WACC 19 Flashcards

1
Q

what is WACC

A

It is the average cost of raising finance for a business, taking into account both debt and equity capital.

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2
Q

The importance of the weighted average cost of capital

A

The weighted average cost of capital (WACC) is important because it is used to evaluate the feasibility of investment projects. It represents the minimum rate of return that a company must earn on its investments to satisfy its investors and creditors.\

By using WACC as the discount rate in net present value calculations, a company can determine whether an investment project will generate enough cash flows to cover its costs and provide a return that meets or exceeds the required rate of return

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3
Q

In addition, WACC can be used to determine the optimal capital structure for a company by balancing

A

the costs and benefits of debt and equity financing.

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4
Q

In this chapter, we usually deal with market values. Thus ‘gearing’ could also be defined as:

A

market value of debt /
market value of debt market value of equity
or
market value of debt/
market value of equity

(where the market value of the equities and debt (bonds) would be the number of each issued
multiplied by the market price of each)

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5
Q

The cost of debt and the cost of equity
It is the net cost of debt that appears in the formula, where:

A

It is the net cost of debt that appears in the formula, where:
net cost of debt = gross cost of debt × (1 – t)
where t is the rate of corporation tax.
Interest payments on debt finance are tax deductible. They appear before the tax line on the
statement of profit or loss.

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6
Q

Question
A company’s dividend yield is 3% and the gross redemption yield on its debt is 6%. Discuss the
expected rate of return for an equity investor and the rate of return for a bond investor

A

Solution
The rate of return for a bond investor is relatively clear; it is the redemption yield on the bond,
namely 6%.
The expected return for equity investors can’t be determined from the information given, as this
is equal to dividend yield plus capital growth.
The equity shareholders are accepting a greater risk than the bond investors, and must therefore
be expecting a return greater than 6%. This greater return must be expected in the form of
capital growth through retained earnings and increasing dividends.CB1-19: WACC Page 5
The Actuarial Education Company © IFE: 2019 Examinations
The term ‘cost of equity’ is the return that the managers of the company have to provide to keep
equity capital providers happy, and in a fair world is equal to the expected return on equity

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7
Q

This is the essence of a weighted cost of capital calculation example.

A

Example
Suppose that Growmore plc has:
 debt with a market value of £100m trading at a gross redemption yield (GRY) of 5% in the
market
 £100m market value of equity with analysis suggesting equity investors expecting 10% pa
from their investment.
Growmore’s weighted cost of capital, assuming no tax is paid, is 7.5% pa (ie weighted average of
the cost of equity and the gross cost of debt). If the company can earn 7.5% pa return on its
assets, it can give a 5% pa return to the loan capital providers and a 10% pa return to the equity
capital providers.
This is the essence of a weighted cost of capital calculation.

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8
Q

Question
Explain what is meant by ‘exploiting arbitrage possibilities’.

A

Solution
Arbitrage is the buying and selling of financial assets in order to make a risk-free profit from
known pricing anomalies.
The MM model predicts that for companies with the same business risk and the same earnings,
the WACC is the same, regardless of gearing.
Let us now consider the effect of gearing on the return on equity.
The following graph shows the rates of return on debt and equity for a single company as its
gearing ratio increases.
Modigliani and Miller argued that the WACC remains constant as gearing increases. As gearing
increases, the cost of equity increases by just enough to offset the increasing proportion of the
cheaper debt.
A more highly geared structure offers a higher return on equity, but it also offers a higher risk.
These two features cancel out to leave the price of the shares, the value of the company and the
WACC unchanged.
Additionally we can argue that increasing the gearing within a company only gives the
shareholders the same increase in returns that they could have achieved themselves by
borrowing money from a bank and buying more shares. So gearing up a company adds no value,
because shareholders can increase their own risk by borrowing money from a bank and buying
more shares.
This thinking was further developed by the Capital Asset Pricing Model (CAPM) which
attempts to provide a coherent framework for understanding the interaction of risk and
return.

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9
Q

Question
Suppose Growmore plc (from page 5) raises a further £50 million of debt finance in order to buy
back shares with a value of £50 million.
Explain the impact on Growmore’s WACC.

