Cost of Capital – Chapter 7

Learning Objectives • Concept of WACC • Cost of debt • Cost of preference share capital • Cost of equity - Dividend growth model & CAPM • Practical issues of CAPM parameters • Capital structure & WACC • WACC • WACC in determining a firm’s EVA

Usefulness of WACC • Evaluate capital projects • Valuation of companies • Determination of EVA

WACC/EVA and ENRON • Applying WACC to Enron’s performance?

WACC – Some Principles • • • • • • •

Weighted average costs of all finance sources Uses market rates of debt and equity at target D:E or MV Includes corporate tax effects (Kd after tax) Ke and Kd include inflation, so should expected cash flows Real Return (r) (14%) = Risk-free (8%) + Risk (6%) Nominal rate (Rn)(21%) =Rf (8%)+Risk (6%)+Inflation (7%) Nominal rate (Rn) = (1 + r)(1 + f) – 1

If real required return (r)= 9% and inflation (f)= 10%. Nominal rate (Rn)? • Rn = (1+r)(1+f)–1 Thus Rn = [(1+,09)(1+,1)]–1 =0,199 or 19,9% What is real rate (r) if nominal rate (Rn)=19,9% and inflation (f) =10%? • Rn = (1+r)(1+f)–1 Thus r =[(1+Rn)/(1+f)]–1 and [(1+,199)/(1+,1)]-1=9% What is inflation (f) if real rate (r)=9% and nominal rate (Rn) is=19,9% • Rn = (1+r)(1+f)–1 Thus f =[(1+Rn)/(1+r)]–1 and [(1+,199)/(1+,9)]-1=10%

WACC Formula

Acceptable project return>WACC? • Why not use the cost of specific finance? Identify the sources of water in a swimming pool! • Example: Cost of Equity = 14% and cost of debt = 8% – Capital structure = 50% debt and 50% equity. WACC is 11% – RA =10% and is debt financed. RB = 12% and is equity financed.

– – – –

Based on Kd both A and B are acceptable! Based on Ke none are acceptable! Based on WACC only B is acceptable! Projects should meet same criterion - WACC.

Component

Cost

Equity 14% Debt 8% Weighted Average Cost of Capital (WACC)

Weight 0.50 0.50

Contribution 7% 4% 11%

Component Costs of Capital Balance Sheet Assets Non-current assets Net current assets Equity and Liabilities Equity Ordinary share capital (100m shares of R1 each) Share Premium Retained profits Liabilities 10% Debentures (3m debentures at R100) 12% Preference shares (R1 each)

Rm

800 200 1,000

{ 60% { {

100 150 350

30% 300 10% 100

1,000

The three sources of long-term finance

Component Costs of Capital

Cost of Debt â€˘ Cost of Debt = Interest rate (1 - tax rate) [Formula 7.1] Example 7.2 10% Debentures of R100 each have a market-related interest rate of 11%. The company marginal tax rate is 29%. Kd = I (1 - t) = 0,11 (1-0,29) = 7,8%

Component Costs of Capital

Cost of Debt Amount raised per perpetual debenture Coupon rate of debenture = 10% Market rate on date of issue = 11% If no issue cost: Vd = (10%/11%) x R100 = R90,91 If flotation (issue) costs is 2%: Net receipt = Vd(1-F) = R90,91(1â€“0,02) =R89,09 Cash interest cost = Interest paid/Net receipt = (10% of R100)/89,09 = 11,23% Effective rate (after tax) = 11,23%(1-0,29) = 7,97%

Yield to Maturity: redeemable debentures • Cost of redeemable debentures = YTM • Assume debenture is currently trading at R93,84. Coupon rate is 10%; Redemption in 5 years time. Rm

Year

0 -93.84

Price Coupons Par 1/1,117 R93,84 -93.84 YTM 11.70%

1

2

3

4

10

10

10

10

,8015

0,7175

10

10

,8953

10

5

10 ,6424 ,5751 100 10 110

IRR

• After-tax based on YTM, then effective cost of debt is 0,117 x (1-0,29) = 8,31%

Component Costs of Capital Cost of Preference Shares 12% Preference shares of R1. Market rate is 14%. Vp = Expected dividend/required dividend = (0,12 /0,14) x R1 = 85,71 cents. IF THERE ARE FLOTATION COSTS

NO TAX SHIELD - DIVIDENDS ARE NOT TAX DEDUCTIBLE

Component Costs of Capital

Cost of Equity Example 7.4 Current market price: Expected EPS for the next year Dividend payout ratio Expected growth rate Beta Rf

R7,68 R1,28 30% 11% p.a. 1,2 8%

METHOD 1: DIVIDEND GROWTH MODEL KEQUITY = (D1/P0)+g = [(1,28 x 0,3)/7,68] + 0,11 = 16% IF FLOTATION COSTS: P = P(1 – F%) METHOD 2: CAPITAL ASSET PRICING MODEL KEQUITY = Rf + Beta(Rm - Rf) = 0,08 + 1,2(0,14 – 0,08) = 15,2%

Calculating the WACC Source

Cost

Equity Preference shares Debt After-tax Weighted average cost of capital

15.20% 14.87% 7.97%

Weightings 60.0% 10.0% 30.0% 100.0%

WACC 9.12% 1.49% 2.39% 13.00%

If the prime rate is 12%, the bank will subscribe preference shares at 72% (-tax) of prime. STC is payable on preference dividends. What is the WACC?

