CAPM and Valuation Practice Flashcards
One of your clients is Greenway, a high-street supermarket chain which is listed on the LSE. Shareholders have recently expressed concern that it does not have an adequate online sales platform.
In response, the directors recently approached a listed online supermarket, eFood, about the potential acquisition of eFood by Greenway. Your firm has been asked to advise Greenway’s directors on the potential acquisition.
Relevant market data on 30 September 2020.
Greenway:
- Ordinary share price (cum-div): 226.4p
- Number of ordinary shares issued: 2,250 million
- Equity beta: 0.70
- Dividends per share (due to be paid 1 October 2020): 14.4p
- Number of debentures issued (Note 2): 9 million
eFood:
- Ordinary share price (cum-div): 562,2p
- Number of ordinary shares issued: 200 million
- Equity beta: 1.20
- Dividends per share (due to be paid 1 October 2020): 2.2p
- Number of debentures issued (Note 2): 4 million
1: Greenway’s dividend per share have increased at a steady rate over the past five years. On 1 October 2015, the ordinary dividend per share paid by Greenway was 12.4p. The dividends per share of eFood have remained constant over the same period.
The number of ordinary shares in both companies has not changed in the last six years.
2: Greenway has issued 6% redeemable debentures which are currently trading at an ex-interest market value of £106 per £100 nominal value. These debentures are redeemable at par in 20 years’ time.
eFood has issued 5.75% irredeemable debentures which are currently trading at an ex-interest market value of £112 per £100 nominal value.
Extra info:
- Both expected to pay corporation tax at 25%
- Risk-free rate to be 3% pa and the market risk premium is expected to be 6% pa
- The finance required to acquire eFood would be raised using a mixture of equity and debt such that Greenway’s current gearing by market values, remains constant.
Ignoring the potential acquisition of eFood, calculate Greenway’s weighted average cost of capital on 30 September 2020 using:
- The dividend valuation model
- The CAPM
Dividend growth = (14.4p / 12.4p)^1/5 - 1 = 3.04%
Ke = (14.4p x 1.0304 / (226.4p - 14.4p) + 0.0304 = 10.04%
Market value of equity = 2,250 million x £2.12 (ex-div) = £4,770m
Redeemable debentures using the RATE function in Excel:
Number of payments: 20
Annual coupon: 6
MV: -106
Redemption: 100
Annual YTM using the rate function = 0.055
=RATE(20, 6, -106, 100)
Kd = 5.5% x (1 - 0.25) = 4.13%
Market value of debt = 9 million x £106 = £954m
WACC using DVM:
Ordinary shares:
- Cost: 10.04%
- MV: £4,770m
- Cost = £478.9m
Debentures:
- Cost: 4.13%
- MV: £954m
- Cost = £39.4m
—–
MV = 4,770 + 954 = £5,724m
Cost = 478.9 + 39.4 = 518.3m
WACC = 518.3/5,724.0 = 9.05%
WACC using CAPM
Ke = 3 + (0.70 x 6) = 7.20%
Ordinary shares:
- Cost: 7.2%
- MV: £4,770m
- Cost = £343.4m
Debentures:
- Cost: 4.13%
- MV: £954m
- Cost = £39.4m
MV = 4,770 + 954 = £5,724m
Cost = 343.4 + 39.4 = 382.8m
WACC = 382.8/5,724.0 = 6.7%
One of your clients is Greenway, a high-street supermarket chain which is listed on the LSE. Shareholders have recently expressed concern that it does not have an adequate online sales platform.
In response, the directors recently approached a listed online supermarket, eFood, about the potential acquisition of eFood by Greenway. Your firm has been asked to advise Greenway’s directors on the potential acquisition.
Relevant market data on 30 September 2020.
Greenway:
- Ordinary share price (cum-div): 226.4p
- Number of ordinary shares issued: 2,250 million
- Equity beta: 0.70
- Dividends per share (due to be paid 1 October 2020): 14.4p
- Number of debentures issued (Note 2): 9 million
eFood:
- Ordinary share price (cum-div): 562,2p
- Number of ordinary shares issued: 200 million
- Equity beta: 1.20
- Dividends per share (due to be paid 1 October 2020): 2.2p
- Number of debentures issued (Note 2): 4 million
1: Greenway’s dividend per share have increased at a steady rate over the past five years. On 1 October 2015, the ordinary dividend per share paid by Greenway was 12.4p. The dividends per share of eFood have remained constant over the same period.
