Weighted Average Cost of Capital

Question 1

What are the advantages of dividend valuation models? [3]

Answer 1

• Cash method eliminates the subjectivity of profits.
• Time value is considered, aligning with earning potential.
• Suitable for small shareholders seeking regular cash dividends.

Question 2

What are the assumptions (limitations) of dividend models? [8]

Answer 2

• Investors are assumed to act rationally and homogenously, not accounting for varied shareholder expectations.
• The D0 figure may need adjustment from trend figures of past dividends.
• Estimates of future dividends and prices, and cost of capital should be reasonable; historical trends might not always be reliable.
• Different cash flows at different times can be modeled using discounted cash flow arithmetic.
• Directors use dividends to signal company strength; zero dividends do not imply zero share values.
• Dividends either show constant growth or no growth, influenced by the b = x in the model assumptions that are constant.
• Other influences on share prices are typically ignored in these models.
• Companies’ earnings must increase sufficiently to maintain dividend growth levels exceeding the dividend growth rate.

Question 3

Q: What is the Capital Asset Pricing Model (CAPM)?

Answer 3

A: CAPM is used to calculate the cost of equity and incorporates risk, based on a comparison of the systematic risk of individual investments with the risks of all shares in the market.

Question 4

Q: What does portfolio theory suggest?

Answer 4

A: It suggests that investors can reduce total risk on their investments by diversifying their portfolio of investments.

Question 5

Q: How is total risk divided according to CAPM?

Answer 5

A: Total risk is divided into company-specific (unsystematic) and market activity-related (systematic) risks.

Question 6

Q: What is non-systematic or unsystematic risk?

Answer 6

A: It applies to a single investment or class of investments and can be reduced or eliminated by diversification.

Question 7

Q: How does a risk-averse investor react to systematic risk?

Answer 7

A: A risk-averse investor will expect to earn a return higher than the return on a risk-free investment for accepting systematic risk.

Question 8

Q: How can an investor avoid systematic and unsystematic risks?

Answer 8

A: By not investing entirely in one type of securities, holding shares in just a few companies, building up a well-diversified portfolio, and understanding that different companies have different systematic characteristics.

Question 9

Q: What is Beta Factor, and how does it relate to systematic risk? [2]

Answer 9

A: Beta factor measures the systematic risk of a security relative to the average market portfolio.
A higher beta indicates greater sensitivity to market movements and systematic risk.

Question 10

Q: What do different beta factors represent? [4]

Answer 10

A: Here are the descriptions for different beta factors:
- Beta = 1: Measurement of systematic risk for the stock market as a whole.
- Beta = 0: Systematic risk for risk-free investments (unaffected by market risk).
- Beta < 1: Lower systematic risk than the market on average.
- Beta > 1: Higher systematic risk than the market on average (more risky).

Question 11

Q: How do companies adjust their expectations for projects with different systematic risks? [3]

Answer 11

A:
- Companies seek returns that exceed the risk-free rate to compensate for systematic risk.
- Unsystematic risk can be diversified away, so no premium is required for it.
- Companies prioritize higher returns for projects with greater systemic risks.

Question 12

What is the objective of management in terms of company value and cost of capital?

Answer 12

Answer: The objective of management is to maximize shareholder wealth.

Question 13

How is the market value of a company calculated?

Answer 13

It is the sum of the market values of its various forms of finance, equating to the market value of the company’s equity plus debt.

Question 14

How is the market value related to future cash flows and WACC?

Answer 14

The total market value equates to the present value of future cash flows available to investors, discounted at their overall required return or Weighted Average Cost of Capital (WACC).

Question 15

What happens if a company distributes all its earnings?

Answer 15

Answer: It follows that the total market value equates to the present value of future cash flows available to investors, discounted at their overall required return or WACC.

Question 16

What simplified formula can be used to calculate a company’s market value?

Answer 16

Answer: Market Value = Future Cash Flows / WACC

Question 17

What effect does reducing WACC have on a company’s valuation and shareholder wealth?

Answer 17

Reducing WACC results in higher market value or NPV for a company, leading to an increase in shareholder wealth as they own more.

Question 18

The Traditional View of Capital Structure, what is it?

Answer 18

Under the traditional theory of cost of capital, the cost declines initially and then rises as gearing increases. The optimal capital structure will be the point at which WACC is lowest.

Question 19

Assumptions of Traditional View [5]

Answer 19

(a) The company pays out all its earnings as dividends.
(b) The gearing of the company can be changed immediately by issuing debt to repurchase shares, or by issuing shares to repurchase debt. There are no transaction costs for issues.
(c) The earnings of the company are expected to remain constant in perpetuity and all investors share the same expectations about these future earnings.
(d) Business risk is also constant, regardless of how the company invests its funds.
(e) Taxation, for the timing being, is ignored.