Cost of Preference shares

Prime Div. Rate Cost 1+STC Cost 12.00% 72.00% 8.64% 1.125 9.72%

Source

Cost

Equity Preference shares Debt Weighted average cost of capital

15.20% 9.72% 7.97%

Weightings 60.0% 10.0% 30.0% 100.0%

WACC 9.12% 0.97% 2.39% 12.48%

Break points in the WACC Break points are max. increases in capital (i.e. equity & debt) to fund new projects at target D:E & WACC Say Target D:E is 4:6

Equity

Existing equity & debt

R600m R300m R100m

Available new RI, Deb & Prefs

R 90m

D:E ratio would change to 41,3:58,7 +Dif. WACC Break points 90m/0,6; 60/0,3 & 25/0,1

Deb Prefs

60m

25m

690m 360m

125m

150m +50 200m +100 250m

Limit new projects to 1st break point-R150m 90m

45m

15m

New Equity & Debt Total R1150 690m 345m 115m D:E ratio as before 60% 30% 10% WACC will remain the same (Except for new flotation cost

Break points & WACC • If first break point (R150m) is exceeded the WACC will increase from: – New equity share and debt flotation costs, – Higher financial risk.

• Increased RI will: – not increase the WACC (no flotation cost) at the same D:E ratio – lowers financial risk and the WACC (if no new debt or increased dividend pay ratio)

• Internal funding include RI and non-cashflow expenses (Dpn & DT) • External funds include the issue of equity or raising new debt • If dpn-generated funds are used for asset replacement it can not be invested in new projects. • If asset replacements are included in the cost of new projects dpn-generated funds will extend the first break point of the present WACC of R150m.

Break points in the WACC • Investment opportunities. Project

IRR

1 2 3 4

17% 23% 12% 21%

Funds required Rm 30 35 40 65

• If WACC = 13%, then projects 1, 2 and 4 should be accepted. • Limitations of borrowing: – Debentures: R60m – Preference shares: R25m

Pto

Break points in the WACC

For each of the three components, the break-point (B) is: Rm

Bd =

60 0.3

=

200

Bp =

25 0.1

=

250

Bs =

90 RI = 0.6

150

Total new D+E at Target D:E (4:6)

Note: R90m RI sustains overall new capital or break point of R150m (R90m/0,6)

Project Schedule Return ONLY P2, P4, AND P1 ARE ACCEPTABLE BECAUSE THEY ARE ABOVE THE WACC

R30m

R95m

R120m

WACC – Some Practical Issues Capital Structure • • • •

Use Target D:E ratio Use current MV of E & D as implied target Use BV if no MV if it reflects target D:E Use industry capital structures. Useful if company is unlisted • Present financing activities may imply target capital structure

Cost of Debt & Prefs Use current mkt rates (best estimate of prevailing rates) Ignore historical and coupon rates If variable rate financing apply, use LT (higher) rate Use interest rate spreads for different credit ratings Probabilities of default are implied by rating spreads What is the current real (excludes inflation) interest rate? Is it sustainable? • Foreign loans – due to interest rate parity, use the market rate in the local market. (Yet higher liquidity of bond issues in Europe and NY) • Preference shares – non-redeemable = Dividend/Mkt Price. – If redeemable, use market yield. • In RSA, prefs are issued at 70-74% of prime: Taxed prime rate + STC (Say 14%x 0,72)1,1 STC = 11,09% • • • • • •

â€˘ How do SA companies determine Ke?

Cost of Equity Always

Frequent

Often

Seldom ?

CAPM – Some Practical Issues KEQUITY = Rf + Beta(Rm - Rf) • The Risk-free rate 7%-8% – – – –

Treasury Bills or Treasury Bonds? Yield curve: Normally ST rate < LT rate (More risky) Matching of rate to the life of the company Which rate do SA companies use?PWC Survey

• Practitioners use LT RSA government bond rate which matches the term of underlying investments • Consistent with objective of setting a long-term cost of equity • Short-term interest rates are volatile, and this would make the cost of equity equally volatile • Any country risk premium is included in the risk free rate

Risk-free rate (May 2006) RSA Bond

Mkt Yield

Est. average yrs to maturity

R194 R153 R201 R157 R203 R186

7.15% 7.23% 7.46% 7.47% 8.15% 7.25%

1.50 4.20 8.50 9.25 11.25 20.50

Coupon

Redemption date (s)

