Advanced Financial

Management

Tenkir Seifu (PhD)

Chapter 5
Cost of
Capital
 Cost of Capital

• It is the minimum rate of return that a firm

must earn on invested capital if its value is to
remain unchanged.
– it is the break even rate of return
• It is the rate of return at which investors are
willing to provide financing for the project
today.
• Computation of cost of capital is important
for various financial decisions
 Factors Affecting the Cost of Capital
• General Economic Conditions: Affect
interest rates
• Market Conditions: Affect risk premiums
• Operating Decisions: Affect business risk
• Financial Decisions: Affect financial risk
• Amount of Financing: Affect flotation costs and
market price of security

4
 WACC Overview

• A key consideration in financial management is

the firm's WACC.
• The WACC is derived by:
– finding a firm's cost of equity and cost of debt and
– averaging them according to the market value of
each source of finance.
• Costs are returns adjusted for taxes and
transactions cost
WACC Formula
 WACC Overview

• Computation of cost of capital consists of two

important parts:
1. Measurement of specific (component) costs
• Determine the required rate of return on
each capital component /component cost/
2. Measurement of overall cost of capital
• Most firms employ different types of capital and
the cost of these different securities shall be
included to compute the overall cost of capital.
 Cost of equity (Ke)

• The three main methods of calculating ke

are:
1. The Capital Asset Pricing Model (CAPM)
2. The Dividend Valuation Model (DVM)
3. Modigliani and Miller's Proposition 2
formula.
The Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM)
• The beta factor is a measure of the level of
systematic risk (general, market risk) faced by a
well-diversified investor
• Beta factors are derived by statistically analysing
returns from a particular share over a period
compared to the overall market returns.
• If the returns on the individual share are more
volatile than the overall market, the firm's beta
will be greater than 1
The Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM)
Which beta factor to use?
• To calculate the current cost of equity of a firm, the
current beta factor can be used.
• If the firm's current beta factor cannot be derived
easily, a proxy beta may be used.
– A proxy beta is usually found by identifying a quoted
company with a similar business risk profile and using its
beta.
– However, when selecting an appropriate beta
from a similar company, account has to be taken
of the gearing ratios involved.
The Capital Asset Pricing Model (CAPM)
• The beta values for companies reflect both:
– Business risk (resulting from operations)
– Finance risk (resulting from their level of
gearing).
• There are therefore two types of beta:
– 'Asset' or 'ungeared' beta, βa, which reflects purely
the systematic risk of the business area.
– 'Equity' or 'geared' beta, βe, which reflects the
systematic risk of the business area and the
company specific gearing ratio.
The Capital Asset Pricing Model (CAPM)
 Test your understanding
• The directors of Moorland Co, a company which has 75% of its
operations in the retail sector and 25% in manufacturing, are trying
to derive the firm's cost of equity. However, since the company is
not listed, it has been difficult to determine an appropriate beta
factor. Instead, the following information has been researched:
– Retail industry – quoted retailers have an average equity beta of
1.20, and an average gearing ratio of 20:80 (debt: equity).
– Manufacturing industry – quoted manufacturers have an average
equity beta of 1.45 and an average gearing ratio of 45:55 (debt:
equity).
• The risk free rate is 3% and the equity risk premium is 6%. Tax on
corporate profits is 30%. Moorland Co has gearing of 50% debt
and 50% equity by market values. Assume that the risk on
corporate debt is negligible.
• Required: Calculate the cost of equity of Moorland Co using the
CAPM model
 Arbitrage pricing theory (APT)
• Arbitrage pricing theory (APT) is an alternative pricing
model to CAPM, developed by Stephen Ross in 1976.
• It attempts to explain the risk-return relationship using
several independent factors rather than a single index.
• CAPM is a single index model in that the expected
return from a security is a function of only one factor.
– However APT is a multi-index model in that the
expected return from a security is a linear function of
several independent factors.
Arbitrage pricing theory (APT)
 Arbitrage pricing theory (APT)

• Research undertaken to date suggests that there

are a small number of factors, or economic
forces, that systematically affect the returns on
assets.
• These are:
– inflation or deflation
– long run growth in profitability in the economy
– industrial production
– term structure of interest rates
– default premium on bonds
– price of oil.
 Arbitrage pricing theory (APT)