Question 20

Explain the graph of WACC (compared with d/e) as per the traditional theory [5]

Answer 20

• As the level of gearing increases, the cost of debt remains unchanged up to a certain level of gearing. Beyond this level, the cost of debt will increase.
• The cost of equity rises as the level of gearing increases and financial risk increases. There is a non-linear relationship between the cost of equity and gearing.
• The WACC does not remain constant but rather falls initially as the proportion of debt capital increases, and then begins to increase as rising costs (of equity and possibly debt) becomes more significant.
• The optimum level of gearing is where the company’s WACC is minimized.
• Company should gear up until it reaches optimal point and then raise a mix of finance to maintain this level of gearing. However, there is no method, apart from trial and error, available to locate the optimal point.

Question 21

Modigliani-Miller (M&M) View (Net operating income view of WACC without taxes) [4]

Answer 21

• Modigliani and Miller stated that, in the absence of tax relief on debt interest, a company’s capital structure would have no impact on its WACC. WACC would be the same regardless of the company’s capital structure.
• M&M proposed that the total market value of a company, in the absence of tax, will be determined only by two factors:
  (a) The total earnings of the company.
  (b) The level of operating (business) risk attached to those earnings.
• The total market value would be computed by discounting the total earnings at a rate that is appropriate to the level of operating risk. This rate would represent the company’s WACC.
• Thus, M&M concluded that the capital structure of a company would have no effect on its overall value or WACC.

Question 22

Assumptions of Modigliani and Miller Approach (without taxes) [6]

Answer 22

1. There are no taxes.
2. Transaction costs for buying and selling securities, as well as bankruptcy costs, are nil.
3. There is symmetry of information, meaning that investors have access to the same information as corporations and behave rationally.
4. The cost of borrowing is the same for investors and companies.
5. There are no flotation costs (e.g., underwriting commissions, payment to merchant bankers, advertisement expenses).
6. There is no corporate dividend tax.

The Modigliani and Miller Approach indicates that the value of a leveraged firm (a firm with a mix of debt and equity) is the same as the value of an unleveraged firm (a firm wholly financed by equity).

Question 23

M&M with Tax (M&M II)

Answer 23

• In 1963, M&M modified their model to reflect the fact that the corporate tax system gives tax relief on interest payments.
• They admitted that tax relief on interest payments does lower the WACC. The savings arising from tax-deductible interest payments are the tax shield. They claimed that the WACC will continue to fall, up to gearing to 100%.
• This suggests that companies should have a capital structure made up entirely of debt.

Question 24

Gearing Risks and Constraints ignored by MM Theory II (WITH TAXES)

Answer 24

• Bankruptcy Risk
  
  • Gearing increases lead to a higher possibility of bankruptcy.
  • If shareholders are concerned, this will increase the WACC of the company and reduce the share price.
• Agency Costs
  
  • Restrictive conditions in order to safeguard investments.
  • Lenders/debenture holders often impose strict conditions in loan agreements that constrain management’s freedom of action, including restrictions on dividend levels, additional debt raising, and disposal of major fixed assets.
• Tax Exhaustion
  
  • Companies with high gearing levels may have no tax liability left against which to offset interest charges.
  • Kd (1 – t) simply becomes Kd.
• Borrowing/Debt Capacity
  
  • High levels of gearing are unusual because companies run out of suitable assets to offer as security against loans.
  • Companies with assets which have an active second-hand market and low depreciation such as property companies, have a high borrowing capacity.
• Difference Risk Tolerance Levels Between Shareholders and Directors
  
  • Business failure can have a greater impact on directors than on a well-diversified investor.
  • It may be argued that directors have a natural tendency to be cautious about borrowing increases as gearing increases.
• Restrictions in the Articles of Association
  
  • The articles of association may specify limits on the company’s ability to borrow. The cost of borrowing increases as gearing increases.

Question 25

What is a Yield Curve?

Answer 25

• A yield curve is a plot of required rates of return (yields) against maturity.
• The normal expectation is that the yield curve will slope upwards (as described above), although this is not always the case.

Question 26

Assumptions of CAPM [3]

Answer 26

• A perfect capital market where all investors have access to all available information about the financial markets.
• Uniformity of investor expectations.
• All forecasts are made in the context of just one time period.

Question 27

Advantages of CAPM [3][

Answer 27

• Provides a measurable relationship between risk and return.
• Used to estimate the cost of capital for securities, notably equity shares.
• Adaptable for establishing a required (risk-adjusted) DCF return on capital investments by a company.

Question 28

Weaknesses of CAPM [3]

Answer 28

• Difficulty in estimating statistically reliable values for risk-free rate and market rate of return.
• Focuses only on systematic risk, ignoring unsystematic risk which is significant for an investor who does not have a well-diversified portfolio.
• Makes no distinction between ways in which security provides its return.

Question 29

REASONS FOR USING APV INSTEAD OF WACC [3]

Answer 29

• The APV method does not rely on assumptions about the new WACC of the firm if the project is undertaken.
• The APV method allows for specific tax relief on borrowing to finance a project and does not assume that debt will be perpetual debt.
• The APV method allows for other costs, such as costs of raising new finance (issue costs).