FINC5001 Topic Eight - Company Cost of Capital

1、BUSINESS SCHOOLTopic Eight: Company Cost of CapitalCraig MellareLecture OutlineThis lecture will discuss: The company cost of capital, with regard to:- Calculation of the company cost of capital- Estimation of the cost of debt capital- Estimation of the cost of equity capital- The impact of corporat

2、e tax on the company cost of capitalThe calculation and forecasting of free cash flows, including:- Cash flow reporting in financial statements- Preparation of free cash flow forecastsValue of a firmThe company cost of capitalShareholdersDebtholders$10 million investedOpportunity cost = 16%Annual co

3、st = $1.6 million$10 million investedInterest rate = 10%Annual cost = $1millionCOMPANYWhat is the cost of capital?Total required returnRequired return/invested capital-$2.6m/$20m = 13%Total required return (contd)Or calculate using the Weighted Average Cost of Capital (WACC) as follows:where:D = mar

4、ket value of debtE = market value of equityrd = cost of debtre = cost of equityWACC rdDD E reED EExample: WACC The market value of debt and equity of a company are $10 million each. The debtholders of the company charge an interest rate of 10% p.a. while the equity holders require a return of 16% on

5、 their investment. What is the company cost of capital?. %.apEDErEDDrWACCed13130500160500100101010160101010100The cost of debt capital In topic 3, the following expression was used to find the value of a debt security:where:D=the market value of the debtn=the time to maturity of the debtF=the dollar

6、 interest paid on the debtB=the face value of the debtrd=the discount rate = THE COST OF DEBTDF1 rdtt1nB1 rdnEstimating the cost of debt There are several approaches:-Assume the debt is risk-free, and use the 10-year government bond yield-Add 100 200 basis points (1 2%) to the 10-year bond yield to

7、allow for risk-Use the following equation:where: net interest = interest paid - interest received average net debt = reported book value of debt - cashrdnet interestaverage net debtThe after tax cost of debt Because interest expenses are tax deductable we often want the after tax cost of debt:= rd (

8、1-tc)where:rd = before tax cost of debttc = the corporate tax rateeg. if rd = 10%; tc = 30% then after tax cost of debt = 10% (1-.30) = 7.0%Cost of equityThe minimum required rate of return on shares for the risk involvedEstimation methods:implied from current pricesmodelled using the CAPMImplying t

9、he cost of equityImplying the cost of equityExampleExample - SolutionCost of capital is the re that makes the following equation true: 44321106. 006. 1321. 0$1321. 0$129. 0$1261. 0$1233. 0$00. 6$eeeeeerrrrrrEstimating the required return on equity using the CAPME(ri )= rf + x E(rm - rf)where:E(ri) =

10、 required return on equity for stock irf = current risk free rate of returnE(rm - rf) = market risk premiumBi = regression co-efficient estimated from historical data for stock iEstimating the cost of equity using CAPMUsing CAPM to estimate the cost of equity:1. Estimate the beta of the stock using

11、historical data2. Determine the current risk-free rate3. Determine the expected market risk premium4. Substitute these values into the CAPM equationEstimating market risk premiumThere are 3 approaches to estimating market risk premium:-Use historical average returns on the stock market-Imply from sh

12、are prices and analysts forecasts-Estimate the relationship between stock market volatility and stock market returnsEstimating market risk premium (cont)1.Using historical average returns on the stock marketAssumptions:- Realised returns are equivalent to the returns expected by market participants

13、for bearing risk in the future- The market risk premium is constant over timeEstimating market risk premium (cont)2.Using analysts forecasts of earnings and dividends:where:rei=the equity cost of capital for stock id1=the one-year-ahead forecast dividend for stock igi=the constant growth rate for st

14、ock iPit=the current price of stock IAssumption: Analyst forecasts are accuratereid1iPit giEstimating market risk premium (cont)3.Estimating the relationship between stock market volatility and stock market returnswhere rm,t=the market return over period t rf,t=the risk-free rate of return over peri

15、od t b=reward-to-risk ratio 2(t) =stock return volatility period trm,t rf ,t a b2t Problems with using the CAPM to estimate the cost of equityStability of s over time1. Stocks may change in risk through time2. estimates are from a limited number of observations - measurement erroreg. BHP based on di

16、fferent time periodsBHP Excess Returns Versus Market Excess Returns From January 1987 to December 1990-0.350000-0.300000-0.250000-0.200000-0.150000-0.100000-0.0500000.0000000.0500000.1000000.150000-0.400000-0.300000-0.200000-0.1000000.0000000.1000000.200000Excess Returns on MarketExcess Returns on B

17、HP = 0.49Problems with using the CAPM to estimate the cost of equityBHP Versus Market Excess Returns from January 1991 to December 1994-0.150000-0.100000-0.0500000.0000000.0500000.1000000.1500000.200000-0.400000-0.300000-0.200000-0.1000000.0000000.1000000.200000Excess Returns on MarketExcess Returns

