5016 - Investment and Financial Analysis - The Cost of Capital p145 - 217 Flashcards
What is the cost of Equity (Ke)
The dividends payed to shareholders in return for their investment. The return demanded by shareholders
What is the cost of Debt (Kd)
The cost is the interest you pay to debt provider in return for the loan and risk they are taking
Difference between debt capital and equity capital
Debt capital carries the legal obligation to repay
Equity capital is not repaid
Difference between Debt and Equity Legally
Debt holds the legal obligation to pay back both the sum and the interest (fixed or floating)
Equity holds no legal obligation to pay dividends, its only driven by the investors wants and the companies policy. However if shareholders expect a dividend and don’t get it they may sell their share
Dividends
Dividends are similar to interest
When a company makes a profit it belongs to the shareholders which is why dividends exist
Some companies prefer to reinvest the cash rather than pay out dividends
What different rates of interest does debt carry?
Fixed rates - 1-25 years
Variable Rates
Discount Variable Rates
Capped Variable Rates
Fixed interest rate
You fix the interest rate payable for a specified period so say 4% fixed for 3 years
Variable interest rate
The rate depends on bank policy e.g. the base rate set by the BOE +1%, when the BOE changes the base rate they may pass that increase on to you
Discount Variable Interest Rates
An example would be a normal variable rate mortgage with a discount on interest for a set period of time
Capped variable rate
Normal variable rate but capped at a certain percentage say base rate + 1 capped at 5%
Advantages of Fixed Rate Interest
- Unaffected by increases in interest rates
- Peace of mind ) wont change)
- Assuming your financial position stays the same you know you can afford it
- Can factor into budget or cashflow
Disadvantages of Fixed Rate Interest
- No benefit from interest rate reduction
- May incur a fee to obtain
- Once the fixed period has ended you could see a jump in interest
- Hard to re-mortgage
Advantages of Variable Rates of Interest
- Benefits from a reduction in interest rates
- Cheap, no fees, used in basic mortgages
- Easily re-mortgage
Disadvantages of Variable Rates of Interest
- Not protected from interest rises
- Worry - No peace of mind
- Mortgage payments may become too much to pay in the future
- Difficult to budget
Advantages of Discount Variable Rates
- Benefit from the discount for the set period
- Benefit from reductions in interest rates
Disadvantages of Discount Variable Interest Rates
- Often only available to first time buyers
- Adversely impacted by rising interest rates
- Worry
- May not be able to afford in future
- May be tied-in making it difficult to re-mortgage
- May be forced to get expensive house insurance to get fixed mortgage
Advantages of Capped Variable Interest Rates
- Will not pay over 7%
- Benefit from reductions in interest rates
- Peace of mind
- Can budget/build it into cashflow at worst case
Disadvantages of Capped Variable Interest Rates
- During certain periods you may pay more than some fixed rate mortgages
- May be charged a fee
- May be tied-in, hard to re-mortgage
- May be forced to take out expensive insurance
What factors determine the rate of interest charged on debt?
- Amount / Customer Stake
- Period of time
- The Economy
- Availability of security
- The Covenants
- Level of loan risk to loan provider
- Availability of funds
What costs are associated with debt and equity?
Equity means dividend payments
Debt means interest payments
How to work out WACC on Equity and Debt
WACC = Equity/Total Capital x Dividends%
Add
Debt/Total Capital x Interest%
or
Proportion of Finance used x Cost of Finance Used = Finance Element. Add all finance elements together to get the WACC
A company has raised £56,500,000 in Equity paying 6% dividends and £31,250,000 through debt at an interest rate of 1.5% what is the WACC - Weighted Average Cost of Capital
56,500,000 + 31,250,000 =
87,750,000
Debt:
£56,500,000 / £87,750,000 = 0.6439 x 6% = 0.03863
Equity:
£31,250,000 / £87,750,000
= 0.3561 x 1.5% = 0.0053
0.03863 + 0.0053 = 0.04393
WACC = 4.393%
Calculating the cost of Equity (Ke)
Ke = Dividend / Share Price x 100
Note:
Assuming no increase in dividend payments
Below share price in the equation in small writing would be either Exdiv or Cumdiv, Ex div means no dividend next time, Cumdiv means a dividend will be payed next time
Factors companies need to consider with dividends
Returns Payable elsewhere:
If dividends gave less of a return than the bank people wouldn’t invest as much
Dividends payed by competitors:
Is a competitor offering higher dividend payments, if so investors are more likely to choose them
Shareholders Expectations:
If you increase dividends by 1% every year usually, this will become an expectation
You buy a share for £1 and sell it for £1.50, what is the 50p gain in that called
Capital Gains
How long are dividends payable?
Forever or until the business fails
Is Equity inexpensive in the long run?
No, dividends are payed forever and usually grow due to external pressures so they are expensive
What is the Gordon Growth Model used for?