A

Solution
The obvious conclusion would be that the weighted cost of capital would fall, because the
company is now financed by £150 million of 5% debt and £50 million of 10% equity.
However, according to MM, this argument is flawed because the required return of equity
investors would not remain constant if the company structure were changed in this way.
The company is now much more highly geared and the returns to equity investors are likely to be
much more volatile. In fact so much more, that the equity investors will require a return of 15%
in order to hold the shares.
According to MM, the cost of capital is unchanged, being a mixture of £150 million of debt capital
providers requiring 5% pa and £50 million of equity capital providers requiring a return of 15% pa,
the weighted average of which is 7.5% pa.

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10
Q

Question
Suppose Growmore plc’s existing and new debt are likely to trade on a level of (say) 6% GRY to
compensate for the higher risk of default attaching to the company’s debt. The equity holders
have also increased their required return (to 15%) to reflect the greater risk of default and the
greater volatility of the highly geared company. Determine the new WACC.

A

The cost of capital for the company would now be:
(150x6% +50 *15%)/200
=8.25%

WACC
ie higher than before!

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11
Q

Therefore, in practice, an increase in gearing, beyond the company’s debt capacity, could increase

A

the company’s WACC.

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12
Q

Conclusion
Putting the above arguments together suggests that increasing the level of debt in the business
will initially reduce the

A

WACC as the company takes advantage of the lower cost of debt and the
tax relief on debt finance

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13
Q

However, as debt finance increases, both equity holders and debt holders will require a higher
rate of return. There will be a point at which the costs of increasing the gearing begin to

A

outweigh the benefits and the WACC begins to increase, ie there will be an optimal capital
structure.

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14
Q

Question
Discuss the validity of the following statement:
‘Many investors shy away from equity investment because the risks involved are too high,
therefore the expected return from equities is higher than that from debt.’
Soluti

A

Solution
This statement is correct.
If an investment in equities is more risky than an investment in bonds, but offers the same
expected return, then rational investors will not buy equities. If investors do not buy equities the
prices will fall. Eventually, at much lower prices, equity investments will offer a much better
prospect, and a higher expected return (ie they become ‘cheaper’).
At this level the equity and bond markets are in equilibrium, offering a trade-off between risk and
return.

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15
Q

Cost of Equity:

The cost of equity represents the opportunity cost of capital, which is the rate that shareholders .

A

forego by investing in a project rather than alternative securities

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16
Q

Investors expect to be rewarded for the additional risk they take on by investing in .

A

equity

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17
Q

The cost of equity takes into account the supply and demand considerations in the market and the preference of investors for

A

steady returns or higher volatility.

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18
Q

Validity of the Statement:

The statement “Many investors shy away from equity investment because the risks involved are too high, therefore the expected return from equities is higher than that from debt” is valid.

A

If equities are riskier than bonds but offer the same expected return, rational investors would choose bonds instead.
As investors avoid equities, prices would fall, making equity investments more attractive and offering higher expected returns.
Equilibrium is reached when the risk and return trade-off of equities is in balance with the market demand.

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19
Q

The formula for Cost of Equity:

The conventional approach to calculating the cost of equity is:

A

Cost of Equity = Risk-free rate + Equity risk premium.
The risk-free rate is the return required from a risk-free asset, such as government bonds.
The equity risk premium is the additional reward demanded by equity holders to compensate for the additional risk associated with holding shares instead of risk-free bonds.
More sophisticated versions of the formula may incorporate different risk premiums for different types of equity investments based on their associated risks.

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20
Q

Evidence and Choice of Historical Period:

Historical rates of return on securities, often represented by market indices or bundles of representative securities, are used to

A

analyze the performance.

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21
Q

Equities have generally outperformed fixed-interest investments over the long term, but there can be ________and ________considerations.

A

volatility and inflation-adjusted considerations.

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22
Q

A ______and _________period of historical data is preferable, although subsets of data may be appropriate if the nature of constituents in the portfolio has changed.

A

A long and homogenous period of historical data is preferable

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23
Q

____________, such as_________returns, can enhance the analysis but requires careful interpretation to eliminate bias and statistical factors.

A

Frequency of data collection, such as monthly or annual returns, can enhance the analysis but requires careful interpretation to eliminate bias and statistical factors.

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24
Q

Real and Nominal Rates:

A

> Analyzing real rates (adjusted for inflation) removes heterogeneity, while the risk-free rate can be defined on a nominal basis.
The inflation risk premium, which compensates for uncertain inflation rates, is an important consideration.
Historical data can be decomposed into the risk-free rate and the risk premium to estimate the future required opportunity cost.
Practitioners may adjust the risk premium based on their views about the relevance of past experience to future conditions.

