (1+Ke)2

  9. The dividend growth model It is often convenient to assume a constant expected dividend growth rate in perpetuity. The formula above then simplifies to: d0(1+g) d1 P0 (Ke-g) (Ke-g)

  10. The dividend growth model • The dividend growth model Weakness

  11. The capital asset pricing model (CAPM) Risk of this share Risk free rate Market premium for risk of holding shares • Market or systematic risk non-systematic or unsystematic risk • Systematic risk and unsystematic risk: implications • Systematic risk and the CAPM • Market risk and returns • Risk and returns from an individual security • The market risk premium • The CAPM formula E(ri) = Rf + βi(E(rm)- Rf ) • Problems with applying the CAPM in practice

  12. The cost of debt • Irredeemable debt capital • Redeemable debt capital • Debt capital and taxation • The cost of floating rate debt The cost of debt • The cost of bank debt • The cost of convertible debt • The cost of preference shares • The weighted average cost of capital – general formal for the WACC – marginal cost of capital approach

  13. Irredeemable debt capital Cost of Irredeemable debt capital, paying interest i in perpetuity, and having a current ex-interest price P0: i Kd P0

  14. Redeemable debt capital If the debt is Redeemable then in the year of redemption the interest payment will be received by the holder as well as the amount payable on redemption, so: i i i+pn …… P0= (1+Kd net) (1+Kd net)2 (1+Kd net)n Where pnthe amount payable on redemption in year n.

  15. Redeemable debt capital The above equation cannot be simplified, so ‘r’ will have to be calculated by trial and error, as an internal rate of return(IRR). The best trial and error figure to start with in calculating the cost of redeemable debt is to take the cost of debt capital as if it were irredeemable and then add the annualised capital profit that will be made from the present time to the time of redemption.

  16. Debt capital and taxation The interest on debt capital is likely to be an allowable deduction for purposes of taxation and so the cost of debt capital and the cost of share capital are not properly comparable costs. This tax relief on interest ought to be recognised in computations. The after-tax cost of irredeemable debt capital is: i(1-T) Kd net P0

  17. The cost of convertible debt The cost of capital of convertible to debt is harder to determine. The calculation will depend on whether or not conversion is likely to happen. If conversion is not expected, the conversion value is ignored and the bond is treated as redeemable debt, using the IRR method. 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 replaced by the conversion value is the market value of the shares into which the debt is to be converted. Conversion value P0(1+g)nR

  18. The cost of preference shares For preference shares the future cash flows are the dividend payment in perpetuity so that: d d d …… P0 (1+Kpref) (1+Kpref)2 (1+Kpref)3 Simplifies to: d P0 Kpref

  19. The cost of preference shares • Attention Don’t forget however that tax relief is not given for preference share dividends. When calculating the weighted average cost of capital, the cost of preference shares is a separate component and should not be combined with the cost of debt or the cost of equity.

  20. WACC Cost of equity Cost of debt WACC

  21. WACC formula WACC = Ve Ke + Vd Kd(1-T) Ve+Vd Ve+Vd % of total finance that is equity % of total finance that is debt

  22. Chapter summary

  23. Chapter summary – cont’d

  24. Chapter 16 Capital structure

  25. Contents 1 Capital structure theories 2 Impact of cost of capital on investments

  26. Syllabus Guide Detailed Outcomes

  27. Syllabus Guide Detailed Outcomes – cont’d

  28. Overview – gearing Maximisation of shareholder wealth Financing decision • Cost of capital • impact of using debt

  29. Capital structure theories

  30. Capital structure theories The traditional view As the level of gearing increases, the cost of debt remains unchanged up to a certain level of gearing. Beyond this leel, the cost of debt will increase. 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. 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. The optimum level of gearing is where the company’s weighted average cost of capital is minimised.

  31. Capital structure theories The net operating income (MM) view of WACC Assumptions of net operating income approach A perfect capital market exists, in which investors have the same information, upon which they act rationally, to arrive at the same expectations about future earnings and risks. There are no tax or transaction costs. Debt is risk-free and freely available at the samecost to investors and companies alike.

  32. Capital structure theories – retained earnings – straight debt – convertible debt – preference shares – equity shares • Reasons for following pecking order • Consequences of pecking order theory • Limitations of pecking order theory • Pecking order theory

  33. Impact of cost of capital on investments Using the WACC in investment appraisal Using CAPM in investment appraisal Limitations of using CAPM in investments decisions CAPM and MM combined- geared betas The relationship between company value and cost of capital

  34. Lecture example BPP has a debt: equity ratio of 1:2. It wishes to expand into recruitment consultancy. It has identified that the Beta of a highly geared recruitment consultancy company (company X) is 1.8 - this is its equity beta and is influenced by its high level of gearing of 1:1 debt to equity. Assume that debt has a beta of 0. Risk free rate = 4% Market rate = 12% Tax = 30%

  35. Lecture example – cont’d Required Calculate the cost of capital that BPP should use to appraise this investment.

  36. Answer to lecture example Step 1: beta of recruitment company = 1.8 ungear Ba = 1.8 * (1/1.7) = 1.059 Step 2: regear Be = 1.059/ (2/2.7) = 1.430

  37. Answer to lecture example – cont’d Step 3: Ke = 4 + (8)1.43 = 15.44%. This reflects the new scenario – that BPP does have debt finance & that it is investing in a new business area. In other words it reflects the financial risk & business risk of the investment. NB: the WACC = (15.44% x 2/3) + (4% x 0.7 x 1/3) = 11.23%

  38. Chapter summary

  39. Chapter summary – cont’d

  40. Thank You !

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