Workshop 6 Dr Francesca Gagliardi 7BSP0379 – Financial Management Cost of Capital Workshop 6 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 Appreciate the reasons for preferring market values to book values Understand how to apply the (weighted average) cost of capital in investment appraisal

Knowledge development In previous weeks: We looked at the sources of finance that are available to companies We analysed how investment appraisal methods can be applied to make capital investment decisions We 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

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 cost of available financing sources is needed Knowledge of how to combine different sources of finance to reach an optimal capital structure is required

Calculating the cost of capital A company’s cost of capital can be used as: Discount rate in investment appraisals 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

Ordinary shares 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 = cost of equity D0 = current dividend g = the expected growth rate of dividends P0 = the current ex-dividend share price Example: If D0 = 12p per share, g = 5%, and the current share price is 120p, the cost of ordinary share is calculates as: Ke = [12p * (1 + 0.05) / 120p] + 0.05 = 15.5%

Ordinary shares Rj = Rf + βj (Rm - Rf) 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

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: where: Kps = cost of preference shares P0 = current ex-dividend preference share price Dp = preference dividend

Kid(after-tax) = Kid(1 – CT) Irredeemable bonds Like preference shares, bonds involve a constant annual payment in perpetuity 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

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%

Redeemable bonds Redeemable bonds involve several fixed interest payments plus redemption value. The after-tax cost of debt is: I = interest payment RV = redemption value Kd = cost of debt capital n = number of years to maturity CT = corporation tax rate Note: The before-tax cost of debt is found by using I instead of I(1-CT)

Convertible bonds To calculate 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 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

The relationship between the costs of different sources of finance The cost of each financing 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 Cost of preference shares less than 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, cost of debt less than cost equity Whether bank debt is 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

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 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

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

Class activity Source of finance Cost Market value (£000) Equity Ke = 16.9% 633.6 Preference shares Kp = 13.4% 33.5 Irredeemable debt Kid = 9.7% 68.4 Redeemable debt Krd = 8.7% 76.0 Bank loans Kbl = 8.8% 60.0 871.5 Required: calculate the WACC

Solution

Practical problems with WACC Calculating the cost of particular sources of finance may not be straightforward Ordinary shares of private companies 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 Market value of bonds 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

Practical problems with WACC Which sources of finance should be included in the WACC calculation? The difficulty of finding the market value of securities impacts on the weightings applied 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 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

WACC in the real world Companies pay attention to the value of WACC A company’s WACC is of interest to national regulatory bodies to determine what is considered to be a ‘fair’ level of profit A company’s WACC is of interest to 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

WACC and investment appraisal WACC is often used by companies as a discount rate for new projects However, companies should use their current WACC as a discount rate when appraising a future investment only when: The company intends to maintain the same long-term capital structure Any new project has the same systematic risk as the existing company

Summary Today we looked at: How to calculate the cost of different sources of finance How to calculate the WACC Main issues arising from WACC