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25
Q

Typical Results:

The Barclays Equity Gilt study in the UK provides accessible information on historic returns.

A

> The study calculates the historic return on equity as 5% real, assuming a risk-free real rate of 1.5-3%, suggesting an equity risk premium of 2-3.5%.
Different calculations, such as the geometric mean and arithmetic mean, can lead to variations in apparent returns.
It’s important to understand the principles and avoid excessive focus on mathematical accuracy when dealing with risk and uncertainty.

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26
Q

Remember, it’s crucial to grasp the principles and apply judgment consistently when

A

Remember, it’s crucial to grasp the principles and apply judgment consistently when determining the cost of equity. Accuracy is important, but it’s the ranking of projects rather than precise pricing that matters.

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27
Q

Risk and volatility:

A

The comparison between an individual company and market indices is necessary to determine the cost of equity for the company.
The cost of equity consists of two parts: the risk-free return and the equity risk premium specific to the company.
Market portfolios of equities have a relatively high degree of volatility, with the standard deviation of annual returns for the UK stock market being around 20%.
Not all shares move in the same direction or to the same degree, indicating that diversification can reduce risk.
The variance of individual stock returns is typically different from and greater than the market as a whole due to imperfect correlation.
The Capital Asset Pricing Model (CAPM) provides a theoretical framework to examine the volatility of an individual share compared to the market average.
CAPM is based on specific assumptions, such as rational and risk-averse investors, efficient markets, and the use of volatility as a measure of risk.

28
Q

Specific risk:

A

Specific risk refers to the risks unique to a particular company, which cannot be diversified away.
Examples of specific risks include problems related to labor shortages, environmental issues, project management, or damage to a company’s reputation.
CAPM assumes that shareholders hold well-diversified portfolios of shares, which reduces specific risk.
Specific risk can be eliminated by diversification, and shareholders with diversified portfolios are not concerned about earning returns to compensate for a company’s specific risk.

29
Q

Systematic risk:

A

Even with a fully diversified portfolio, companies are still exposed to systematic risk.
Systematic risk is the risk associated with the overall economy and cannot be diversified away.
Market-wide events, such as interest rate movements, inflation, or currency fluctuations, affect all companies and cannot be eliminated by holding many shares.
Systematic risk, or market risk, is an inherent risk that remains even after diversification.

30
Q

Specific risk in the business deal:

A

If the project involves throwing a fair die only three times, there is a specific risk of incurring a loss.
However, this specific risk can be diversified away if many such projects are undertaken or if the die is thrown many times.
The law of large numbers ensures that, in the long run, the average score will converge to 3.5 and the average profit to $0.50 per throw.
Specific risk can be eliminated through diversification, leaving only systematic risk, which represents the volatility of the individual share compared to the market as a whole.
These study points provide an explanation of risk, volatility, specific risk, systematic risk, and their relationship within the context of the Capital Asset Pricing Model (CAPM).

31
Q

Question
The following business deal is being offered:
Throw a fair die a specified number of times (the number of throws is subject to negotiation).
Receive (or pay if negative) the difference between 4 and the average score, x , ie   4  x times
one dollar for each throw of the dice.
Describe the specific risk if the project involves throwing the die:
(a) three times
(b) one million times.

A

Solution
If only three throws of the dice are made there is a specific risk that the project may yield a loss.
This is a specific risk though, and could be diversified away if many such projects were undertaken
(or if the die is thrown many times).
The law of large numbers guarantees that ultimately the thrower will achieve an average score of
3.5 and an average profit of $0.50 per throw.

32
Q

Systematic risk refers to

A

the risk that is inherent in the entire market or economy and cannot be eliminated through diversification. It is also known as non-diversifiable risk or market risk.

33
Q

Sources of systematic risk include:

A

a. Business or trade cycle: There is a cycle of business activity that affects all businesses simultaneously. Different sectors may be impacted at different times, so diversification across sectors is important. Diversification across countries can also help reduce systematic risk.
b. Interest rates: Changes in interest rates affect all businesses but to different degrees based on their borrowing levels. Variations in interest rates across countries can further impact international businesses.
c. Inflation: Rising inflation can depress short-term profits, but in the long run, price increases can restore margins. No company can escape the impact of inflation, making it a systematic risk.
d. Tax: Changes in tax rates can affect price levels and impact all companies, especially if the taxes are applicable to all businesses.
e. Currency: Currency movements can affect companies trading in affected countries due to exchange rate fluctuations.
f. Freak events: International crises, wars, embargoes, natural disasters, or man-made events can have major unpredictable effects on the global economy, impacting all companies.

