Revision 5 Cost of Capital

Answer 1 (a) Weighted average cost of capital (WACC) calculation Cost of equity of KFP Co = 4 ! ("# $ (" % & 4 )) = 4 ! '( = ""() using the capital asset pricing *odel [2 marks] +o calculate the after,ta$ cost of de-t. linear interpolation is needed After,ta$ interest pay*ent = " $ ' $ (" & /) = 041

[1 mark]

After,ta$ cost of de-t = % ! ((" & %) $ 4'")2(4'" ! "1%1) = % ! " = 3 ) [3 marks] 4u*-er of shares issued -y KFP Co = 0"%*2 % = / *illion shares 5ar6et value of equity = / * $ 4# = 0"#3 *illion 5ar6et value of -onds issued -y KFP Co = "%* $ 14'42" = 0"4#"" *illion +otal value of co*pany = "#3 ! "4#"" = 0"4 #"" *illion WACC = ((""( $ "#3) ! (3 $ "4#""))2"4 #"" = ""#) [1 mark] [1 mark] [2 marks]

(-)(i) Price2earnings ratio *ethod 7arnings per share of 484 = ( c per share Price2earnings ratio of KFP Co = ( 9hare price of 484 = ( $ ( = 34 c or 034 4u*-er of ordinary shares of 484 = %2 % = " *illion shares :alue of 484 = 34 $ " * = 034 *illion

[2 marks]