• The main practical difficulties in applying ATP

are:
– Determining which variables to include in
the model since the model does not specify
them, and
– Forecasting the value of the variables
The dividend valuation model (DVM)
The dividend valuation model (DVM)
 Deriving g in the DVM formula
• There are two ways of estimating the likely
growth rate of dividends:
1. Extrapolating based on past dividend
patterns.
2. Assuming growth is dependent on the level
of earnings retained in the business.
Deriving g in the DVM formula
Deriving g in the DVM formula
Modigliani and Miller's Proposition 2 formula

• Modigliani and Miller formulated theory on

financing decision.
• They derived a formula which can be used to
derive a firm's cost of equity:
rs = r0 + (B / SL) (r0 - rB)
• rB is the interest rate (cost of debt)
• rs is the return on (levered) equity
• r0 is the return on unlevered equity
• B is the value of debt
• SL is the value of levered equity
 Test your understanding
• Moondog Co is a company with a 20:80 debt:
equity ratio. Using CAPM, its cost of equity has
been calculated as 12%.
– It is considering raising some debt finance to change
its gearing ratio to 25:75 debt to equity. The
expected return to debt holders is 4% per annum,
and the rate of corporate tax is 30%.
• Required: Calculate the theoretical cost of
equity in Moondog Co after the refinancing.
 The cost of debt
• The company's cost of debt is found by:
– taking the return required by debt holders/lenders
(kd) and
– adjusting it for the tax relief received by the firm as
it pays debt interest
• the cost of debt is normally quoted pre-tax
– because this is the rate at which the companies
will pay interest on their borrowings
• ‘True' cost of debt will be net of tax because
companies benefit from the 'tax shield'
 Using the DVM to estimate cost of debt
• The basic theory of the DVM is:
– The value of a share = the present value of the
future dividends discounted at the shareholders'
required rate of return.
• Using the same logic
– The value of a bond = the present value of the
future receipts (interest and redemption amount)
discounted at the lenders' required rate of return.
• This theory gives rise to two alternative
calculations of kd (1–T), for irredeemable debt
and redeemable debt
Using the DVM to estimate cost of debt
 Using the DVM to estimate cost of debt

Redeemable debt
• kd (1–T) = the Internal Rate of Return
(IRR) of:
– the bond price
– the interest (net of tax)
– the redemption payment
 Test your understanding

• Dodgy Co's 6% coupon bonds are currently

priced at $89%. The bonds are redeemable at
par in 5 years. Corporation tax is 30%.
• Required: Calculate the post-tax cost of debt.
 Pre-tax cost of debt ('yield' to the debt holder)

• In order to compute the pre-tax cost of debt

(sometimes called the yield to the investor, or
yield to maturity) the method is very similar.
– For irredeemable debt, the pre-tax cost of debt is
simply I/MV.
– For redeemable debt, the pre-tax cost of debt is
the IRR of the bond price, the GROSS interest (i.e.
pre-tax) and the redemption payment.
 Credit Spread
• An alternative technique used for deriving cost of
debt is based on:
– an awareness of credit spread (sometimes referred
to as the 'default risk premium’)
– and the formula:
• kd (1–T) = (Risk free rate + Credit spread) (1–T)
• The credit spread is a measure of the credit risk
associated with a company.
• Credit spreads are generally calculated by a
credit rating agency
Credit risk, rating agencies and spread

• Credit or default risk is the uncertainty

surrounding a firm’s ability to service its debts
and obligations.
• Credit risk can be defined as:
– the risk borne by a lender
– that the borrower will default either on interest
payments, the repayment of the borrowing at the
due date or both.
 The role of credit rating agencies
• Credit rating agencies are key sources of
information to assess whether a borrower is
likely to default on the debt.

• They provide vital information on

creditworthiness to:
– potential investors
– regulators of investing bodies
– the firm itself
 The assessment of creditworthiness
• The three largest international agencies are
Standard and Poor's, Moody's and Fitch.
• Factors predicting company’s default on its
obligations include:
– The magnitude and strength of the company’s cash
flows.
– The size of the debt relative to the asset value of
the firm.
– The volatility of the firm’s asset value.
– The length of time the debt has to run.
 The assessment of creditworthiness
• Using the main factors and other data, firms are
scored and rated on a scale, as shown here:
 Credit spread
• There is no way to tell in advance which firms will
default on their obligations and which won’t.
• As a result, to compensate lenders for this uncertainty,
firms generally pay:
– a spread or premium over the risk free rate of
interest
– proportional to their default probability.
• The yield on a corporate bond is therefore given by:

Yield on corporate bond =

Yield on equivalent treasury bond + credit spread
 Test your understanding

• The current 4-year risk free return is 2.6%.