The number of ordinary shares in both companies has not changed in the last six years.
2: Greenway has issued 6% redeemable debentures which are currently trading at an ex-interest market value of £106 per £100 nominal value. These debentures are redeemable at par in 20 years’ time.
eFood has issued 5.75% irredeemable debentures which are currently trading at an ex-interest market value of £112 per £100 nominal value.
Extra info:
- Both expected to pay corporation tax at 25%
- Risk-free rate to be 3% pa and the market risk premium is expected to be 6% pa
- The finance required to acquire eFood would be raised using a mixture of equity and debt such that Greenway’s current gearing by market values, remains constant.
Calculate the following, for both Greenway and eFood:
- Their current gearing ratio (by market values)
- Their asset beta on 30 September 2020
With reference to these calculations, explain why eFood has a higher equity beta than Greenway
Gearing levels:
- Market value of equity at eFood = (£5.622 - £0.022) x 200 million = £1,120m
- Market value of debt at eFood = £112 x 4 million = £448 million
eFood’s gearing:
- D/D+E = £448m / (£448m + £1,120m) = 28.57%
OR
- D/E = £448m / £1,120m = 40.00%
Greenway’s gearing =
Market value of equity = 2,250 million x £2.12 (ex-div) = £4,770m
Market value of debt = 9 million x £106 = £954m
Greenway:
- D/D+E = 954m / (4,770 + 954) = 16.67%
- D/E = 954m / 4,770mm = 20.00%
One of your clients is Greenway, a high-street supermarket chain which is listed on the LSE. Shareholders have recently expressed concern that it does not have an adequate online sales platform.
In response, the directors recently approached a listed online supermarket, eFood, about the potential acquisition of eFood by Greenway. Your firm has been asked to advise Greenway’s directors on the potential acquisition.
Relevant market data on 30 September 2020.
Greenway:
- Ordinary share price (cum-div): 226.4p
- Number of ordinary shares issued: 2,250 million
- Equity beta: 0.70
- Dividends per share (due to be paid 1 October 2020): 14.4p
- Number of debentures issued (Note 2): 9 million
eFood:
- Ordinary share price (cum-div): 562,2p
- Number of ordinary shares issued: 200 million
- Equity beta: 1.20
- Dividends per share (due to be paid 1 October 2020): 2.2p
- Number of debentures issued (Note 2): 4 million
1: Greenway’s dividend per share have increased at a steady rate over the past five years. On 1 October 2015, the ordinary dividend per share paid by Greenway was 12.4p. The dividends per share of eFood have remained constant over the same period.
The number of ordinary shares in both companies has not changed in the last six years.
2: Greenway has issued 6% redeemable debentures which are currently trading at an ex-interest market value of £106 per £100 nominal value. These debentures are redeemable at par in 20 years’ time.
eFood has issued 5.75% irredeemable debentures which are currently trading at an ex-interest market value of £112 per £100 nominal value.
Extra info:
- Both expected to pay corporation tax at 25%
- Risk-free rate to be 3% pa and the market risk premium is expected to be 6% pa
- The finance required to acquire eFood would be raised using a mixture of equity and debt such that Greenway’s current gearing by market values, remains constant.
Calculate the following, for both Greenway and eFood:
- Their asset beta on 30 September 2020
With reference to these calculations, explain why eFood has a higher equity beta than Greenway
Asset betas:
eFood:
Ba = 1.20 / (1 + ((448 x 0.75)/1,120)) = 0.92
Greenway:
Ba = 0.70 / (1 + ((954 x 0.75)/4,770)) = 0.61
Equity beta factors indicate a company’s total level of systematic business and financial risk.
Systematic business risk is the type of risk that all companies are exposed to, no matter what industry they are in and cannot be diversified eg economic factors. Nor can financial risk be diversified away.
Asset beta factors indicate the systematic business risk of an ungeared business.
eFood’s equity beta is affected by eFood having higher gearing (financial risk) than Greenway and higher systematic business risk (asset beta above)
One of your clients is Greenway, a high-street supermarket chain which is listed on the LSE. Shareholders have recently expressed concern that it does not have an adequate online sales platform.