;o<ever. it can -e argued that a reduction in the applied price2earnings ratio is needed as 484 is unlisted and therefore its shares are *ore difficult to -uy and sell than those of a listed co*pany such as KFP Co= >f <e reduce the applied price2earnings ratio -y " ) (other si*ilar percentage reductions <ould -e accepta-le). it -eco*es '# ti*es and the value of 484 <ould -e (( 2" ) $ '# $ " * = 0%'3 *illion
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(-)(ii) @ividend gro<th *odel @ividend per share of 484 = ( c $ 4% = /3c per share [1 mark] 9ince the payout ratio has -een *aintained for several years. recent earnings gro<th is the sa*e as recent dividend gro<th. i=e= 4%)= Assu*ing that this dividend gro<th continues in the future. the future dividend gro<th rate <ill -e 4%)= 9hare price fro* dividend gro<th *odel = (/3 $ " 4%)2 ( "# & 4%) = % #c or 0% # :alue of 484 = % # $ " * = 0% # *illion [3 marks] (c) A discussion of capital structure could start fro* recognising that equity is *ore e$pensive than de-t -ecause of the relative ris6 of the t<o sources of finance= 7quity is ris6ier than de-t and so equity is *ore e$pensive than de-t= +his does not depend on the ta$ efficiency of de-t. since <e can assu*e that no ta$es e$ist= We can also assu*e that as a co*pany gears up. it replaces equity <ith de-t= +his *eans that the co*panyAs capital -ase re*ains constant and its <eighted average cost of capital (WACC) is not affected -y increasing invest*ent= Traditional view of capital structure: "= +he traditional vie< of capital structure assumes a non linear relations!ip "etween t!e cost of e#uit$ and financial risk = As a co*pany %ears up. there is initiall$ ver$ little increase in t!e cost of e#uit$ and t!e &ACC decreases -ecause the cost of de-t is less than the cost of equity= #= A point is reached. ho<ever. <here t!e cost of e#uit$ rises at a rate t!at e'ceeds t!e reduction effect of c!eaper de"t and the &ACC starts to increase= >n the traditional vie<. therefore. a minimum &ACC e'ists and. as a result. a ma'imum value of t!e compan$ arises= [1 2 marks] ()( and capital structure: /= 5odigliani and 5iller assumed a perfect capital market and a linear relations!ip "etween t!e cost of e#uit$ and financial risk= +hey argued that. as a co*pany geared up. the cost of e#uit$ increased at a rate t!at e'actl$ cancelled out t!e reduction effect of c!eaper de"t= &ACC <as therefore constant at all levels of %earin% and no optimal capital structure. <here the value of the co*pany <as at a *a$i*u*. could -e found= 4= >t <as argued that the no ta' assumption *ade -y 5odigliani and 5iller <as unrealistic. since in the real world interest pa$ments were an allowa"le e'pense in
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calculating ta$a-le profit and so t!e effective cost of de"t was reduced "$ its ta' efficienc$= %= +hey revised t!eir model to include this ta$ effect and sho<ed that. as a result. the &ACC decreased in a linear fas!ion as a compan$ %eared up = +he value of t!e compan$ increased -y the value of the Bta$ shieldA and an optimal capital structure would result "$ %earin% up as muc! as possi"le= [2 3 marks] (arket imperfections: 3= >t <as pointed out that market imperfections associated wit! !i%! levels of %earin%. such as -an6ruptcy ris6 and agency costs. <ould limit t!e e'tent to w!ic! a compan$ could %ear up= '= >n practice. therefore. it appears that companies can reduce t!eir &ACC "$ increasin% %earin%. w!ile avoidin% t!e financial distress that can arise at high levels of gearing= [1 2 marks] *t!er relevant discussion: (= >t has further -een suggested that companies c!oose t!e source of finance <hich. for one reason or another. is easiest for t!em to access (peckin% order t!eor$)= +his results in an initial preference for retained earnin%s . followed "$ a preference for de"t "efore turnin% to e#uit$= 1= +he vie< su%%ests t!at companies ma$ not in practice seek to minimise t!eir &ACC (and consequently *a$i*ise co*pany value and shareholder <ealth)= [1 2 marks] Comment on de"t finance for cas! offer: " = +urning to the suggestion that de-t could -e used to finance a cash -id for 484. the current and post acquisition capital structures and their relative gearing levels should -e considered. as <ell as the a*ount of de-t finance that <ould -e needed= +arlier calculations su%%est that at least ,5-m would "e needed. ignoring any pre*iu* paid to persuade target co*pany shareholders to sell their shares= +he current de"t.e#uit$ ratio of /01 Co is 234 ("%*2#%*)= +he de"t of t!e compan$ would increase "$ ,5-m in order to finance t!e "id and "$ a furt!er ,23m after t!e ac#uisition . due to ta6ing on the e$isting de-t of 484. %ivin% a total of ,53m= >gnoring other factors. the %earin% would increase to 3624 (1/*2#%*)= ""= KFP Co <ould need to consider !ow it could service t!is dan%erousl$ !i%! level of %earin% and deal wit! t!e si%nificant risk of "ankruptc$ that it *ight create= >t <ould also need to consider <hether the "enefits arisin% from t!e ac#uisition of 484 <ould compensate for t!e si%nificant increase in financial risk and "ankruptc$ risk resulting fro* using de-t finance=
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[2 3 marks] ACCA (arkin% 7c!eme

Answer 2 (a)(i) As the invest*ent is an e$pansion of e$isting activities. the ris6 of the invest*ent <ill -e esti*ated using the co*panyAs current equity -eta= +he cost of equity *ay -e esti*ated using either CAP5 or the dividend gro<th *odel= Csing CAP5D Ke = ?f ! (?* & ?f) -eta. or /%) ! ("") & /%)) E ""% = "#"/) Csing the dividend gro<th *odelD
D" /3=4 "= 4 +g = + = 4 = =""1# or ""=1#) P 4'(

Ke =

Foth *ethods give a cost of equity of appro$i*ately "#) +he current pre ta$ cost of de-t is '=%). although this cost <ill vary as the proposed loan is at a floating rate= +he <eighted average cost of capital should -e esti*ated using *ar6et values of equity and de-t= +he current *ar6et <eighted gearing of Gendec6 isD