MM Co has 4-year bonds in issue but has an
AA rating. The credit spread for an AA rated,
3-year bond and 5-year bond is 30 and 37,
respectively.
• Required:
(a) calculate the expected yield on MM’s bonds
(b) find MM’s post-tax cost of debt associated with
these bonds if the rate of corporation tax is 30%
 Test your Understanding

• An entity has the following information in its

balance sheet (statement of financial position):
– Ordinary shares (50c nominal) $2,500,000
– Debt (8%, redeemable in 5 years) $1,000,00
• The entity's equity beta is 1.25 and its credit
rating according to Standard and Poor's is A.
The share price is $1.22 and the debenture
price is $110 per $100 nominal.
 Test your Understanding …
• Extract from Standard and Poor's credit spread
tables:

• The risk free rate of interest is 6% and the

equity risk premium is 8%. Tax is payable at
30%.
• Required: Calculate the entity's WACC
 How do lenders set their interest rates?
• Lenders set their interest rates after assessing
the likelihood that the borrower will default.
• Lender will assess the likelihood (using normal
distribution theory) of the firm's cash flows
falling to a level which is lower than the
required interest payment in the coming year.
– If it looks likely that the firm will have to default,
the interest rate will be set at a high level to
compensate the lender for this risk
 Normal distribution theory
• Represented by a bell shaped' curve, with its
peak at the mean in the centre

• The figure shows the size of an area (shaded on

the diagram) between the mean and a point z
standard deviations away.
 Test your understanding
• Villa Co has $2m of debt, on which it pays annual
interest of 6%. The company's operating cash flow
in the coming year is forecast to be $140,000, and
currently the company has $12,000 cash on
deposit.
• The annual volatility (standard deviation) of the
company's cash flows (measured over the last 5
years) has been 25%. Assume that the company has
no other lines of credit available.
– Required: Calculate the probability that Villa Co will
default on its interest payment within the next year
The use of WACC as a discount rate in project appraisal

• When evaluating a project, it is important to use a cost

of capital which is appropriate to the risk of the new
project.
• The existing WACC will therefore be appropriate as a
discount rate if both:
1. the new project has the same level of business risk
as the existing operations.
2. undertaking the new project will not alter the firm's
gearing (financial risk).
• If one or both of these factors do not apply
when undertaking a new project, the existing
WACC cannot be used as a discount rate
 Risk adjusted WACC
• In most cases, the business risk of the new project is
different from the business risk of a company's existing
operations
• Hence, the company's shareholders will expect a
different return to compensate them for this new level
of risk.
– Here, the appropriate WACC is not the company's
existing WACC
– Rather, a 'risk adjusted' WACC which incorporates
this new required return to the shareholders shall
be applicable.
 Risk adjusted WACC

I) If the business risk of the new project

differs from the entity's existing business
risk
– A risk adjusted WACC can be calculated,
by recalculating the cost of equity to reflect
the business risk of the new project
– This often involves the technique of ‘de-
gearing' and ‘re-gearing' beta factors.
 Calculating a risk-adjusted WACC