In response, the directors recently approached a listed online supermarket, eFood, about the potential acquisition of eFood by Greenway. Your firm has been asked to advise Greenway’s directors on the potential acquisition.
Relevant market data on 30 September 2020.
Greenway:
- Ordinary share price (cum-div): 226.4p
- Number of ordinary shares issued: 2,250 million
- Equity beta: 0.70
- Dividends per share (due to be paid 1 October 2020): 14.4p
- Number of debentures issued (Note 2): 9 million
eFood:
- Ordinary share price (cum-div): 562,2p
- Number of ordinary shares issued: 200 million
- Equity beta: 1.20
- Dividends per share (due to be paid 1 October 2020): 2.2p
- Number of debentures issued (Note 2): 4 million
1: Greenway’s dividend per share have increased at a steady rate over the past five years. On 1 October 2015, the ordinary dividend per share paid by Greenway was 12.4p. The dividends per share of eFood have remained constant over the same period.
The number of ordinary shares in both companies has not changed in the last six years.
2: Greenway has issued 6% redeemable debentures which are currently trading at an ex-interest market value of £106 per £100 nominal value. These debentures are redeemable at par in 20 years’ time.
eFood has issued 5.75% irredeemable debentures which are currently trading at an ex-interest market value of £112 per £100 nominal value.
Extra info:
- Both expected to pay corporation tax at 25%
- Risk-free rate to be 3% pa and the market risk premium is expected to be 6% pa
- The finance required to acquire eFood would be raised using a mixture of equity and debt such that Greenway’s current gearing by market values, remains constant.
Using the CAPM, calculate a cost of equity that the directors of Greenway could use when appraising the potential acquisition of eFood and briefly explain the implications that this may have for Greenway’s investment decision
Re-gear eFood’s asset beta with Greenway’s gearing:
Be = 0.92 x (1 + ((954 x 0.75)/4,770)) = 1.06
Calculate ke using the CAPM
Ke = 3 + (1.06 x 6) = 9.4%
As a result of the higher systematic business risk in online retailing, Greenway’s shareholders are likely to require a higher return from the company’s investment in eFood. This increases the cost of equity and weighted average cost of capital. All else equal this would result in a lower NPV.
Discuss whether it is appropriate for Greenway’s board to assume that the Greenway share price will rise after an announcement to the LSE. Explain how behavioural factors might influence any movement in its share price and describe three kinds of behavioural factor that might occur.
The expectation that the share price will rise immediately after the announcement is based on the assumption that there is a semi-strong form market where share prices reflect both past price movements and public information.
In a semi-strong market share prices will be influenced by the nature of the information that is made public.
Information communicated to shareholders could include the potential benefits of the acquisition and the price that will be paid to acquire the shares.
Details of how the finance will be raised may also be communicated when the announcement is made.
The impact on the share price will depend on whether shareholders react favourably (price up) or unfavourably (price down) to this information.
Behavioural factors: that question the validity of the efficient markets hypothesis.
These can lead to irrational investment decisions that affect the movement of the share price.
Including:
- Overconfidence: Investors may overestimate the potential benefits of the acquisition
- Representativeness; investors judgement may be too focused on a representative observation rather than statistical evidence
- Narrow framing: investors may just focus on one specific factor and not consider the broader picture
- Miscalculation of probabilities: investors may attach too low probability to likely outcomes or too high probability to less likely outcomes
- Ambiguity aversion: investors may be afraid of investments where there is a lack of information
- Extrapolative expectations: investors may expect shares prices to continue to follow past trends
- Cognitive dissonance: Investors will continue to hold long-term beliefs, even if there is evidence to contradict those beliefs
- Availability bias: investors may pay more attention to facts or events which are most prominent or recent in their minds
- Conservatism: investors tend to be naturally conservative and resistant to changes in opinion
Just Breathe is a sportswear manufacturer listed on the LSE.
- Floated on the LSE in 2W5 (7 years ago)
- Between 20W6 and 20W9, they paid a small dividend per share and reinvested a large proportion of annual profit in product development. Grew rapidly to become one of the most recognised sportswear brands in the UK.
- From March 20X0 onwards, Just Breathe paid a much larger dividend per share than previously.
