2.1 Lecture_03_FINC202_Week_02_

2.1 Lecture_03_FINC202_Week_02_ - FINC 202 2009 Lecture 03:...

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Unformatted text preview: FINC 202 2009 Lecture 03: WACC (3) 1 Diagram putting all the breakpoint information Diagram together together WACC % MCC4 MCC3 MCC2 MCC1 MCC5 9.6 20 44 60 Funds $m 2 Ingredients of the 5 MCCs Cross out the bit that does not apply and put in the correct debt level: Prefs + RE / New shares + Debt # 1 Prefs + RE / New shares + Debt # 1 Prefs + RE / New shares + Debt # 2 Prefs + RE / New shares + Debt # 3 Prefs + RE / New shares + Debt # 4 1. 2. 3. 4. 5. 3 Income Opportunity Schedule Why use IRR? Rank in order of IRR Initial Outlay of project on horizontal Axis IOS % Proj 1 Proj 2 Proj 3 Proj 4 Outlay $m $6m 4 WACC & IOS Diagram WACC & IOS % A B C MCC3 MCC2 MCC1 E IOS MCC4 MCC5 WACC D Budget $m 5 firm should accept projects up to • Where the MCC = Marginal IRR • Below that a project loses cash optimal capital budget determined by • • Intersection of IOS and WACC Schedule Part projects not accepted Whole project IRR step must be ______________________. 6 Marginal Cost versus A “weighted Marginal average” average” Why do we use an MCC and not the “average “ of all of the relevant MCCs as the WACC for our investment budget? Answer: • All projected borrowing is future borrowing • All borrowing will be at the same time, same YTM and have same rd. You MUST use marginal cost of debt You cannot ____________________________________________ 7 Depreciation-generated Funds (DGF) ATCF ­ NPAT = Depn generated funds (DGF) • assumes Depn is the only non­cash expense Same cost as : Retained Earnings Because: Cash is retained in firm and not spent on maintenance or routine replacement • Hides in “Accumulated Depreciation” on Balance Sheet (the “negative asset”) • Could be returned to shareholders just like RE And affects: ___________________________________ 8 Yolanda Skateboards forecasts the following information for next year: Problem 1 NPAT = $4 m Dividend payout ratio = 40% Cost of equity capital ks = 10% Weighting of equity = 25% Depreciation­generated funds = $1.4m What is the maximum dollar value of investments Yolanda can now make with funds sourced from RE & DGF before it has to raise new equity? 9 Solution 1 BPwith DGF NPAT × ( 1 − d ) = wS = = + DGF 10 How stable is WACC? WACC is based on future cost projections with today’s assumptions • For instance today’s: (a) Known cost of borrowing which increases with debt­size (as default risk rises) (b) Projected NPAT and Dividend Payout Ratio • (c) Changes in Market interest rates from ________________________________ 11 WACC Estimates for large US Corporates WACC May v Nov 1999 May May 1999 % 12.9 11.3 11.2 10.0 9.8 8.5 8.2 November 1999 % 15.1 11.6 12.1 12.0 9.9 10.7 9.4 12 Intel Gen. Electric 11.9 Motorola Coca­Cola Walt Disney AT&T H.J. Heinz BellSouth Intel Gen. Electric 13.8 Motorola Coca­Cola Walt Disney AT&T H.J. Heinz BellSouth Factors affecting WACC that the firm cannot Factors control control Market interest rates Market interest rates ⇑ ⇒ YTM ⇑ (and rd ⇑ ) Cost of new borrowing ⇑ Shifts WACC ⇑ Optimal budget shrinks Tax rates: • • Tax rate ⇑ ⇒ rd(1­tC) ⇓ • Shifts WACC ⇓ ____________________________________________ 13 Factors affecting WACC that the firm can Factors control control Capital Structure Policy • Market­value weights • …for target Capital Structure) Sets target pattern of weighting according to preferred market value of debt If rd ⇓ then debt more attractive, so use ______________________________ 14 But the bigger the weight of debt (wd) • Initially WACC will reduce to some minimum value • After that, WACC is forced up by rises in both rd and rS • Can we see this in that list of big US companies? … see next slide 15 WACC versus Capital Structure WACC albeit in Book value terms! albeit WACC % Intel 15.1 General Electric 13.8 Motorola 11.6 Coca­Cola 12.1 Walt Disney 12.0 AT&T 9.9 H.J. Heinz BellSouth 10.7 9.4 Book Value Debt Ratio % The answer 2.3 is not easily 2.1 13.9 9.9 33.0 23.2 55.5 32.6 But then even Heinz with the biggest wd probably could take on more debt at the time of these figures 16 Factors affecting WACC that the firm can Factors control (2) control Dividend Policy • • Increase dividend at expense of ∆ RE Smaller ∆ RE ⇒ Need to ______________________________________ Impact of Dividend Payout Ratio & Problem 2 Low versus high (with example) Set NPAT = $4m, tax = 40%, ws = 0.25 and d = 60% and recompute the breakpoint of Equity • Ignore depreciation­generated funds as there are none this time! 17 Solution 2: Dividend change BPequity NPAT ( 1 − d ) = ws = = = Breakpoint now less than before when Dividend payout ratio was 40% of NPAT (BP was then $9.6m) 18 Factors affecting WACC that the firm can Factors control (3) control Investment Policy • Current WACC based on riskiness of existing assets “Assets” also known as Investment Project Outlays Embedded assumption = Level of risk kept constant Is this assumption reasonable? Only if you stay in same line of business and consumers ________________________________ What about conglomerates? 19 Fisher and Paykel • Fisher and Paykel Healthcare • Fisher and Paykel Appliances Fisher and Paykel Finance 20 WACC and Adjustment for Risk We relax constant business risk assumption here. This occurs when: Moving into new markets with new risks Moving into new product lines Some of these are riskier than others Business Risk ⇑ means WACC ⇑ So how do we deal with ________________________________ 21 Adjusting the Cost of Capital for Risk (across Adjusting firms) firms) Return % Acceptance Region A H WACC B Rejection Region L Risk 22 Adjusting the Cost of Capital for Risk (across Adjusting Divisions within Firm) Divisions Return % H WACC Y X L Composite WACC Risk 23 But what if the firm used a single WACC ? If low return (low risk) projects rejected because promised returns below company WACC And high return (high risk) projects accepted because promised returns exceed company WACC THEN… Firm’s risk profile will _______________________________ 24 Note: Similar projects have similar levels of risk Projects that are similar will be handled by the same division of the firm • Each division will have its own WACC Assume in FINC 202 that projects have the same level of riskiness • UNLESS you are told otherwise. We now look at adjusting for risk in a firm with two divisions each running one project… 25 Adjusting WACC for Risk Increases in risk will impact on WACC via: • rd ⇑ via the YTM of bonds • rS ⇑ via β ⇑ YTM ⇑ as a firm’s riskiness ⇑ and credit rating ⇓ Standard and Poors (or other credit rating agencies) will downgrade firm’s credit rating Let’s ignore effect on rd for meantime and concentrate on effect on rS 26 CAPM often used to generate risk­ adjusted WACC • Relates to Cost of Equity component of WACC. • Uses β associated with type of project (β j) WACC = wd rd (1 − tC ) + wp rp + ws rsj where rsj = rRF + β j ( rM − rRF ) 27 Brassy-Giraffe Example: Assessing a New Project with different Brassy-Giraffe Market Risk Market Brassy­Giraffe Ltd is an all­equity firm producing brass goods. Its Beta is 1.2, rRF is 9% and rM is 15% and its Cost of Capital is: rS = 9% + (15% ­ 9%)(1.2) = 16.2% Brassy­Giraffe is considering a project producing pewter goods. The average Beta of pewter firms is 1.8 Production will be: 70% brass and 30% pewter goods. What is: • The minimal acceptable rate of return for the pewter project ? • The firm’s new average beta? • The firm’s new overall cost of equity? (average required rate of return) 28 Find kS of Pewter and New Company Beta rS PEWTER = 9% + 1.8(15% ­ 9%) =19.8% rS FIRM = 0.7(16.2%) + 0.3(19.8%) =17.28% AND: New company Beta = 0.7(1.2) + 0.3(1.8) = 1.38 rS FIRM = 9% + 1.38(15% ­ 9%) =17.28% 29 Rate of Return % SML rs= 19.8 rs= 17.28 rs= 16.2 rRF = 9 Brass Pewter Coy Average 1.2 1.38 1.8 β 30 Problem 3 An all­equity firm currently produces plastic goods. Its Beta is 0.8, rRF is 8% and rM is 16% and its Cost of Capital is: The firm is thinking about a project to produce silver goods: The average Beta of silver firms is 1.4 Production will be: 60% plastic and 40% silver goods. If the expected rate of return for the silver project is 20%, • Should the firm accept or reject it? • If yes, then what will the firm’s new average rS be? 31 Solution 3 Minimum required rate of return on silver will be: rS SILVER = 8% + 1.4(16% ­ 8%) = Check via weighted average of the project costs of equity: 16.32% = (0.6 × 14.4) + (0.4 × X) = 8.64 + 0.4X 7.68 = 0.4X X = E(rS SILVER) @ __________________________ 32 Solution 3 Continued rS PLASTIC = 8% + 0.8(16% ­ 8%) = _____% Composite β = (0.6× 0.8)+(0.4 × 1.4) = = New rS FIRM = 8% + 1.04(16% ­ 8%) = 33 ...
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