18、 on BHP=1.28Problems with using the CAPM to estimate the cost of equityExample- estimating the cost of equityBurswood Ltd has a beta of 1.31, the market risk premium is 5.3% and the risk free rate is currently 5.5%. What is the cost of equity capital?E(ri) = rf + i . E(rm - rf)E(ri) = 0.055 + 1.31 (

19、0.053) = 0.1244A digression: the imputation system of taxFor every $1 of tax paid by the company, the shareholder gets a franking credit (tax credit)Thus $1 of corporate income only gets taxed once, at the personal tax rate of the shareholderA companys income of $1 is paid out as an after-tax divide

20、nd. What is the shareholders after-tax income if his tax rate is 45%? ClassicalImputationCorporate levelNet income$1.00$1.00Company tax0.300.30Cash dividend0.700.70Shareholder levelTaxable income0.701.00Personal tax liability0.320.45Franking creditn.a.0.30Tax paid0.320.15After-tax income0.380.55Exam

21、ple: the impact of imputation on shareholder returnsReturns to shareholder under imputationUnder the classical system of tax:rt = (pt-pt-1) + dt/pt-1Under imputation (assuming shareholders use all franking credits)*rt = (pt-pt-1)+(dt+Ct)/pt-1where dt+ Ct = grossed up value of dividends = dt/(1-tc)CA

22、PM under an imputation system of tax The CAPM also needs to be redefined so that the value of franking credits is included in returns on both the stock and on the market:where: rj? =expected return on stock j before personal tax, including the value of franking credits usedrft=risk-free rate of retu

23、rn over period trmt=return on the market over period t =value of franking credits paid on stocks in the indexj=beta of stock jjftmtmtftjrrErrIncorporating the effect of tax into the company cost of capital The WACC needs to be adjusted to reflect the effect of tax Under the classical system- if disc

24、ounting forecast cash flows estimated before tax:- if discounting forecast cash flows estimated after tax:where: tc = the corporate tax rateWACC rdD V re1 tcE VWACC rd1 tcD V reE VIncorporating the effect of tax into the company cost of capital Under the imputation system- if discounting forecast ca

25、sh flows estimated before tax:- if discounting forecast cash flows estimated after tax:where: re,rd=expected return on equity and debt before taxE,D,V=market value of equity, debt & the firm, respectivelyT=effective rate of company tax on company cash flow?=proportion of franking credits valued

26、by the companys shareholders VE1t1rVDrWACCced VDT1rVE1T1T1rrdei Incorporating the effect of tax into the company cost of capital (cont)Example 8.8Using the following information for Tabcorp Holdings Ltd estimate the company cost of capital Estimated required rate of return on equity = 15.5%Estimated

27、 cost of debt = 8.11%Net debt = $1729.9m Number of shares = 688 millionShare price= $7.72 _1) Market value of equity = 688m x 7.72 = $5311.36m2) Market value of firm = 5311.36m + 1729.9m = $7041.26m.%58. 90958. 026.70419 .172930. 010811. 026.704136.53111130. 0130. 01155. 0V1111apDTrVETTrrDEiFinancia

28、l reporting and calculating free cash flows The cash flows of a company after reinvestment costs (capital expenditure) are distributed to the government, shareholders and debtholders of the company The value of a company is determined by the cash flows distributed to its shareholders and debtholders

29、 the free cash flows after tax Hence, the free cash flows need to be forecast and discounted at the company cost of capitalAustralian corporate financial reporting The real assets of a firm generate cash flows, some of which are reinvested in real assetsReal assetsCapital expenditureFIGURE 8.1Austra

30、lian corporate financial reporting (cont) Some of the free cash flows are then distributed to the government by way of taxReal assetsGovernmentCapital expenditureFree cash flowsbefore taxFIGURE 8.1 Free cash flows after tax are then distributed to capital providers (shareholders and debtholders)Real

31、 assetsShareholdersDebtholdersGovernmentCapital expenditureFree cash flowsafter taxFree cash flowsbefore taxFIGURE 8.1Australian corporate financial reporting (cont)Statement of cash flows The cash flow statement is divided into three sections:Cash flows from operating activitiesCash flows used in i

32、nvestment activitiesCash flows used in financing activitiesStatement of cash flows (cont) The cash flow statement is divided into three sections:Cash flows from operating activitiesCash flows used in investment activitiesCash flows used in financing activitiesExamples: Cash receipts and payments in

33、the course of operations Income tax paid Dividends received Interest received or paid The cash flow statement is divided into three sections:Cash flows from operating activitiesCash flows used in investment activitiesCash flows used in financing activitiesExamples: Purchases of property, plant and e

34、quipment Sales of property, plant and equipment Purchases and sales of businessesStatement of cash flows (cont) The cash flow statement is divided into three sections:Cash flows from operating activitiesCash flows used in investment activitiesCash flows used in financing activitiesExamples: Funds le

35、nt, borrowed or repaid Proceeds of share issues Funds used for share buybacks Dividends paidStatement of cash flows (cont)Calculation of free cash flows Hence, the free cash flows can be calculated from a companys cash flow statement using the following calculation:Cash receipts from operationsLess:Cash payments from operationsLe