Dividend per share (in pence):
2016: 5.0p
2017: 5.8p
2018: 6.9p
2019: 7.5p
2020: 33.0p
2021: 34.0p
2022: 35.0p
The number of ordinary shares in issue has not changed over this period
Other info:
An extract from the most recent management accounts is below:
Balance Sheet as at 31 March 20X2
- Ordinary share capital (£0.50 shares) = £120m
- Retained earnings = £850m
—
970m
3% redeemable debentures at nominal value = 400m
—-
£1,370m
On 31 March 20X2 the ordinary shares have a market price of £5.60 (ex-div)
On 31 March 20X2 the 3% debentures have a market price of £94 (ex-interest). The debentures are redeemable at par in five years’ time.
Assume that corporation tax will be payable at the rate of 25% for the foreseeable future.
With reference to both dividend policy theory and practical dividend policy factors, discuss:
- The appropriateness of Just Breathe’s dividend policy from 2016 to 2019 and
- The impact that the change in dividend policy in March 2020 may have had on Just Breathe’s share price
Reasons why it may be appropriate:
- Shareholders’ wealth will not be increased by paying dividends. Their wealth will be increased by investing in projects with a positive NPV (M&M Theory)
- If a company is able to achieve significant growth, as a result of reinvesting profits
- Some shareholders may prefer to receive capital gains rather than dividends for tax purposes (tax effect)
- If shareholders need cash now then they can raise this by selling some of their shares (DIY dividends)
- Using retained earnings before a rights issue or new issue of shares is consistent with the pecking order theory (The pecking order theory states that managers display the following preference of sources to fund investment opportunities: first, through the company’s retained earnings, followed by debt, and choosing equity financing as a last resort)
Reasons why it may be inappropriate:
- Shareholder’s may prefer to receive money today rather than dividends or capital gains in the future (traditional theory/bird in the hand theory)
- The shareholders may not want the company to make this investment but they are not being given a choice (agency problem)
Reaction to the increase in dividend:
- Shareholders are expecting 14.5% pa growth based on 2016-2019
- Changing the dividend policy may have sent out a worrying or confusing signal to the market (signalling)
- Some shareholders will have invested in the company based on the policy of paying low dividends and reinvesting profits (clientele effect/tax)
- The share price may have fallen/fluctuated as a result of the uncertainty caused by the change in the dividend policy
Just Breathe is a sportswear manufacturer listed on the LSE.
- Floated on the LSE in 2W5 (7 years ago)
- Between 20W6 and 20W9, they paid a small dividend per share and reinvested a large proportion of annual profit in product development. Grew rapidly to become one of the most recognised sportswear brands in the UK.
- From March 20X0 onwards, Just Breathe paid a much larger dividend per share than previously.
Dividend per share (in pence):
2016: 5.0p
2017: 5.8p
2018: 6.9p
2019: 7.5p
2020: 33.0p
2021: 34.0p
2022: 35.0p
The number of ordinary shares in issue has not changed over this period
Other info:
An extract from the most recent management accounts is below:
Balance Sheet as at 31 March 20X2
- Ordinary share capital (£0.50 shares) = £120m
- Retained earnings = £850m
—
970m
3% redeemable debentures at nominal value = 400m
—-
£1,370m
On 31 March 20X2 the ordinary shares have a market price of £5.60 (ex-div)
On 31 March 20X2 the 3% debentures have a market price of £94 (ex-interest). The debentures are redeemable at par in five years’ time.
Assume that corporation tax will be payable at the rate of 25% for the foreseeable future.
Explain whether it would have been appropriate for Just Breathe to use the following as an alternative to increasing the dividend per share in March 2020:
- Special dividend
- Share repurchase
Special dividend:
- A special dividend is a ‘one-off’ dividend in addition to the ordinary dividend
- Special dividends can be used to pay extra dividends to shareholders without disrupting the normal dividend pattern
- This would only be appropriate if the directors believed that the increase in dividend was temporary and would eventually return to a lower dividend per share. The market circumstances suggest otherwise, this would be inappropriate.
Share repurchase:
A repurchase of shares may be achieved by buying shares in the stock market, inviting shareholders to tender their shares or by arrangement with particular shareholders
- This method would only be appropriate if the directors wanted to release cash to shareholders on a ‘one-off’ basis. Market circumstances suggest otherwise, this would be inappropriate.