10.00% 13.00% 8.75% 13.50% 8.25% 10.50%

28 FEB 2007/8/9 31 AUG 2009/10/11 21 DEC 2014 15 SEP 2014/15/16 15 SEP 2017 21 DEC 2025/26/27

The R153 was the rate most often used. However, the R153 was becoming too close to the redemption date to be considered a long-term rate. Perhaps use the R157

Market (Equity) Risk Premium (MRP) • The Market Risk Premium (Rm - Rf) = 5% to 8% – Expected rate of return less risk free rate. – How do we measure market premiums? • Historical • Surveys • Dividend growth model for the economy Ke=D1/Ve

– Market premium in South Africa 5%-8% – Average market (equity) premium Pto

+g

Market risk premiums Compoundedl

RSA

The Market risk Premium was close to 5% in 2005 (geometric mean).

Historical Premiums • • • •

Most common method for determining risk premium Extrapolate past premiums into the future How far back do we go? 1910 Use of Arithmetic or Geometric average historical equity returns: – Arithmetic = simple average of past returns. – Geometric mean is IRR of a single outlay and end value or compound return over past periods – Say Return Yr1 =50% & Yr2 =-20%. Calculate mean. – Arithmetic mean = (50-20)/2 = 30%/2 = 15% pa – Geometric mean =[(1+0,5)(1-0,2)-1](1/2) = 9,54% pa R100 is R150 end yr1 & R120 end yr2 -lost 20%xR150yr2 Compound growth rate: √120/100 -1 = 9,54% pa

Mkt Premium used in SA â€˘ PWC Survey - 2003

McKinsey’s approach to MRP • Measure Mkt Risk Premium over long a period as possible • Use Arithmetic average returns • Adjust arithmetic downward by 1,5%-2% for survivorship (Risk) bias • Premium is added to LT government bonds

Warren Buffet use: – LT government bond yield as MRP. – Then adds a Margin of Safety (same as risk premium)

Dividend Growth Model This is a “big picture” view. • Dividend Yield (DY) averages 2,5% on JSE. • Real growth rate=±4,5%+5,5% inflation= 10% approx. nominal future growth rate • Ke = D1/Po +g = 2,5% + 10% = 12,5% (Rm) • Bond yield = approx. 8,5% (Rf) • Thus market premium = 4% (Rm-Rf) • Practitioners use a risk premium of 4%-7%.

Beta • How does one determine a forward looking beta? • Use of historical returns of company versus the market – How far back? What time interval? Which index as proxy for the market portfolio? – Beta services such as UCT / Cadiz (Financial Risk Service), McGregor, Bloomberg – Individual company betas vs sector betas

Estimating Betas • Correia & Uliana researched the effect of choosing either market proxy • Betas adjust to regression unity over time • Fundamental Betas are reflected in indices • Positive correlation between betas of comparable firms • Levered betas are converted to unlevered betas (eliminate D:E effect) and relevered by the specific firm’s capital structure

Betas Sector betas in late 2005 were: (Market beta=1) – Resources – 1,35 – Food producers – 0,52 – Financials – 0,59 – IT – 1,72 – Food & Drug retailers – 0,29

Betas • Cost of Equity using the CAPM formula;

• Assume firm’s Ke = 9% + 1,1(14% - 9%) = 14,5% • If this firm invests in another industry, the beta of that industry should be used for the required return • However, higher debt-equity ratios result in higher equity betas. So, adjust for differences in financial leverage. How? Unlever the industry beta and relever it in terms of the particular firm’s D:E ratio

Unlevering Equity Betas A has D:E of 50% and Beta of 1,1. It invests in a different industry sector with an equity beta of 0,89 and D:E ratio of 92%. The tax rate is 28%. Use Hamada formula to unlever the new industry equity Î˛;

Ke + (Taxed Kd x D%)

Unlevered Beta = 0,89/[1+(1-0,28)(0,92)] = 0,5354 Relevered Beta: Beta with 50% debt = 0,5354 x [1+(1-0,28)(0,5)] = 0,728 Re for new industry asset: = Rf + Î˛ (Rm - Rf) 9% + 0,728(14% - 9%) =12,6

Why use a risk-adjusted discount rate? Why is firm’s unadjusted WACC inappropriate to calc.a project’s NPV?

SML

Rf

ITO WACC: – High risk projects are accepted & low risk projects rejected. – Project A is rejected, but has high return relative to its risk – Project B is accepted, but has high risk relative to its return

WACC of South African companies

•

Truworths

30% 25%

Woolworths

19.0% 20%

17.5%

16.3%

15%

13.7%

13.7%

12.4%

10% 5%

11.6%

12.9%

18.3%

23.7%

25.7%

27.4%

Jun-00

Jun-01

Jun-02

Jun-03

Jun-04

Dec-04

ROE

WACC

0%

Astral Foods – WACC = 14% Barloworld – Real WACC = 8%