说明学校homework五月9.1cost of capital

1、Strategic Corporate FinanceWeek 9 The cost of capitalCalculate and explain the cost of debt capital, before and after tax considerations capitalDescribe the difficulties in estimating the equity cost of capitalCalculate the weighted average cost of capital and explain the meaning of the number produ

2、cedDescribe how companies actually calculate the WACCLearning esThe return that a company has to offer finance providers to induce them to buy and hold a financial securityThe rate is determined by the returns offered on alternative securities with the same riskCost of capital isConsequences of usin

3、g the wrong cost of capitalIf too high, profitable investment will not take placeIf too low, unprofitable projects will be undertakenBut it is not an exact scienceCost of capitalCapital comes in different formsEquityDebtHybrid (a mixture of debt and equity)Each has its own level of risk and returnTh

4、e required rate of returnManagement perspectiveCost of capital is the return the firm will have to pay to the providers of finance Providers of finance perspectiveCost of capital is the return required to provide the finance Two sides of the same coinThe cost of capital for a business financed by bo

5、th debt and equity is based on a weighted averageThis is determined by the cost of each source and its weight or contribution to the overall level of capitalCost of each sourceCost of debt (KD)Cost of equity (KE)Weighted average cost of capitalVD = value of debtVE = value of equityThe weight of each

6、 part is calculated as belowWeighted average cost of capitalWeight of debt=VDVD+ VEWeight of equity=VEVD+ VEThe WACC is thereforeWeighted average cost of capitalWACC=KD x VD+KE x VE(VD+ VE)(VD+ VE)Example: Foss plc has the following capital structureEquity with a value of 5m and cost of 12%Debt with

7、 a value of 3m and cost of 8%Required: Calculate the WACCWeighted average cost of capitalWeighted average cost of capitalWACC (%)= KD x VD+KE x VE(VD + VE)(VD + VE)WACC (%)= 8x 3+12x 5(5+3)(5+3)WACC (%)=24+6088WACC (%)= 10.5%WACC is dependant on the capital structureIf this changes WACC will changeE

8、.g. Calculate WACC if Foss plc had debt of 5m and equity of 3mImplications of WACCWACC(%)=8x 5+12x 35+35+3WACC(%)=9.5%Increasing debt has lowered WACCThis increases the value of the businessIf it was that easy everyone would do itWhy dont businesses just add more and more debt?Modigliani and Miller:

9、 As gearing increases, equity holders require a greater return to compensate for the increased riskTherefore the WACC may not changeImplications of WACCInterest on borrowings reduces taxable profitInterest is tax deductibleThis reduces the cost of debtDividends are paid from after tax e and are not

10、tax deductibleWACC and taxationE.g. Foss plc has debt of 5m and equity of 3m and the tax on profits is 20%Interest on debt is 8%Profit before tax is 1,000,000Required:Calculate the WACC with and without taxation WACC and taxationWACC and taxationInterest tax deductible Interest not tax deductible 00

11、0000Profit before interest and tax1,0001,000Interest400Profitbefore tax6001,000Taxation120200Profit after tax480800Interest 400Available to shareholders 480400If interest is tax deductible an extra 80,000 is available to shareholdersThe net interest paid is now 320KThis is a net rate of 6.4% (320K/5

12、m)WACC and taxationThis tax shield reduces the cost of debt WACC will also be lowerThis could lead firms to increase gearingBut. Equity investors will want extra compensation for the extra risk WACC and taxationCapital asset pricing modelGordon growth modelThe cost of equity capitalCapital asset pri

13、cing modelRate of return on shares = Risk free rate + risk premiumRisk free rate compensates for inflation and impatience to consumeRisk premium:Estimate the return required by investors to buy a portfolio of average risk shares (return on market)Adjust the risk premium for the risk level of that co

14、mpany (beta)The cost of equity capitalCapital asset pricing modelKe = rf + x (rm-rf)The cost of equity capitalGordon growth modelThe value of a share is based on the present value of future dividendsAdjusted for future growth in dividendsKe = Cost of equityP0 = price of share todayd1 = dividends pai

15、d next yearg= Expected growth of dividendsThe cost of equity capitalKe=d1+gP0Gordon growth modelThis model relies on the ability to predict future dividendsIt is very sensitive to changes in gThe cost of equity capitalKe=d1+gP0Stonegate plc: Current share price 100pCurrent Dividend 8pCalculate the c

16、ost of equity (Ke) assuming growth in dividends as follows:Zero growth 5% growth 8% growthGordon growth model exampleStonegate plc: Dividend next year: Zero growth 8p5% growth 8.4p (8 x 1.05)8% growth8.64p (8x1.08)Gordon growth model exampleKe=d1+gP0Gordon growth model exampleKe=8+0=8%100Ke=8.64+8=1

17、6.64%100Ke=8.4+5=13.4%100The cost of equity can change a lotThe formula can be re-arranged to give an indication of todays price.Gordon growth model example 2P0=d1+gKeMinster plc has the following information:Cost of equity: 15%Current annual gross dividend/share: 8pRequired: Calculate the Current s

18、hare price using the dividend growth model assuming that growth is:Zero5%8%Gordon growth model example 2Gordon growth model example 2P0=8+0=53p15P0=8.64+8=65.6p15P0=8.4+5=61p15The price of a share will vary according to the assumptions about growth An important source of long term financeSome may co

19、nsider it to be free financeRetained earnings belong to shareholdersThere is an opportunity cost of retaining itCost is the same as the cost of equityCost of retained earningsPreference shares have some features in common with both debt and equity If they give a rate of interest in perpetuity they c

20、an be valued using the Gordon dividend growth model (without the growth)Cost of preference share capitalKe=d1PThe overall return for a business is based on its portfolio of current projectsThe risk of the firm is based on the risk of its individual projectsSome aspects of a firm may be higher risk than othersDifferent divisions make need to make different returnsApplying WACC to projects & SBUs Academic literature promotes the use of WACCArnold and Hatzopolous (20