- This would reduce equity, which would have an impact on the dividends per share in future years (and would increase gearing)
Just Breathe is a sportswear manufacturer listed on the LSE.
- Floated on the LSE in 2W5 (7 years ago)
- Between 20W6 and 20W9, they paid a small dividend per share and reinvested a large proportion of annual profit in product development. Grew rapidly to become one of the most recognised sportswear brands in the UK.
- From March 20X0 onwards, Just Breathe paid a much larger dividend per share than previously.
Dividend per share (in pence):
2016: 5.0p
2017: 5.8p
2018: 6.9p
2019: 7.5p
2020: 33.0p
2021: 34.0p
2022: 35.0p
The number of ordinary shares in issue has not changed over this period
Other info:
An extract from the most recent management accounts is below:
Balance Sheet as at 31 March 20X2
- Ordinary share capital (£0.50 shares) = £120m
- Retained earnings = £850m
—
970m
3% redeemable debentures at nominal value = 400m
—-
£1,370m
On 31 March 20X2 the ordinary shares have a market price of £5.60 (ex-div)
On 31 March 20X2 the 3% debentures have a market price of £94 (ex-interest). The debentures are redeemable at par in five years’ time.
Assume that corporation tax will be payable at the rate of 25% for the foreseeable future
Calculate Just Breathe’s compound annual dividend growth rate for the following periods and discuss which of the rates would be more appropriate for calculating the cost of equity in the dividend valuation model:
- March 20W6 to March 20X2
- March 20W0 to March 20X2
March 20W6 to March 20X2:
Using Excel:
- Most recent dividend: 35p
- Oldest dividend: 5p
- Time period of growth: 6
- Average annual growth: 38.31%
AAG =POWER(35/5,1/6)-1
March 20X0 to March 20X2
Using Excel:
- Most recent dividend: 35p
- Oldest dividend: 33p
- Time period of growth: 2
- Average annual growth: 2.99%
AAG =POWER(35/33,1/2)-1
The dividend policy has changed in March 20X0, which makes it less appropriate to consider the dividends paid before then.
It seems unlikely that 38.3% growth would be sustainable in the future.
The problem with only considering the dividend from March 20X0 is that it is difficult to predict future growth based on three years.
However, overall it would be most appropriate to use the growth rate from March 20X0 to March 20X2
Just Breathe is a sportswear manufacturer listed on the LSE.
- Floated on the LSE in 2W5 (7 years ago)
- Between 20W6 and 20W9, they paid a small dividend per share and reinvested a large proportion of annual profit in product development. Grew rapidly to become one of the most recognised sportswear brands in the UK.
- From March 20X0 onwards, Just Breathe paid a much larger dividend per share than previously.
Dividend per share (in pence):
2016: 5.0p
2017: 5.8p
2018: 6.9p
2019: 7.5p
2020: 33.0p
2021: 34.0p
2022: 35.0p
The number of ordinary shares in issue has not changed over this period
Other info:
An extract from the most recent management accounts is below:
Balance Sheet as at 31 March 20X2
- Ordinary share capital (£0.50 shares) = £120m
- Retained earnings = £850m
—
970m
3% redeemable debentures at nominal value = 400m
—-
£1,370m
On 31 March 20X2 the ordinary shares have a market price of £5.60 (ex-div)
On 31 March 20X2 the 3% debentures have a market price of £94 (ex-interest). The debentures are redeemable at par in five years’ time.
Assume that corporation tax will be payable at the rate of 25% for the foreseeable future
Calculate Just Breathe’s WACC on 31 March 20X2 using the dividend valuation model and the growth rate of 2.99%
Cost of equity =
Ke = (35.0p x 1.0299 / 560.0p) + 0.0299 = 9.43%
Market value of equity = £120m / £0.50 = £240 million x £5.60 = £1,344m
3% redeemable debentures:
Using the rate function the inputs are:
- Number of payments = 5
- Annual coupon (payment) = 3
- Present value (current ex-interest MV) = -94
- Future value (Redemption) = 100
- Annual yield to maturity = 4.36%
AYTM = RATE(5,3,-94,100)
Less: tax @25% = 4.36% x (1 - 0.25) = 3.27%
Market value of debt = £400m x £94/£100 = £376m
WACC:
Ordinary shares:
- Cost: 9.43%
- MV: £1,344m
- Cost = £126.7m
3% Debentures:
- Cost: 3.27%
- MV: £376m
- Cost = £12.3m
—–
MV = 1,344 + 376 = £1,720m
Cost = 126.7 + 12.3 = 139m
WACC = 139/ 1720 = 8.1%
Biddle requires additional finance to promote and launch an innovative nutrition and fitness app, due to launch in September 20X2. Biddle’s bank is unwilling to provide a loan, because Biddle only has digital assets that are not considered appropriate to be used as security.
