Ch 18 - Weighted average cost of capital

Question 1

Why is WACC important?

Answer 1

It’s accepted that discounted CF techniques for evaluating projects are far superior to the use of simple payback approaches or accounting rates of return. The SH value-added approach enhances these techniques further.
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However to use these techniques require the calculation of the project cost of capital, in the absence of a suitable discount rate, NPV & IRR approaches have no meaning.
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Provided that the project achieves the expected return and that, when adjusted for the risk of that project, the return is more than the co’s WACC, the SH’s are better off than before.

Question 2

Will the cost of equity or cost of debt be higher?

Answer 2

The cost of equity will tend to be higher than the cost of debt in part due to the more favourable tax treatment of debt. The WACC may be very sensitive to the ratio of debt to equity on a company’s balance sheet.

Question 3

Explain Modigliani & Miller’s school of thought

Answer 3

Gearing was irrelevant and that each increase in debt carried a compensating increase in the cost of equity.
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key concepts were:
1) MV of any firm is independent of its capital structure
2) The e(rate of return) on the common stock of a leverage firm increases in proportion to the D:E ratio, expressed in MV’s
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the propositions are only valid under certain assumptions

Question 4

Explain the relationship between debt and WACC

Answer 4

Debt is cheaper than equity finance, so as gearing increases, the WACC should fall.

Question 5

Cost of equity

Answer 5

represents the opportunity cost of capital - rate foregone by shareholders investing in the project rather than investing in alternative securities
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Cost of equity = risk-free rate + equity risk premium

Question 6

CAPM & cost of equity

Answer 6

Market portfolios of equities suffer a relatively high degree of volatility. We know diversification reduces risk - the variance of returns experienced by individual stocks are different to the market as a whole. There’s a consequence of that fact that the individual stock returns are not perfectly correlated.

Question 7

Portfolio variance

Answer 7

ΣiΣj xixjρijσiσj
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where xi,xj are the proportions of stock i and j held, σi &σj are the standard deviations of stock returns and ρij is the correlation coefficient between the returns on stocks i and stocks .
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CAPM divides the volatility of a stock’s price into 2 parts, the specific risk (eliminated by diversification) & systematic risk (cannot be diversified away).

Question 8

Sources of systematic risk

Answer 8

• Business or trade cycle
• Interest rates
• Inflation
• Tax
• Currency
• Freak events

Question 9

Beta

Answer 9

def: measure of the systematic risk in terms of its business activities & financing activities. It reflects the volatility of a company’s share price & how the share price returns are correlated with the returns from a fully diversified portfolio

Question 10

What is the key result of the CAPM for a single stock?

Answer 10

Cost of equity for stock = rf rate + equity risk premium*beta for stock
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CAPM states that an investor will require a higher return to invest in a more volatile & risky stock (i.e beta>1) compared to the diversified market portfolio.

Question 11

If the company’s gearing were to change, then the volatility of returns would change & hence the beta would change. How can the effect be measured?

Answer 11

With the ffg formula:

geared beta = ungeared beta * (1 + debt:equity ratio* (1-tax rate))
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if the gearing changes, the new beta must be found in 2 stages”
> find the ungeared beta first
> then find the new beta for the new level of gearing

Question 12

What is the difference between marginal & average cost?

Answer 12

marginal: cost of raising further debt
average: cost of existing debt plus new debt

Question 13

Cost of debt and creditworthiness

Answer 13

This will vary from company to company depending on its creditworthiness, often expressed as a credit rating. The cost of debt will be related to the credit rating. The lower the credit rating the more the company will have to pay for debt.

Question 14

Determinants of the cost of debt

Answer 14

i) Interest & asset cover: debt carrier will at the security provided & the key components of net assets to amount at risk & PBT as well as the credit rating agencies assessing the risk of default will depend on the level of interest cover & the volatility of the profit stream
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ii) gearing: marginal cost of debt will increase as the level of debt is pushed up because of the adverse effect on the company’s credit rating
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iii) beta: can have a direct effect on the credit rating since a high beta will indicate more volatile profits. The level of gearing itself will increase the beta - there comes a point where taking on further debt increases the average cost of capital because of these secondary effects
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iv) tax: cost of debt can usually be offset against profits and serves to reduce the effective cost of debt

Question 15

The tax system rewards the issue of debt & therefore the net cost of debt is used. What is the value of this?

Answer 15

Cost of debt depending on the rating of company * (1-tax rate)

Question 16

Give an alternative formula for WACC

Answer 16

(cost of equity* equity capital + net cost of debt*debt capital) / total capital