week 7 Flashcards
Why would we use a property fund’s weighted average cost of capital to assess an investment opportunity?
The rationale for discounting property cash flows by the WACC is that a property earning this rate will be able to cover interest payments and pay the required return on equity.
If the calculated NPV, using the WACC as the discount rate, is positive the property investment will earn a sufficient return to satisfy the claims of both debt and equity holders
When using the weighted average cost of capital to assess an investment, how do we account for interest costs in the cash-flows?
We do not subtract interest costs from the cash flows when using the WACC to discount the future cash flows of an investment. This is because the interest costs are captured in the cost of debt in the WACC formula.
How do we accommodate the following costs when deriving the weighted average cost of capital?
i) An ongoing management fee of 0.6%.
ii) A capital raising has a one-off cost of $600,000 to finance an investment.
i) Include the management fee into the WACC rate. See table 13.1 example of how this is done.
ii) A one-off cost can be included in the cash flows. In this case the capital
Margot Property Company is listed on the ASX. You have the following information:
• Share price: $12.25
• Number shares on issue: 50 million
• Cost of equity: 11.2%
• Outstanding debentures: $1.02 billion, with a yield of 6.3%
• Corporate tax rate: 30%
Calculate Margot’s after-tax WACC
kd = 6.3% ke = 11.2% D = $1.02 billion E = $12.25 x 50 million = $612.5 million V = $1.02b + $612.5m = $1,632.5 million D/V = $1,020m/$1,632.5m = 0.625 E/V = $612.5m/$1,632.5m = 0.375 Tc = 0.3 WACC=k= k_d (1-T_c )(D/V)+k_e (E/V)=6.3%(1-0.3)(0.625)+11.2%(0.375)=6.96%
Define the theory ‘clientele effect’. How does this theory impact on the level of debt a property fund may include in its capital structure?
The clientele effect theory suggests that specific investors are attracted to different fund/company policies, and that when a fund/company changes its policy, investors will adjust their unit/share accordingly. As a result of this adjustment, the unit/share price will move up or down.
Under this theory, managers will attempt to achieve a particular capital structure that will attract a certain type of investor. For example, managers may take on higher leverage to generate a higher return on equity to attract an investor who is prepared to accept a higher level risk for a higher return.
Macbeth Property Group has the following capital structure:
Debt: $140 million
Equity: $200 million
The cost of debt is 7.5% and the cost of equity is 9.8%, calculate the WACC.
ANSWER:
kd = 7.5% ke = 9.8% D = $140 million E = $200 million V = $140m + $200m = $340 million D/V = $140m/$340m = 0.412 E/V = $200m/$340m = 0.588 WACC=k= k_d (D/V)+k_e (E/V)=7.5%(0.412)+9.8%(0.588)=8.85%
In most large property funds, ownership and management are separated. What are the main implications of this separation?
The separation of ownership and management typically leads to agency problems, where the managers (the agent) does not necessarily act in the best interest of the owners (unit holders). Managers may prefer to consume private perks or make other decisions for their private benefit—rather than maximise unit holder wealth.
a. Modigliani and Miller’s theorem assumes perfect financial markets, with no distorting taxes or other imperfections.
true
b. Modigliani and Miller’s theorem says that the cost of equity increases with borrowing and that the increase is proportional to D/V, the ratio of debt to firm value.
b) FALSE – the cost of equity increases with the ratio D/E.
c. Modigliani and Miller’s theorem assumes that increased borrowing does not affect the interest rate on the firm’s debt.
c) FALSE - the formula ke = ku + (D/E)(ku - kd) does not imply that kd is constant as borrowing increases.
define peaking order theory
The pecking order theory suggests that managers prefer to finance an acquisition with first retained earnings, second debt and finally equity
Oracle REIT has a current debt-to-asset ratio of 30%. Within their debt covenant, they have a maximum loan to value ratio of 45%. How far do Oracle’s property values have to decline before they are in breach of their covenant?
Current D/V = 0.3
Max Dm/V = 0.45
Decline=1-(D⁄V)/(D_m⁄V)=1-0.3/0.45=0.3333=33.33%
Define the ‘hedging principle’. What are two risks that a property fund faces if the hedging principle is not followed?
Hedging principle: the cash-flow-generating characteristics of an asset should be matched with the maturity of the source of financing used for its acquisition.
A property fund that does not attempt to match maturity of a cash-flow-generating asset with the maturity of the source of financing opens themselves up to liquidity risk and interest rate risk.
Liquidity risk is the risk the fund may not be able to renegotiate a new loan at maturity of the current loan (or roll-over of existing loan).
Interest rate risk is the risk that interest rates increase when the existing loan matures and they have to pay a higher rate
contrast debt and equity
Companies like to issue Debt because of the tax advantages. Interest payments are tax deductible. Debt also allows a company or business to retain ownership, unlike equity. Additionally, in times of low interest rates, debt is abundant and easy to access.
Equity is more expensive than debt, especially when interest rates are low. However, unlike debt, equity does not need to be paid back if earnings decline. On the other hand, equity represents a claim on the future earnings of the company as a part owner.
what is the WACC
The WACC is a calculation of a firm’s cost to borrow money in which each category of capital is proportionately weighted. All sources of capital within the capital stack are included here which include stocks, bonds etc. and any other long-term debt, are included in a WACC calculation.
Most often used internally by a company to ascertain if investing in a new Project will be financially viable when contrasting it against the cost of capital.