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7quity / *illion shares at 4'( cents = 0"4/4 *illion @e-t 0/4* ! (0%3* E " '() = 014/' *illion +his is 3 /) equity. /1') de-t -y *ar6et values= 5aintaining the current capital structure the esti*ated <eighted average cost of capital isD "#) ( 3 /) ! '%) (" & /) ( /1') = 1/#) (a)(ii) +here is no easy *ethod of adHusting the CAP5 cost of equity for issue costs. instead cash flo<s <ould -e adHusted <hen underta6ing the invest*ent appraisal= Csing the dividend gro<th *odel the revised equation including issue costs isD D" Ke = + g (<here > is the issue costs) P I
Ke = /3=4 "= 4 + = 4 = ="#% or "#=%) 4'( /"

(/" is issue costs = 4'( E = 3%) Assu*ing the ne< de-entures carry the sa*e ris6 as the e$isting ones. and that there are three years until the rede*ption of the e$isting de-entures. the current gross rede*ption yield (cost) of de-entures *ay -e esti*ated fro*D
0" '=( = "" "" "" " + + + # / " + K d (" + K d ) (" + K d ) (" + K d ) /

Fy +rial and error Iear Cash flo< 5ar6et value >nterest ?ede*ption

0 (" '=() "" "

"&/ /

1) discount "= #=%/" =''#

P: (0) (" '=() #'=(4" ''=# (#='%1)

') discount "= #=3#4 =("3

P: (0) (" '=() #(=(34 ("=3 #=334

K d = ') +

#=334 (1) ')) = () #=334 + #='%1

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+he gross rede*ption yield of e$isting de-entures is appro$i*ately ()= Assu*ing the ne< de-entures have a si*ilar ris6 to e$isting de-entures they <ill -e issued at par of 0" <ith a coupon of ()= +hey are also assu*ed to -e issued for the e$pected *aturity of the invest*ent. five years= +he effective cost of the de-entures *ay -e esti*ated -y solvingD
(" /=%) = ( ( ( ( ( " + + + + + # / 4 % " + K d (" + K d ) (" + K d ) (" + K d ) (" + K d ) (" + K d ) %

Iear "&% %

Cash flo<s (0) (13=%) ( "

@F J 1) "= /=(1 =3%

P: (0) (13=%) /"="# 3% ( =/()

At () the value is 0" Fy interpolationD

K d = () +

-y definition

/=% (1) ()) = (=1) /=% + =/(

+he <eighted average cost of capital isD "#%) E ( 3 /) ! (1 E (" & /) E ( /1') = " ) +he issue costs and use of a different type of de-t increase the WACC -y a-out ' )= (-) As the co*panies are unlisted. there is no s!are price <ith <hich to esti*ate CAP5 or to use the dividend gro<th *odel= >t *ight -e possi"le to use t!e "eta of similar risk #uoted companies (<ith adHust*ent for differences in gearing). "ut suc! companies are often difficult to identif$ . and the de%ree of accurac$ of the esti*ate of WACC is likel$ to "e reduced= +here is also the pro"lem that no measure of t!e market value of e#uit$ e'ists <ith <hich to estimate %earin%. although a target gearing *ight -e used. pro-a-ly "enc!marked a%ainst ot!er companies in the sa*e sector= Cnlisted co*panies sometimes use a cost of capital esti*ate of a similar listed compan$. and add a furt!er risk premium to reflect the fact that they are unlisted=
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>nevita-ly this involves su-Hectivity= Answer 3 (a) Cost of e#uit$ 8eo*etric average dividend gro<th rate = (#"(2"1/() #% & " = #1( or /) [1 mark] Csing the dividend gro<th *odel. 6e = / ! ((#"( $ " /)2#% ) = / ! 1 = "#) [2 marks] (arket values of e#uit$ and de"t 5ar6et value of equity = :e = " * $ #% = 0#% *illion 5ar6et value of -onds = :d = 3 * $ (" 42" ) = 03#4 *illion +otal *ar6et value of AK? Co = :e ! :d = #% ! 3#4 = 0/"#4 *illion [1 mark] Current WACC calculation +he current after,ta$ cost of de-t is ') WACC = ((6e $ :e) ! (6d(" & +) $ :d)2(:e ! :d)) = (("# $ #% *) ! (' $ 3#4*))2/"#4* = "") [2 marks] +he <eighted average after,ta$ cost of capital -efore the ne< issue of -onds is "") After,ta$ cost of de-t of ne< -ond issue After,ta$ interest rate = ( $ (" & /) = %3) per year Csing linear interpolationD