Therefore, Biddle’s owners are looking for an equity investor who can provide additional funds in exchange for 50% of Biddle’s ordinary share capital.
The amount of funds required will depend on Biddle’s current owners and the investor being able to agree and appropriate valuation of Biddle.
Just Breathe are considering investing in Biddle.
Information relating to companies that have developed similar apps to Biddle is available below:
Perspire Plc: Health and fitness app
- Equity beta: 1.75
- Total equity by MV: £225m
- Total debt by MV: £120m
EatRite Plc: Health and nutrition app
- Equity beta: 1.30
- Total equity by MV: £150m
- Total debt by MV: £125m
Nutrifit Plc: Nutrition and fitness app
- Equity beta: 1.65
- Total equity by MV: £75m
- Total debt by MV: £50m
The risk-free rate is expected to be 2% pa and the market return is expected to be 8% pa.
Assume that JustBreate’s current gearing (by market value) would remain the same after any investment in Biddle.
Using the CAPM, calculate an appropriate WACC that Just Breathe’s directors could use to appraise the Biddle investment and explain the reasoning behind your approach
NutriFit plc should be used to find an appropriate asset beta as this is the only company which has an app covering both nutrition and fitness.
NutriFit’s asset beta:
Ba = 1.65 / (1 + ((50 x 0.75)/75)) = 1.10
Re-gear with Just Breathe’s gearing:
Be = 1.10 x (1 + ((376 x 0.75)/1344)) = 1.33
Calculate ke using the CAPM:
Ke = 2 + (1.33 x (8-2)) = 10.0%
WACC:
Ordinary shares:
- Cost: 10.00%
- MV: £1,344m
- Cost = £134.4m
3% Debentures:
- Cost: 3.27%
- MV: £376m
- Cost = £12.3m
—–
MV = 1,344 + 376 = £1,720m
Cost = 134.4 + 12.3 = 146.7m
WACC = 146.7/ 1720 = 8.5%
The cost of equity will have to reflect the systematic business risk of the diversification and the (systematic) financial risk of Just Breathe
The calculation shows that the systematic business risk of the diversification is higher than sportswear manufacturing as the cost of equity (or WACC) is higher than Just Breathe’s current cost of equity (or WACC).
You should assume the current date is 31 August 20X7
Ramsey’s financial year end is 31 August
Details of Ramsey’s long-term finance at 31 August 20X7 and total dividend and interest payments for the year to 31 August 20X7 are below:
£1 ordinary shares (Note 1):
- MV at 31/8/X7: £65,600,000
- Nom value at 31/8/X7: £32,000,000
- Div paid in year to 31/8/X7: £5,440,000
- Interest paid in yr to 31/8/X7: £0
£0.50 Preference Shares:
- MV at 31/8/X7: £10,800,000
- Nom value at 31/8/X7: £2,000,000
- Div paid in year to 31/8/X7: £640,000
- Interest paid in yr to 31/8/X7: £0
£100 Irredeemable debentures
- MV at 31/8/X7: £6,000,000
- Nom value at 31/8/X7: £5,000,000
- Div paid in year to 31/8/X7: £0
- Interest paid in yr to 31/8/X7: £275,000
£100 redeemable debentures (Note 2):
- MV at 31/8/X7: £4,200,000
- Nom value at 31/8/X7: £4,000,000
- Div paid in year to 31/8/X7: £0
- Interest paid in yr to 31/8/X7: £240,000
Notes:
1: Ordinary share dividends have been growing at 3% pa for the past four years
2: The redeemable debentures are redeemable at par on 31 August 20Y0. The redeemable debentures have semi-annual coupon payments, and interest is paid annually on the irredeemable debentures.
