Cost of capital Flashcards
What does WACC stand for?
Weighted average cost of capital
WACC formula
( (MVe x ke) + (MVp x kp) + (MVd x kd) ) / (MVe + MVp + MVd) )
WACC: Cost of equity: Assumptions
In a perfect market:
- Current share price = PV of expected future dividends, discounted at the investor’s required return (Ke)
(Therefore)
- The investor’s required rate of return (Ke) = the IRR when investing at the current price and receiving the future dividends
WACC: Ke formula
D1/P0 + g
( (D0(1+g)) / P0 ) + g
g = growth %
p = market price of a share (ex div)
d = dividend
WACC: 2 ways to calculate (estimate) growth
-
Historic method (extrapolation)
Extrapolating based on past dividend patterns -
Earnings retention method
Aka Gordon growth model
Assuming growth is dependent on the level of earnings retained in the business
WACC: Growth: Historic method: Formula
POWER ( [newest value] / [oldest value] , 1/[no. periods])
!No. periods -1 i..e not T0 i.e. the gaps between periods i.e. times div paid (?)!
WACC: Growth: Earnings retention model: Formula
[ARR] X [Earnings retention rate]
WACC: Growth: Historic method: How to treat bonus issues
The earlier dividends per share must be calculated by adjusting the number of shares for subsequent bonus issues.
WACC: Kp: Formula
D / P0
WACC: Kd: Irredeemable debentures: Assumption
Price of a debenture = Present value of the future interest stream received in perpetuity discounted at the investor’s required return
And therefore:
The investors’ required rate of return = The IRR achieved by investing the current price and receiving the future interest
WACC: Kd: Irredeemable debentures: Formula
i(1-T)/P0
i = interest
T = corp tax rate
P = market price of a share (ex div)
WACC: Kd: Redeemable debentures: Assumption
Price of a debenture = Present value of the future interest received up to redemption plus the redeemed amount all discounted at the investors’ required return
And therefore:
The investors’ required
rate of return = The IRR achieved by investing the current price and receiving the future interest and redemption payment
WACC: Kd: Redeemable debentures: Formula
None - calculate manually:
- Market/issue price
- Yield and cost of debt
WACC: Kd: Redeemable debentures: Formula: Market/issue price
PV ( [investor’s required return], [no. periods], [interest value], [redemption
value] )
WACC: Kd: Redeemable debentures: Formula(s): Gross yield
1.
RATE ( [number of time periods], [interest payment], [market value], [redemption value])
2.
=IRR( [cash flows] )
WACC: Kd: Redeemable debentures: Formula: Cost of debt
[Yield] * (1-T)
T = corp tax rate
WACC: Kd: Convertible debentures: Treatment
- compare the redemption value with the value of the conversion option
- select the higher of the two values as the amount to be received at t(n) (the redemption date)
- find the internal rate of return of the cash flows
WACC: Kd: Non-tradable debt: Treatment
Bank and other non-tradable fixed interest loans simply need to be adjusted for
tax relief
Cost = [interest rate] × (1 – T)
When is it appropriate to use WACC as a discount rate for a project?
If the proportions of debt and equity (gearing) are NOT going to change over the life of the project. If the gearing changes, then the WACC itself will change – and another approach (the APV approach, described in Chapter 6) is used.
If the level of risk is NOT going to change. The company’s current ke is
dependent on the current level of risk the shareholders are suffering – which will depend on the type of business that the company is in. If the new project is in a different business sector to the existing operations, then the level of risk (and therefore the ke) may be different (CAPM).
If the finance is NOT project-specific. The WACC utilises several different types of finance in order to calculate an average. If we use only one method of
finance to invest in the project, then an average is not required and we will need to use an alternative approach, such as APV.
Assumptions when using the dividend valuation model (WACC)
A perfect market is operating to ensure that the share price is the present value of the future dividends discounted at ke. (In practise this will only be true if the shares/debentures are listed).
Dividends are paid only once a year (and either have just been or are just about to be paid. (In practise, a company will often pay interim dividends). Dividend
growth is expected to be reasonably constant and predictable (In practise
dividends may be non-existent or at best erratic).
Growth assumption
If using historic dividends to predict growth – then we are assuming that the past is a good guide to the future (If circumstances change – for example the
company getting a listing, this may not be true).
If using the earnings retention model to predict growth we are assuming that both the rate of return and the retention rate will remain constant over time
(again, this may not be true if circumstances change).
Other issues when using the dividend valuation model (WACC)
1. Other sources of income
Ideally we should only be using permanent long term sources of finance in the calculation of WACC (equity, prefs, debentures, loans), but arguably, some
companies use overdrafts, leasing and even trade creditors for finance over long periods of time. Although we would not conventionally include these as part of our
WACC calculation, there is no doubt that they could affect the true cost of capital.
2. Small companies
Calculating a WACC for a small, unquoted company is very difficult, because there are no market values to obtain accurate returns and the small size usually results in more expensive finance.