[1 mark]

After,ta$ cost of de-t = % ! L((3 & %) $ ''")2(''" ! "1)M = % ! 1( = %1() or 3) [1 mark] ?evised WACC calculation +he *ar6et value of the ne< issue of -onds is 04 *illion +he total *ar6et value of AK? Co increases to /"#4 ! 4 = 0/%#4 *illion WACC = (("# $ #% *) ! (' $ 3#4*) ! (3 $ 4 ))2/%#4* = " 4) [2 marks] After the ne< issue of -onds. the <eighted average after,ta$ cost of capital has decreased fro* "") to " 4) -ecause the proportion of de-t finance. <hich has a lo<er required rate of
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return than equity finance. has increased= 8earing on a *ar6et value -asis has increased fro* # ) (3#42/"#4) to #1) (" #42/%#4)= [1 mark] +he WACC calculation assu*es that the cost of equity has not changed. <hen in reality the cost of equity *ight -e e$pected to rise in response to the increase in financial ris6 caused -y the ne< issue of de-t= +he share price of the co*pany has also -een assu*ed to -e constant= (-) +he factors that influence the *ar6et value of traded -onds are represented in the -ond valuation *odel= Amount of interest pa$ment +he *ar6et value of a traded -ond <ill increase as t!e interest paid on the -ond increases. since the re<ard offered for o<ning the -ond -eco*es *ore attractive= [1 2 marks] 0re#uenc$ of interest pa$ments >f interest pa$ments are more fre#uent. say every si$ *onths rather than every year. then the present value of t!e interest pa$ments increases and hence so does t!e market value= [1 2 marks] Redemption value >f a !i%!er value t!an par is offered on redemption. as is the case <ith the proposed -ond issue of AK? Co. the re<ard offered for o<ning the -ond increases and hence so does the *ar6et value= [1 2 marks] 1eriod to redemption +he *ar6et value of traded -onds is affected "$ t!e period to redemption. either -ecause the capital pay*ent -eco*es *ore distant in ti*e or -ecause the nu*-er of interest pay*ents increases= [1 2 marks] Cost of de"t +he present value of future interest pay*ents and the future rede*ption value are heavily influenced -y the cost of de-t. i=e= the rate of return re#uired "$ "ond investors = +his rate of return is influenced "$ t!e perceived risk of a compan$ . for e$a*ple as evidenced -y its credit rating= As the cost of de"t increases. the market value of traded "onds decreases. and vice versa= [1 2 marks] Converti"ilit$ >f traded -onds are converti-le into ordinary shares. the *ar6et price <ill -e influenced "$
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t!e likeli!ood of t!e future conversion and t!e e'pected conversion value . <hich is dependent on t!e current s!are price . the future s!are price %rowt! rate and t!e conversion ratio= [1 2 marks] (c) +here is certainly a relationship -et<een the <eighted average cost of capital (WACC) and the *ar6et value of the co*pany. since the *ar6et value can -e e$pressed as the present value of future corporate cash flo<s. discounted -y the WACC= (ar%inal and avera%e cost of de"t As for decreasing the WACC -y issuing traded -onds. if the *arginal cost of capital. in this case the cost of de"t of t!e new "ond issue . is less t!an t!e wei%!ted avera%e cost of capital 8&ACC9. it <ould see* logical to e'pect t!e &ACC to decrease= :owever. as noted in an earlier discussion. increasin% %earin% <ill increase financial risk and *ay lead to an increase in t!e cost of e#uit$ . offsettin% t!e effect of t!e c!eaper de"t= +he relationship -et<een capital structure and WACC has -een de-ated for *any years= [1 2 marks] Traditional view of capital structure >n the