3: All dividends and interest for the year to 31 August 20X7 have been paid in full
You should assume that corporation tax will be payable at the rate of 17% for the foreseeable future and tax will be payable in the same year as the cash flows to which it relates
Using the information in the table, calculate Ramsey’s WACC at 31 August 20X7
Cost of equity (ke) = (d1)/MV + g = (5,440 x 1.03)/65,600 + 3% = 11.54%
Cost of preference shares (kp) = (d)/MV = (640)/10,800 = 5.93%
Dividend/MV
Cost of irredeemable debt (kdi) = (275 x 83%)/6,000 = 3.80%
Cost of redeemable debt (kdr)
Value of a £100 debenture is 4,200 / 4,000 x 100 = 105
MV / Nominal value x redemption value
Coupon rate = 240 (interest paid in year) / 4,000 x 100 - 6%. Paid twice a year so, £3 per year
Number of six-month periods: 6
Payment: 3
Pval (value today): 105
Value in future: 100
Yield to maturity (six months): 0.021
=RATE(6,2,105,100)
Annual yield to maturity is 0.021 x 100 x 2 (paid twice a year) = 4.2%
Less tax = 4.2-% x (1 - 0.17) = 3.49%
WACC
The 86,600 is the total MV of all debt and equity
Equity:
£’000 - 0
Total MV’s: £65,600,000
Cost x weighting: 11.54% x 65,600/86,600 = 8.74%
WACC: 8.74%
Pref shares
£’000 - 10,800
Total MV’s: 0
Cost x weighting: 5.93% x 10,800/86,600 = 0.74%
Irredeemable debt
£’000 - 6,000
Total MV’s: 0
Cost x weighting: 3.80% x 6,000/86,600 = 0.26%
Redeemable debt
£’000 - 4,200
Total MV’s: 0
Cost x weighting: 3.49% x 4,200/86,600 = 0.17%
MV’s of debt = 21,000
WACC = 0.17 + 0.26 + 0.74 = 1.17%
Total MV’s = 65,600 + 10,800 + 6,000 + 4,200 = 86,600
WACC = 8.74% + 1.17% = 9.91%
You should assume the current date is 31 August 20X7
Ramsey’s financial year end is 31 August
Details of Ramsey’s long-term finance at 31 August 20X7 and total dividend and interest payments for the year to 31 August 20X7 are below:
£1 ordinary shares (Note 1):
- MV at 31/8/X7: £65,600,000
- Nom value at 31/8/X7: £32,000,000
- Div paid in year to 31/8/X7: £5,440,000
- Interest paid in yr to 31/8/X7: £0
£0.50 Preference Shares:
- MV at 31/8/X7: £10,800,000
- Nom value at 31/8/X7: £2,000,000
- Div paid in year to 31/8/X7: £640,000
- Interest paid in yr to 31/8/X7: £0
£100 Irredeemable debentures
- MV at 31/8/X7: £6,000,000
- Nom value at 31/8/X7: £5,000,000
- Div paid in year to 31/8/X7: £0
- Interest paid in yr to 31/8/X7: £275,000
£100 redeemable debentures (Note 2):
- MV at 31/8/X7: £4,200,000
- Nom value at 31/8/X7: £4,000,000
- Div paid in year to 31/8/X7: £0
- Interest paid in yr to 31/8/X7: £240,000
Notes:
1: Ordinary share dividends have been growing at 3% pa for the past four years
2: The redeemable debentures are redeemable at par on 31 August 20Y0. The redeemable debentures have semi-annual coupon payments, and interest is paid annually on the irredeemable debentures.
3: All dividends and interest for the year to 31 August 20X7 have been paid in full
Using the information in the table, calculate Ramsey’s WACC at 31 August 20X7
Calculate and briefly comment upon the impact on the market value of Ramsey’s redeemable debentures of a rise in their gross annual redemption yield to 5% pa.
Return required per six month period: 0.025
Number of periods: 6
Payment: 3
Fval: 100
Present value: -102.75
=PV(0.025,6,3,100)
Yield increases to 5% and market value falls to £102.75. It’s an inverse relationship.
Investment 1: Ramsey wishes to invest £9.5 million in a new computerised manufacturing system, making use of robotic techniques.
Half of this investment would be funded from Ramsey’s retained earnings and the balance via a bank loan at an agreed rate of 7.5% pa.