34
Q

Two diversifiable freak events:

A

a. An earthquake in one location: If investments are spread across hundreds of different locations, the impact of an earthquake in one location can be diversified away.
b. Sudden spike in the price of a specific raw material: Investing in companies that use multiple raw materials can diversify away the risk associated with a sudden spike in the price of a specific raw material.

35
Q

Two difficult-to-diversify freak events:

A

a. Banking crisis: A banking crisis can have a widespread impact on the economy, affecting every company invested in the market.
b. Overthrow of a government: Political instability and the overthrow of a government can impact all companies operating in the country, making it difficult to diversify away the risk.

36
Q

Beta is a measure of

A

systematic risk associated with a particular stock. It compares the individual stock’s volatility to that of the overall market.

37
Q

Beta can be calculated using the formula:

A

Beta = Covariance(Stock Return, Market Return) / Variance(Market Return)

38
Q

Beta values indicate the stock’s relationship to the market:

A

Beta > 1: The stock amplifies the market’s return (positive or negative).
Beta close to 0: The stock provides a more stable return than the market.
Negative Beta: The stock’s performance is counter-cyclical, offsetting the overall market experience.

39
Q

The cost of equity can be estimated using the Capital Asset Pricing Model (CAPM), which states:

A

Cost of Equity = Risk-Free Rate + Equity Risk Premium * Beta

40
Q

Adjusting beta for gearing: Changes in a company’s gearing (debt-to-equity ratio) affect its beta. The formula to calculate the geared beta is:

A

Geared Beta = Ungeared Beta * [1 + (Debt:Equity Ratio) * (1 - Tax Rate)]

41
Q

Beta can be measured using historical returns by comparing a stock’s returns with the market returns.

A

Regression analysis can also be used to estimate beta.

42
Q

Using an industry beta can improve the estimate of a company’s beta by considering the average beta of similar companies in the industry. However, adjustments

A

need to be made for differences in gearing between the company and the industry.

43
Q

WACC Components: The cost of equity is just one part of the Weighted Average Cost of Capital (WACC). Another crucial component is

A

the cost of debt, which represents the expense associated with the debt capital utilized by a company.

44
Q

Marginal vs. Average Cost:

A

When determining the relevant cost of debt, it is important to consider whether the marginal cost or the average cost is more appropriate for analysis.

45
Q

Marginal Cost:

A

If new debt is being raised to finance a specific project, it is reasonable to use the marginal cost. This cost represents the expense of acquiring additional debt.

46
Q

Average Cost:

A

The average cost of debt includes both the cost of existing debt and the cost of new debt. It considers the overall expense associated with the company’s debt capital.

47
Q

Determinants of Cost of Debt:

A

The cost of debt varies from company to company based on their creditworthiness, often expressed through a credit rating. A lower credit rating indicates higher risk, resulting in a higher cost of debt.

48
Q

Interest and Asset Cover:

A

Debt carriers (investors in debt securities) assess the security provided by a company. Key factors considered are the level of net assets compared to the amount at risk and the ratio of profits before tax and interest to debt interest.

49
Q

Credit Rating and Risk:

A

Credit rating agencies evaluate the risk of default, which depends on the interest cover level and the volatility of the profit stream. A higher risk of default typically leads to a higher cost of debt.

50
Q

Gearing and Beta:

A

The level of gearing (debt-to-equity ratio) can impact the company’s credit rating and, consequently, its cost of debt. Higher gearing increases the company’s beta, indicating more volatile profits.

51
Q

Tax Considerations:

A

The cost of debt is usually tax-deductible, reducing the effective cost. When a company pays debt interest, it lowers its profits before tax, resulting in a reduced tax payment. The net cost of debt is lower than the gross cost due to this tax benefit.

52
Q

Impact on WACC: Changes in the debt-to-equity ratio and the cost of debt affect the overall WACC. By incorporating

A

the new cost of debt and the updated beta, the WACC can be recalculated to reflect the company’s financial structure and cost of capital.

53
Q

Definition of WACC:

A

The Weighted Average Cost of Capital (WACC) is a financial metric used to determine the average cost of capital for a company. It considers the mix of debt and equity in the company’s capital structure and represents the required rate of return that the company needs to generate to satisfy its investors.