Calculating the cost of dividend growth
Gordon Growth Model Formula
Latest Dividend (£) x (1+Dividend growth rate) / Share price + 0.10 x 100
D0 (1+g) / Share Price + g x 100
Calculating Dividend Growth Rate ‘g’
Dividend B - Dividend A / Dividend A x 100
Cost of Equity Shares Assuming Constant Dividends
The dividend in year 1 / Current market value of the share
K0 = D1/P0
Cost of Equity Shares Assuming Dividend Growth
(Dividend in year 1 / current market value of share) + expected annual growth rate in dividends
K0 = (D1/P0) + g
Cost of Preference Shares
Cost of preference shares = Annual Dividend Payments / Current market value of the shares
Kp = Dp/Pp
P = Subscript
Is a company took out a loan at 10% interest, why is the cost of debt not 10%?
Because interest is tax deductible and reduces your profit. and you pay tax based on profit. This is known as a tax shield
True/Net cost of debt example
2 companies have a gross profit of £1000 each, business A has £100 in interest payments, Business B dose not. Tax is 30% so…
Business A is taxed 30% on a net profit of 900, meaning 270 in tax payments
Business B is taxed 30% on 1000, meaning 300 in tax payments
Business A spent £100 to pay off their debt, but after deducting this from tax it gives them £30 off their tax bill, making the true cost £70
If business B used equity, and paid out the same as the interest payments in dividends they would have a net profit after tax of £600 whilst business A would have £630, showing an advantage to debt over equity
True/Net Cost of debt Formula
Cost of debt/interest (1 - corporation tax rate)
Kd(1-CT) = Kdat (Cost of debt after tax)
What tax do you pay on interest and dividends?
None, but interest payments are tax deductible whilst dividends are not
Tax Shield
The tax shield is the process of using interest to reduce taxable income, if you pay interest of 5% on 1000 that’s £50, the CT rate is 30% so that amount due in tax is reduced by 30% meaning you actually only pay £35, this is the true cost of debt
Cost of Loan Capital
Interest Expense x (1 - Tax Rate) / Market Value of Loan Capital
Cost of Equity Summary
- Cost of Equity comes from the return demanded by shareholder
- Dividends may increase and are payable forever,
- We use the Gordon Growth Model to calculate this cost
Cost of Debt Summary
- Cost of debt comes from the return demanded by debtholders (interest) which may be fixed or floating
- Interest is tax deductible, dividends are not
- The True cost of debt is KD x (1 - Tc)
Weighted Average Cost of Capital Summary
Made up of cost of equity (Ke) and Cost of Debt (Kd) weighted according to the proportion of equity and debt in the firm
What are Bonds
Debt sold to other people with interest given to them for holding that debt e.g. a bond for £100 with an interest rate of 5% would give you £5 after a year.
Bonds can be traded and sold to other investors
What is WACC also known as?
Hurdle Rate
What is a minimum hurdle rate?
The return your investment needs to make to be profitable
WACC Test:
Equity of £34 Million @ 6%
Debt of £12 Million @ 12%
34 + 12 = 46,000,000 / 100 = 460,000
£34 Million / 460,000 = 73.91%
£12 Million / 460,000 = 26.09%
6% x 0.7391 = 4.43%
12% x 0.2609 = 3.13%
4.43 + 3.13 = 7.56
WACC = 7.56%
ROIC
Return on Invested Capital
TRS
Total Return to Shareholders
Return on Invested Capital (ROIC) Formula
Net Operating Profit - Adjusted Taxes / Invested Capital (Both Equity and Debt)
What is Gearing
Level of Debt (%)
Capital Structure
The mix of debt and equity
WACC at Various Capital Structures Example
Debt %: Weight(Ke) + Weight(Kd) = Cost of Capital%
0%: 1(4) + 0(2) = 4%
10%: 0.9(4.5) +0.1(2.2) = 4.27%
20%: 0.8(5) + 0.2(2.4) = 4.48%
30%: 0.7(5.6) + 0.3(2.8) = 4.76%
40%: 0.6(6.4) + 0.4(3.4) = 5.2%
EPS
Earnings Per Share
PAI
Profits After Interest
Earnings Per Share Formula
PAI/Number of shares
Calculating Share Price
Earnings Per Share (EPS) / Cost of Equity (Ke)
What did Modigliani and Miller (1958) suggest?
That the Weighted Average Cost of Capital was not affected by the level of gearing and argued gearing up reduces the WACC because debt is tax deductible. They had a modernist view that challenges the traditional view
What is the average gearing ratio in the UK
30-40% - Suggesting people reject mm’s view and maintain a traditional approach to capital structure
Does higher gearing impact the cost of equity?
Yes, as the amount of gearing rises the probability of investors getting a zero return on their investment increases, more debt means more interest payments so less profit to distribute if any.
