Unformatted text preview: TBS 907 AUTUMN 2005 MODULE 3 (Contd) COST OF CAPITAL 1 WHY DO YOU NEED COST OF CAPITAL Net Present Value Analysis Calculation requires: net cash flows required rate of return/cost of capital consistency in the definition of cash flows and the discount rate applied to the cash flows Required rate of return = opportunity cost. Opportunity cost: rate of return that could be earned on another investment of similar risk. 2 Cost of Capital Minimum rate of return needed to compensate suppliers of capital for committing resources to an investment. 3 Risk, Return and the Cost of Capital The returns received by investors in securities must be provided by the issuers of those securities and, from the issuer's viewpoint, the return demanded by investors is effectively a cost (cost of capital). 4 Risk Independence Implicit in the use of a discount rate related to the risk of a project is that the cost of capital for a project does not depend on the characteristics of the company considering the project. The value of a project depends on what the project is, not who the investor is. 5 Taxes and the Cost of Capital Taxes should be treated consistently in the net cash flows and in the cost of capital. Projects are normally evaluated on an after- tax basis. Approach to be adopted: after-tax cash flows = before-tax cash flows multiplied by (1 te) where te is the effective company income tax rate 6 Finding the Appropriate Discount Rate Direct use of CAPM to estimate the project's beta. Rproject = Rf + (RM Rf) project Can Rf , RM and the project's Beta be observed? 7 Finding the Appropriate Discount Rate (cont.) Estimate the required rate of return as a weighted average of the required return on debt and equity (weighted average cost of capital -- WACC). WACC = kd (D/V ) + ke (E/V ) The CAPM can be used to estimate the costs of the equity source of financing. A cost of debt is then estimated, and these costs are then weighted to calculate the company's required rate of return for use in capital budgeting decisions. 8 Calculating the Cost of Capital Steps involved: Determine the permanent sources of capital the company utilises. Cost each component of capital based on current conditions. The historical cost of raising funds is irrelevant. Weight each component to determine the weighted average cost of capital. 9 Sources of Finance Likely to be Found in the Balance Sheet Debt: overdrafts trade creditors commercial bills notes mortgage loans debentures convertible notes unsecured notes Equity: ordinary shares preference shares retained earnings 10 Costing Each Source -- Debt The costs of some non-marketable short- term debts are taken into account in other ways, so they are excluded from the calculation. Calculate the effective annual interest rate for sources of debt. If current cost cannot be measured, estimate the rate that the company would now have to pay to raise those funds. 11 Costing Each Source -- Debt (cont.) Interest rates applicable to individual sources of debt are before tax and need to be converted to after-tax: after-tax kd = before-tax kd (1 te) 12 Costing Each Source -- Equity Preference shares: Preference shares represent a preferred claim on the firms cash
flows. The holders of preference shares will receive a dividend usually in the form of a percentage of the par value of the preference share issue before ordinary shareholders receive their dividends. The current cost to the firm of the preference shares is thus the preference dividend divided by the market value of the firm's preference shares- k = p D P s Kp = Market cost of preference shares D= Annual dividend paid as % of the par value Ps = market price of the firms preference shares
13 Costing Each Source --Equity (cont.) Ordinary shares: CAPM ke = Rf + e [E (RM Rf]
Where Ke= Rf = e = Cost of equity Risk Free Rate systematic risk of asset in comparison to the market portfolio (covariance between the asset and the market divided by the variance of the market portfolio) 14 Return on the market R = Costing Each Source --Equity (cont.) DCF Approach (Dividend Valuation Models) ke = D0 (1 + g) + g Po
Where Ke= Do = g= Po= Cost of equity Current Period's Dividend constant growth in dividends Current market price of the share 15 The Weighting System The appropriate weights are the proportion that each source of funds represents of the total sources used to finance proposed projects. Current capital structure can be used unless the capital structure is expected to change, whereby the company's target capital structure should be used.
16 The Weighting System (cont.) The weights should be calculated using current market values rather than book values. This is consistent with the manner in which the costs of each source of funds have been calculated. These values reflect the amounts investors can realise from selling their investment. 17 Issue Costs and the Cost of Capital For project evaluation, issue costs should not be included in the cost of capital. Issue costs are included in the cash flows associated with the project. 18 WACC
E P D WACC = k e + k p + k d (1 - T c ) V V E 19 Project and Company Cost of Capital The cost of capital should only be used as an estimate of the cost of capital for a new project if: the risk of the new project is equivalent to the risk of existing projects the new project will not cause the company's optimal or target capital structure to change
20 If a company's operations are in more than Calculating the Cost of Capital for Diversified Companies one industry, and the industries differ in risk, the company's cost of capital will not be appropriate for project evaluation. Why? Because the discount rate will not reflect the risk of that particular project and because incorrect investment decisions could be made.
21 Cost of Capital for Diversified Companies To estimate a cost of capital for a division within a company: Identify a pure play company (a company that operates almost entirely in only one industry) with operations similar to the proposed project. Estimate the beta of the pure play's equity. Adjust the equity beta for financial leverage to reflect the equity beta based on business risk (the asset beta). a = e
22 1 + (D / E) Cost of Capital for Diversified Companies (cont.) `Relever' the asset beta to reflect the financial leverage of the company considering the project. Use the CAPM to estimate the cost of equity for the project. Calculate the WACC using the target debt equity ratio for the company considering the project.
23 The Pure Play Approach Conceptual problems adjusting equity betas for financial leverage Practical problems pure play companies are rare 24 Alternative Approach Infer divisional costs of capital from information on diversified companies. Assume that a diversified company's WACC is itself a weighted average of the WACC of its divisions. Information required: the WACC of each division the ratio of the value of each division to total company value for each company 25 Alternative Approach (cont.)
k = w k
j j =1 n j where k = the company cost of capital kj = the cost of capital for the j th division, and 26 wj = the ratio of the value of the j th The Weighted Average Cost of Capital Advantages flexibility simplicity Disadvantages can only be estimated directly for a whole company should not be used to analyse financing decisions excludes strategic options associated with project
27 Summary Cost of capital is critical in valuing projects. CAPM can be used but requires betas specific to the project being evaluated. Weighted average cost of capital (WACC) for the company as a whole is used in practice. Use effective company tax rate in calculation of after-tax cash flows. WACC is only appropriate when project risk matches company risk. 28 ...
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