54
Q

WACC Calculation: The formula to calculate WACC is the weighted average of the cost of equity and the net cost of debt, based on their respective proportions in the company’s total capital. It is calculated as follows:

A

WACC = (Cost of Equity × Equity Capital + Net Cost of Debt × Debt Capital) / Total Capital

55
Q

Cost of Equity: The cost of equity represents the required return by shareholders who invest in the company’s equity shares. It comprises

A

the risk-free rate of return and the equity risk premium. The cost of equity is influenced by the company’s level of risk, which can be adjusted by the effect of gearing (debt-to-equity ratio) on the equity beta.

56
Q

Effect of Gearing on Equity Beta: Gearing has an impact on the riskiness and required return of equity shares. The effect of gearing on the equity beta can be calculated using the formula:

A

Geared Beta = Ungeared Beta × (1 + Gearing × (1 - Tax Rate))

57
Q

Net Cost of Debt: The net cost of debt refers to the expected return required by bondholders holding the company’s bonds. It is equivalent to the gross redemption yield on the bond, adjusted for the tax advantages associated with debt financing. The formula to calculate the net cost of debt is:

A

Net Cost of Debt = Gross Cost of Debt × (1 - Tax Rate)

58
Q

Weighting Factors: The weighting factors used in the WACC calculation are the market values of the different components of capital, namely equity capital and debt capital.

A

The weights reflect the proportion of each component in the company’s total capital structure.

59
Q

Influence of Debt:

A

The WACC calculation allows for the estimation of the WACC at different debt-to-equity ratios. By varying the levels of debt and equity in the capital structure, the impact on the overall cost of capital can be assessed.

60
Q

Credit Rating and Gross Cost of Debt:

A

The gross cost of debt, which is used to calculate the net cost of debt, is influenced by the company’s credit rating. A lower credit rating typically results in a higher cost of debt.

61
Q

Importance of WACC: WACC is a crucial metric in investment decision-making as it provides a benchmark rate of return that a company needs to achieve to generate value for its shareholders.

A

It is used as a discount rate for evaluating investment projects and determining the financial feasibility of capital expenditures.

62
Q

Considerations in WACC Calculation: When calculating WACC, it is important to consider the specific circumstances and factors relevant to the company, such as

A

its industry, market conditions, and financial risk profile. The WACC calculation serves as a starting point and should be tailored to the company’s unique characteristics.

63
Q

what is gearing?

A

Gearing is a financial term that refers to the proportion of a company’s debt to its equity. It is calculated by dividing the book value or market value of debt by the book value or market value of equity. Gearing can also be expressed as a ratio or percentage. A company with high gearing has a larger amount of debt relative to equity, while a company with low gearing has more equity than debt. Gearing can affect a company’s financial risk, cost of capital, and ability to borrow in the future.

64
Q

What is beta

A

Beta is a measure of the systematic risk associated with a particular stock or investment. It measures the volatility of a stock’s returns relative to the returns of the overall market. A beta of 1 indicates that the stock’s returns move in line with the market, while a beta greater than 1 indicates that the stock is more volatile than the market, and a beta less than 1 indicates that it is less volatile. Beta is used in financial analysis to estimate the expected return on an investment and to assess its risk relative to other investments.

65
Q

whats the difference between geared and ungeared beta

A

The difference between geared and ungeared beta lies in the effect of a company’s debt on its equity beta. Ungeared beta, also known as asset beta, measures the risk of a company’s assets without taking into account its debt. It reflects the volatility of a company’s returns relative to the market, assuming that it has no debt. Geared beta, on the other hand, takes into account a company’s debt and measures the risk of its equity after adjusting for financial leverage. It reflects the additional risk that comes from using debt to finance operations and how this affects the volatility of returns to equity shareholders. In general, geared beta is higher than ungeared beta because debt increases financial risk and amplifies fluctuations in earnings and cash flows.

66
Q

whats the difference between geared and ungeared beta

A

The difference between geared and ungeared beta lies in the effect of a company’s debt on its equity beta. Ungeared beta, also known as asset beta, measures the risk of a company’s assets without taking into account its debt. It reflects the volatility of a company’s returns relative to the market, assuming that it has no debt. Geared beta, on the other hand, takes into account a company’s debt and measures the risk of its equity after adjusting for financial leverage. It reflects the additional risk that comes from using debt to finance operations and how this affects the volatility of returns to equity shareholders. In general, geared beta is higher than ungeared beta because debt increases financial risk and amplifies fluctuations in earnings and cash flows.