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8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 1/31
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 2/31
1. The overall approach
How do we find a suitable discount rate?
- weigh the costs of each type of long term
finance
- Weighted Average Cost of Capital (WACC)
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 3/31
1. The overall approach
Traded debt Non-traded debt
Irredeemable Redeemable Convertible Bank loans
Debt
Sources of long-term finance
Prefer
ence sharesE
quity
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 4/31
2. Estimating the cost of capital
Key ideas in estimating cost of capital
A. Cost of a debt or equity instrument is:
- The rate that discounts the future streams of cash-flows to
- The present price of the instrument
B. The cost of debt or equity instrument is implicit in the price.
C. To evaluate cost of a debt or equity instruments we will use
- prices
- streams of cash-flows (interest, dividends etc.)
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 5/31
2. Estimating the cost of equity
COST OF EQUITY – 2 models
A. The Dividend Valuation Model (DVM)
- constant dividends
- constant growth in dividends
B. The Capital Asset Pricing Model (CAPM)
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 6/31
2. Estimating the cost of equity
The Dividend Valuation Model (DVM)
The cost of equity finance is the return the investors expect to
achieve on their shares.
Assumptions:
- Stream of cash-flows is the stream of dividends paid out by
the company
- Dividends will be paid in perpetuity
- Dividends will be constant or growing at a fixed rate
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 7/31
2. Estimating the cost of equity
The Dividend Valuation Model (DVM)
Assuming constant dividends
Where:
D = the constant dividend from year 1 to infinity
P0 = share price now (year 0)
r e = shareholders’ required return, expressed as decimal
00 P
Dr
r
D P
ee
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 8/31
2. Estimating the cost of equity
The Dividend Valuation Model (DVM)
Assuming constant growth in dividends
Where:
g = constant rate of growth in dividends
D1
= the dividend to be received in one year
D0 (1+g) = the dividend just paid adjusted for one year’s growth
P0 = share price now (year 0)
r e = shareholders’ required return, expressed as decimal
g r
D
g r
g D P
ee
10
0
)1(
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 9/31
2. Estimating the cost of equity
The Dividend Valuation Model (DVM)
Assuming constant growth in dividends
Where:
g = constant rate of growth in dividends
D1
= the dividend to be received in one year
D0 (1+g) = the dividend just paid adjusted for one year’s growth
P0 = share price now (year 0)
r e = shareholders’ required return, expressed as decimal
g P
D g
P
g Dr
e
0
1
0
0 )1(
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 10/31
2. Estimating the cost of equity
The Dividend Valuation Model (DVM)
Ex-dividend (ex-div) vs Cum-dividend price
Cum-div
Ex-div
Dividend
declared
Share goes
ex-div
Dividend
paid
Share goesex-div
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 11/31
2. Estimating the cost of equity
The Dividend Valuation Model (DVM)
Use ex-dividend (ex-div) price
In some question the cum-dividend price is
given and a dividend is due shortly
Cum div share price – Dividend due = Ex div share price
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 12/31
2. Estimating the cost of equity
The Dividend Valuation Model (DVM)
Estimating annual growth
- extrapolating based on past dividend patterns
- assuming growth is dependent on the level of
earnings retained in the business
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 13/31
2. Estimating the cost of equity
The Dividend Valuation Model (DVM)
Estimating growth (g) from past dividends
Also known as geometric average.
1
1
0
n
ago yearsn Dividend
D g
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 14/31
2. Estimating the cost of equity
The Dividend Valuation Model (DVM)
The earnings retention model (Gordon’s growth model)
where:
r = the accounting rate of return
b = earnings retention rate
r b g
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 15/31
3. Estimating the cost of preference shares
Use DVM since preference shares pay constant dividend
Where:
D = the constant dividend from year 1 to infinity
P0 = share price now (year 0)
K p = cost of preference share
0
0
P
D K
K
D P p
p
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 16/31
4. Estimating the cost of debt
Types of debt
Traded debt Non-traded debt
Irredeemable Redeemable Convertible Bank loans
Loan notes – bonds – loan stock – marketable debt– used interchangeably
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 17/31
4. Estimating the cost of debt
Cost of irredeemable debt
Cost of debt to company.
Where:
I = annual interest starting in one year’s time
MV = market value of the loan note now (year 0 )
K d (1-T) = post-tax cost of debt to the company
T = corporate taxation
MV
T I T K
d
)1()1(
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 18/31
4. Estimating the cost of debt
Cost of redeemable debt
The company will:
- pay interest for a number of years and then
- repay the principal (sometimes at a premium or a discount
to the original loan).