1. Find the appropriate equity beta from a

suitable quoted company.
2. Adjust the available equity beta to convert it
to an asset beta – degear it.
3. Readjust the asset beta to reflect the project
(i.e. its own) gearing levels – regear the beta.
4. Use this beta in the CAPM equation to find
Ke.
5. Use this Ke to find the WACC.
 Risk adjusted WACC …
II) If the capital structure (financial risk) is
expected to change when the new project is
undertaken:
– The simplest way of incorporating a change in
capital structure is to recalculate the WACC using
the new capital structure weightings.
– This is appropriate when the change in capital
structure is not significant, or
• if the new investment project can be effectively treated
as a new business, with its own long term gearing level.
 Test your understanding
• B Co is a hot air balloon manufacturer whose equity:
debt ratio is 5:2. The company is considering a
waterbed-manufacturing project. B Co will finance the
project to maintain its existing capital structure.
• S Co is a waterbed-manufacturing company. It has an
equity beta of 1.59 and a Ve:Vd ratio of 2:1.
• The yield on B Co's debt, which is assumed to be risk
free, is 11%. B Co's equity beta is 1.10. The average
return on the stock market is 16%. The corporation
tax rate is 30%.
– Required: Calculate a suitable cost of capital to apply to
the project
 Risk-adjusted WACC…
• Method of de-gearing and re-gearing reflects the
business risk of the project and the current capital
structure of the business.
• However, other issues also need to be considered:
– To use this method debt must be perpetual and
risk free.
– Weights in WACC should represent market values
of debt and equity after the project has been
adopted (i.e. the equity value should include the
NPV of the project)
➢However, weights computed before the project assumes
that the project has a zero NPV
 The adjusted present value (APV) technique
• The APV method evaluates the project and the
impact of financing separately.
– Hence, it can be used if a new project has a different
financial risk (debt-equity ratio) from the company
• APV consists of two different elements:
 The investment element (base case NPV)
• The project is evaluated as though it were being
undertaken by an all equity company with all
financing side effects ignored.
• The financial risk is quantified later in the second
part of the APV analysis.
• Therefore:
– ignore the financial risk in the investment decision
process
– use a beta that reflects just the business risk, i.e. ß
asset.
The investment element (base case NPV)

Once the base case NPV is identified, the PV of

the financing package is evaluated.
 The financing impact
• Financing cash flows consist of:
– PV of issue costs
– PV of the tax relief
• The financing cash flows have low risk.
Thus, they are discounted at either:
– the Kd or
– the risk free rate.
 Calculation of APV (in detail)
• The base case NPV is used as a starting point.
• The costs and benefits of the financing are then
added to find a final adjusted present value:
▪ Base case NPV X
▪ PV of the issue costs:
• Equity (X)
• Debt (X)
▪ PV of the tax shield X
▪ Adjusted Present Value X
 Test your Understanding
• Rounding Co is a company currently engaged in the
manufacture of baby equipment. It wishes to diversify into
the manufacture of snowboards.
The investment details
• The company’s equity beta is 1.27 and is current debt to
equity ratio is 25:75, however the company’s gearing ratio
will change as a result of the new project.
• Firms involved in snowboard manufacture have an average
equity beta of 1.19 and an average debt to equity ratio of
30:70.
• Assume that the debt is risk free, that the risk free rate is
10% and that the expected return from the market
portfolio is 16%.
 Test your Understanding …
• The new project will involve the purchase of new
machinery for a cost of $800,000 (net of issue costs),
which will produce annual cash inflows of $450,000 for 3
years. At the end of this time it will have no scrap value.
• Corporation tax is payable in the same year at a rate of
33%. The machine will attract tax allowable depreciation
of 25% pa on a reducing balance basis, with a balancing
allowance at the end of the project life when the machine
is scrapped.
 Test your Understanding…
• The new investment will be financed as
follows:
– Bonds (redeemable in three years' time): 40%
– Rights issue of equity: 60%
• The issue costs are 4% on the gross equity
issued and 2% on the gross debt issued.
Assume that the debt issue costs are tax
deductible.
• Required: Calculate the adjusted present
value of the project
 International CAPM
• When a company operates internationally in
integrated markets,
– investors should consider applying the international cost
of capital to investment appraisal, rather than a
domestic CAPM.
• A company involved in international operations will
be exposed to currency risk and political risk, in
addition to the usual risk.
– These are mainly unsystematic and can be diversified
away by holding an internationally diversified portfolio.
– Part of the systematic risk of the domestic market is in
fact unsystematic risk from an international viewpoint.
International CAPM
 International CAPM
• Investors can diversify their risk more effectively
in an integrated market, because:
– returns on domestic and foreign assets are not
perfectly correlated.
• The cost of capital is lower if markets are
integrated than in a closed economy.
• Companies whose shareholders are international
investors should therefore consider:
• Applying the international cost of capital to
investment appraisal, rather than a domestic CAPM
• This can be done by looking at the international
CAPM.
 International CAPM
• In practice, significant international diversification
can be achieved by:
– Holdings in unit trusts specialising in overseas
companies
– Investing in multinational companies.
• In principle, risk reduction can be achieved either
by:
– investing directly in an international portfolio of
shares or
– investing in local companies with significant overseas
activities
Thank you
QUESTIONS?