traditional vie< of capital structure. there is a non linear relations!ip -et<een the cost of equity and financial ris6. as *easured -y gearing= +#uit$ investors are indifferent to t!e addition of small amounts of de"t . so as a co*pany gears up -y replacin% e'pensive e#uit$ wit! c!eaper de"t . the &ACC initially decreases= @e-t is cheaper than equity -ecause of the relative positions of the t<o sources of finance in the creditor hierarchy (the traditional vie< of capital structure ignores ta$ation)= As e#uit$ investors start to respond to increasin% financial risk. ho<ever. the cost of e#uit$ "e%ins to increase until a point is reached <here WACC ceases to fall= +his corresponds to an optimal capital structure . since at this point &ACC is at a minimum and hence the market value of t!e compan$ is at a ma'imum= After t!is point. the &ACC starts to increase as the co*pany continues to gear up. rising *ore quic6ly at very high levels of gearing due to t!e appearance of "ankruptc$ risk= Cnder the traditional vie< the finance director *ight -e correct in his -elief that issuing de-t <ill decrease WACC. depending on the position of the co*pany relative to its opti*al capital structure= [1 2 marks]
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(iller and (odi%liani ()( ; 8155-9 5iller and 5odigliani sho<ed that in a perfect capital market wit!out corporate ta'ation. the replacement of e'pensive e#uit$ wit! c!eaper de"t did not lead to a decrease in t!e &ACC. since the effect of addin% in c!eaper de"t <as e'actl$ offset "$ t!e increase in t!e cost of e#uit$ . <hich had a linear relations!ip wit! financial risk. as represented -y gearing= +his *eant that the market value of t!e compan$ <as independent of its capital structure (financial ris6) and depended onl$ on its "usiness operations (-usiness ris6)= ()( ;; 815239 >n their second paper on capital structure 5iller and 5odigliani sho<ed that. if ta'ation were allowed (so that the after,ta$ cost of de-t <as considered. rather than the -efore, ta$ cost of de-t). replacin% e#uit$ wit! de"t led to a linear decrease in t!e &ACC . "ecause of t!e ta' s!ield on profits gained -y interest pay*ents -eing an allo<a-le deduction in calculating ta$ lia-ility= Cnder this contri-ution to capital structure theory. %earin% up as muc! as possi"le <ould ma'imise t!e market value of the co*pany and the finance director <ould -e correct in his -elief that issuin% traded "onds would decrease t!e &ACC of AK? Co= [1 3 marks] (arket imperfections view >n reality. it <as noted that companies do not %ear up as muc! as possi"le -ecause of the dan%ers of !i%! %earin%= Further *ar6et i*perfections. relative to the idea of a perfect capital *ar6et in 5iller and 5odiglianiAs first paper on capital structure. included "ankruptc$ risk and t!e costs of financial distress at high levels of gearing= +hese reduced and finall$ reversed t!e ta' s!ield effect noted -y 5iller and 5odigliani. resultin% in an optimal capital structure at the point <here the WACC <as at its lo<est and the value of the co*pany <as at its highest= [1 2 marks] 1eckin% order t!eor$ >n practice it has -een noticed that co*panies do not appear to -ase their financing decisions on the o-Hective of achieving an opti*al capital structure. -ut rather have a preference for sources of finance in the order of retained earnings. -an6 loans. ordinary de-t. converti-le de-t and equity= A nu*-er of reasons have -een suggested for this Bpec6ing orderA= [1 2 marks]
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ACCA (arkin% 7c!eme:

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Answer < (a) Csing the dividend gro<th *odel. the share price of 44 Co <ill -e the present value of its e$pected future dividends. i=e= (33 $ " /)2( "# & /) = '%% cents per share or 0'%% per share= [2 marks] 4u*-er of ordinary shares = % 2 % = " * shares :alue of 44 Co = " * $ '%% = 0'%%*

[1 mark]

4et asset value of 44 Co = total assets less total lia-ilities = "4/ & #1 & # & #% = 031* [2 marks] >n calculating net asset value. preference share capital is included <ith long,ter* lia-ilities. as it is considered to -e prior charge capital= (-) +he after,ta$ cost of de-t of 44 Co can -e found -y linear interpolation +he annual after,ta$ interest pay*ent = ' $ (" & #%) = ' $ '% = 0%#% per year [1 mark]

After,ta$ cost of de-t = 4 ! L(" $ / #)2(/ # ! ##%)M = 4 ! %' = 43) [3 marks] (7$a*inerAs noteD the calculated value of the after,ta$ cost of de-t <ill -e influenced -y the choice of discount rates used in the linear interpolation calculation and so other values <ould also gain credit here=) (c) Annual preference dividend = () $ % cents = 4 cents per share Cost of preference shares = " $ (423') = 3) 4u*-er of ordinary shares = % 2 % = " * shares
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[1 mark]

5ar6et value of equity = :e = " * shares $ (/ = 0(/ * [1 mark] 4u*-er of preference shares = #%2 % = % * shares 5ar6et value of preference shares = :p = 3' $ % * = 0//%* [1 mark] 5ar6et value of long,ter* -orro<ings = :d = # $ " /% 2" = 0# '* [1 mark] +otal *ar6et value of co*pany = (:e ! :d ! :p) = ((/ ! //% ! # ') = 0((4#* WACC = (6e:e ! 6p:p ! 6d(" & +):d)2 (:e ! :p ! :d) = ("# $ (/ ! 3 $ //% ! 43 $ # ')2((4# = ""3) [2 marks] (d) A nu*-er of factors should -e considered in for*ulating the dividend policy of a stoc6, e$change listed co*pany. as follo<s= 1rofita"ilit$ Co*panies need to remain profita"le and dividends are a distri-ution of after,ta$ profit= A co*pany cannot consistently pay dividends higher than its profit after ta$= A !ealt!$ level of retained earnin%s is needed to finance t!e continuin% "usiness needs of the co*pany= [1 2 marks] =i#uidit$ Although a dividend is a distri-ution of profit. it is a cash pay*ent -y the co*pany to its shareholders= A co*pany *ust therefore ensure it !as sufficient cas! to pa$ a proposed dividend and that paying a dividend <ill not compromise da$ to da$ cas! financin% needs= [1 2 marks] =e%al and ot!er restrictions A dividend can only -e paid out in accordance wit! statutor$ re#uirements. such as the require*ent in the Cnited Kingdo* for dividends to -e paid out of accu*ulated net realised profits= +here *ay also -e restrictions on dividend pa$ments imposed "$. for e$a*ple. restrictive covenants in "ond issue docu*ents= [1 2 marks] T!e need for finance +here is a close relationship -et<een invest*ent. financing and dividend decisions. and the dividend decision *ust consider the invest*ent plans and financing needs of the co*pany= A large invest*ent progra**e. for e$a*ple. <ill require a large a*ount of finance. and the need for e$ternal finance can -e reduced if dividend increases are 6ept in chec6= 9i*ilarly. the decision to increase dividends *ay reduce retained earnin%s to the e$tent <here e'ternal finance is needed in order to *eet invest*ent needs= [1 2 marks] T!e level of financial risk >f financial risk is !i%!. for e$a*ple due to a high level of gearing arising fro* a su-stantial
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level of de-t finance. maintainin% a low level of dividend pa$ments can result in a !i%! level of retained earnin%s. <hich <ill reduce %earin% "$ increasin% t!e level of reserves = +he cash flo< fro* a higher level of retained earnings can also -e used to decrease the a*ount of de-t -eing carried -y a co*pany= [1 2 marks] T!e si%nallin% effect of dividends >n a se*i,strong for* efficient *ar6et. infor*ation availa-le to directors is *ore su-stantial than that availa-le to shareholders. so that infor*ation asy**etry e$ists= +his is one of the causes of the agency pro-le*= >f dividend decisions conve$ new information to t!e market. they can have a si%nallin% effect concernin% t!e current position of t!e compan$ and its future prospects= +he signalling effect also depends on the dividend e$pectations in the *ar6et= A co*pany should therefore consider the li6ely effect on share prices of the announce*ent of a proposed dividend= [1 2 marks] ACCA (arkin% 7c!eme

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