A report was presented by the production director at the 22 August board meeting. It concluded that this new system would generate efficiencies that would increase manufacturing profit by 6-8% pa. At the same meeting, one of Ramsey’s other directors, Michael Bateman, said that ‘Because the company should be striving for a higher share price, any press releases regarding the new system should state that profits are expected to increase by at least 15% pa.”
Advise, with reason, whether Ramsey should use the WACC figure calculated in 50.1 above when appraising investment 1
Explain the ethical implications for you, as an ICAEW CA, arising from Bateman’s suggesting regarding the press releases for Investment 1
When using WACC to appraise projects the following assumptions are implied:
1) Ramsey’s historic proportions of debt and equity are not to be changed
2) Ramsey’s systematic business risk is not be changed
3) The finance is not project-specific (eg, cheap government loans)
In this case the finance is of a material size, being 11% of total funds at market value (£9.5/£86.6m) and the historic gearing does not appear to be met (it is 50:50 ignoring project NPV)
The systematic business risk, as far as we are aware, does not change as it is still the same industry
It is not project-specific finance
Therefore it is unwise to use the existing WACC, but that after-tax cost of the bank loan is not the WACC either, as this ignores the required returns of shareholders
Ethics:
Integrity: members need to show honesty, fair dealing and truthfulness
Objectivity: members must not succumb to the undue influence of others
Interest of shareholders and owners must be taken into account - members must not let their own self-interest influence their actions
Investment 2:
Ramsey’s board is considering a major change in strategy by investing in the development of driverless cars. The finance for this investment would raised in such a way so as not to alter Ramsey’s current gearing ratio (measured as debt: equity by market values). The debt element of the finance will come from a new issue of 9% irredeemable debentures at par.
Ramsey’s directors want to establish a cost of capital that could be used to appraise the investment in driverless cars. They are aware that such a diversification would be very risky and is likely to increase Ramsey’s equity beta which is currently 1.25
The following data, collected at 31 August 20X7:
Driverless car industry sector:
Equity beta; 2.10
Ratio of long-term funds (debt:equity) by market values: 16:72
Expected risk free rate: 2.25% pa
Expected return on the market: 9.15% pa
17% corporation tax.
Calculate an appropriate WACC that Ramsey could use when appraising Investment 2 and explain the reasoning behind your approach
New market geared beta = 2.10
New market ungeared beta =
(2.10 x 72) / (72 + (16 x 83%)) =
(2.10 x 72) / 85.28 = 1.77
Ramsey’s geared beta =
1.77 x (65.6 + 10.8 + (10.2 x 83%))/65.6 = 2.29
10.2 = MV of existing redeemable and irredeemable debentures
So, cost of equity = (2.29 x (9.15% - 2.25%)) + 2.25 = 18.05%
Cost of debt = 9% x 83% = 7.47%
WACC = (18.05% x £65.6/86.6m) + (7.47% x £21m/86.6m)) = 15.48%
It would be unwise to use the existing WACC (9.91%) as Ramsey’s plan involves diversification, and therefore a change in the level of systematic risk (beta rises to 2.29 from 1.25).
Thus a new WACC must be calculated.
Systematic risk is accounted for by taking into account the beta of the driverless cars market, and this is then adjusted to eliminate the financial risk (level of gearing) in that market.
The resultant beta is then ‘re-geared’ by taking into account the level of gearing of the new funds being raised.
Cost of new debt (which is higher than existing because of the increased risk discussed above) is used.
Using this, the new WACC can be calculated.
The board also discussed the possible negative impact of this risky investment on Ramsey’s share price.
One director, Laura Young, commented: ‘It’s okay. Markets are efficient. Even if it does fall, the share price will soon adjust to its normal level.”
Evaluate briefly Young’s comments regarding Investment 2’s effect on Ramsey’s share price.
Markets set prices based on the information available.
If the market ‘takes fright’ at the proposed investment in driverless cars, then the market value of Ramsey’s shares will fall and may not recover. It all depends on the market’s view of the company’s likely future success.
Efficiency does not mean that prices return to a ‘normal level’.
Markets have no memory. Efficiency means that shares cannot be bought cheaply and then sold quickly at a profit.
Share prices are ‘fair’, and investment returns are those that would be expected for the risks undertaken.