Expected cahs-flow stream:
- interest paid to redemption;
- repayment of principal.
Market price = PV of interest and redemption payment
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 19/31
4. Estimating the cost of debt
Cost of redeemable debt
Cost of redeemable debt to the company - the IRR of the following
MV Price paid to invest in debt instrument (x)
T 1-n Interest received × (1-T) xTn Capital repayment x
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 20/31
4. Estimating the cost of debt
Cost of redeemable debt at current market price
Use the formula for irredeemable debt
MV T I T K d )1()1(
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 21/31
4. Estimating the cost of debt
Cost of convertible debt
A form of loan note that allows the investor to choose between
taking the redemption proceeds or converting the loan note
into a pre-set number of shares.
Method:
(1) Calculate the value of the conversion option (estimated value
of shares on option date);
(2) Compare the conversion option with the cash option. Assume
all investors will choose the option with the higher value.
(3) Calculate the IRR of the flows as for redeemable debt
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 22/31
4. Estimating the cost of debt
Cost of non-tradeable debt
Includes bank loans and other non-tradeable fixed interest loans
Simply adjust for tax relief
Cost to company = I×(1-T)
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 23/31
5. Estimating the cost of capital
Weighted Average Cost of Capital (WACC)
1. Calculate weights for each source of capital
2. Estimate cost of each source of capital
3. Multiply the proportion of each source in the total sources of
capital by the cost of that source4. Sum the results of step 3 to get the WACC
V d and V e = the market values of debt and equity
K e = the cost of equity
K d (1-T) = the (post-tax) cost of debt
)1( T K
V V
V K
V V
V WACC d
d e
d e
d e
e
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 24/31
5. Estimating the cost of capital
The average is known as Weighted Average Cost of Capital (WACC)
Choice of weights
- Book values (BVs)
- Market values (MVs)
Whenever possible choose market values
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 25/31
7. Cost of equity – Capital Asset Pricing Model (CAPM)
A. CAPM relies on the following assumptions:
- Investors would require a rate of return at leastequal to the risk-free rate
- To compensate for any extra-risk taken, theyrequire a premium
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 26/31
7. Estimating the cost of equity – the Capital Asset Pricing Model
Capital Asset Pricing Model (CAPM)
Shows how the minimum required rate of return on a quoted
security depends on its risk.
premium Risk return free Risk returnquired Re
CAPM - works out a formula for the risk premium
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 27/31
7. Cost of equity – Capital Asset Pricing Model (CAPM)
B. CAPM relies on the following assumptions (continued)
- Investors are risk averse;
- Investors deal with risk by way of diversification ;
- Invest in companies whose returns are negatively correlated
- Eliminate company specific risk (unsystematic risk)
- Only face the systematic risk (market risk)
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 28/31
7. Estimating the cost of equity – the Capital Asset Pricing Model
Reducing risk by combining investments - Diversification
Total
portfolio
risk
No. of securities
Systematic risk
(Market risk)
Unsystematic risk
(firm specific risk)
15-20
securities
1 security
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 29/31
7. Cost of equity – Capital Asset Pricing Model (CAPM)
C. CAPM relies on the following assumptions (continued)
- Investors judge investments by the correlation of their returns with the
average market return
)(Re f m f R R Rreturnquired
Rf = risk-free rate of return
Rm = average return on the market
β = relative level of systematic risk (relative to the market)
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 30/31
7. Estimating the cost of equity – the Capital Asset Pricing Model
Capital Asset Pricing Model (CAPM)
Interpretation of beta
β is a measure of the systematic risk of an investment relative to that
of the market.
β >1 – the investment is riskier than the average
- returns have same direction as average market returns but change quicker
0< β < 1 – the investment is less risky than the average- returns have same direction as average market returns but change quicker
β = 0 – the investment is risk free
- no volatility in returns in respect to the average market returns
8/13/2019 Chapter 17-Cost of Capital
http://slidepdf.com/reader/full/chapter-17-cost-of-capital 31/31
7. Estimating the cost of equity – the Capital Asset Pricing Model
Capital Asset Pricing Model (CAPM)
Useful in calculating risk-adjusted cost of equity for projects with risk
profiles that are different than the current risk profile of the
business.
Find a beta factor – by reference to the beta factor of a similar
company operating in the new business are
CAPM – gives you beta and the required rate of return
- this helps compute the cost of equity
But if the project is financed with both equity and debt we need to
weigh the cost of the two sources of finance