Module 9 The Cost of Capital and Capital Structure Theory
1
Learning Objectives
• • • • Understand the cost of capital Calculate the cost of each component Calculate the weighted average cost of capital Discuss the effect that tax and other external factors have on the capital structure and on the cost of capital • Understand the concept of an optimal capital structure • Discuss the factors that impact on an entity’s financing strategies
2
Components of Capital
• A firm’s value is defined as a function of the cash flows generated from the assets constituting the firm. • Assets of a firm are obtained by selling financial assets in the capital market. • Financial assets may be in the form of debt securities (ex: debentures, mortgage loans), equity securities such as ordinary shares, preferred shares, and convertible debt. • Therefore, the components of capital include:
– Various type of debts – Preference and ordinary shares – Retained earnings
i.e. liability and equity compose the capital structure
3
Sources of Finance Likely to be Found in the Balance Sheet
Debt:
– overdrafts – trade creditors – commercial bills – notes – mortgage loans – debentures – convertible notes – unsecured notes
Equity:
ordinary shares preference shares retained earnings
4
Cost of Capital
• Minimum rate of return needed to compensate suppliers of capital for committing resources to an investment. • The returns received by investors in securities must be provided by the issuers of those securities and, from the issuer’s viewpoint, the return demanded by investors is effectively a cost (cost of capital).
5
Cost of Equity: ordinary shares
In Module 4 we saw that the value of equity is based on the present value of future dividends:
P0 D1 D2 D ...... 1 K e 1 K e 2 1 K e
t 1
P0
Dt 1 ke t
where: P0 Dt ke = = = the current price of shares the dividend paid in year t the required return on shares
6
Cost of Ordinary Shares: constant dividend approach
• Shares have a constant dividend into perpetuity, with no growth in dividends. • The value of a share is then the same as the value of an ordinary perpetuity.
D1 P0 ke D1 ke P0
7
Example-Cost of ordinary shares: constant dividend approach
A company has a capital of 10 million ordinary shares fully paid to $2 with a current market price of $2.40. It has been the policy of the firm to pay regular dividends of 18% and this is expected to continue. What is the cost of capital for these shares? (text p.187)
Expected dividend 18 % $2 0.36 D1 0.36 Ke 15% P $2.40
8
Cost of ordinary shares: Dividend Growth Approach
• According to the constant growth model:
D0 (1 g ) D1 P0 ke g ke g
D1 ke g P0
Rearranging:
9
Cost of Ordinary Shares: dividend growth model
When issuing new shares, flotation cost (F) should be reflected
D0 (1 g ) Ke g P0
D1 Ke g P0 (1 F )
10
Example
Reno Co. recently paid a dividend of 15 cents per share. This dividend is expected to grow at a rate of 3 per cent per year into perpetuity. The current market price of Reno’s shares is $3.20 per share. Determine the cost of equity capital for Reno Co.
$0.15 1.03 ke 0.03 $3.20 0.078 or 7.8%
11
Estimating g
One method for estimating the growth rate is to use the historical average.
Year 2000 2001 2002 2003 2004
Dividend $4.00 $4.40 $4.75 $5.25 $5.65
Dollar Change % Change $0.40 10.00% $0.35 7.95% $0.50 10.53% $0.40 7.62%
Average growth rate 10.00 7.95 10.53 7.62/4 9.025%
12
Cost of ordinary shares:
• If companies do not pay dividends on a regular basis, we can use following alternatives of calculating the cost of capital.
– Using earnings per share instead of dividends per share – Use Capital Asset Pricing Model (CAPM)
13
The Capital Asset Pricing Model (CAPM) Approach
Expected required return on a risky investment i is dependent on three factors: – the risk-free rate, rf – the market risk premium, E(rm – rf) – the systematic risk of the asset relative to the average, i
E ( ri ) rf i rm rf
14
Example—Cost of Equity Capital: SML Approach
Using historical data, the beta of Jupiters Ltd is estimated to be 0.91. The yield on 10-year bonds is 5.99%. The market risk premium is estimated to be 5.6% p.a. What is the cost of equity for Jupiters Ltd?
E ri rf E rm rf i
0.0599 0.056 0.91 0.11086 11.086%
15
Cost of Debt
• A firm having no debt in its capital structure is unleveraged, and has debt in its capital structure is leveraged.
• The cost of debt, KD, is the interest rate on new borrowing. • After tax cost of debt = interest rate on a new debt – tax savings Kd –KdT = Kd(1-T) *It is noted that the appropriate interest rate to measure the cost
of debt is the rate that entity would need to pay on borrowing today rather than interest rate of the historical debt. This is because that the calculation of cost of capital aims to help the entity to decide capital budgeting for any new project. For example, buying new facilities.
16
The Cost of Debt
• KD is observable (such as debentures and unsecured notes): – yields on currently outstanding debt – yields on newly-issued similarly-rated bonds.
17
The Cost of Debt-debentures
Remember the following formula for the value of a debt security?
P0
n
1 i
It
t 1
t
1 i n
Pn
where: It = interest payment at time t Pn = face value at maturity n = number of periods to maturity i = discount rate or market interest rate (yield to maturity)
18
Cost of Preference Shares
• Return to preference shareholders in not tax deductible and a tax adjustment is not required to convert the interest payment to an after tax cash flow. • Cost of preferred stock; Pn is the net issue price, i.e. price after adjusting the flotation cost
D1 Kp PN
19
Example—Cost of Preference Shares
• An $8 preference share issue was sold 10 years ago. It sells for $120 per share today.
• The dividend yield today is $8.00/$120 = 6.67 per cent, so this is the cost of the preference share issue.
20
Cost of retained earnings
• Retained earnings is also a source of financing • It seems cheaper as it comes from internal source, however, it is regarded as an opportunity cost to the shareholders. • In practice, we adopt the principle that the cost of retained earnings will be the same as ordinary shares
21
The Weighting System
• The appropriate weights are the proportion that each source of funds represents of the total sources used to finance proposed projects. • Current capital structure can be used unless the capital structure is expected to change, whereby the company’s target capital structure should be used.
22
The Weighting System
• The weights should be calculated using current market values rather than book values.
• This is consistent with the manner in which the costs of each source of funds have been calculated. • These values reflect the amounts investors can realise from selling their investment.
23
Weighted Average Cost of Capital — WACC
The weighted average cost of capital is therefore:
WACC = (E/V)×ke +(D/V) ×kd×(1-tc) +(Dp/V) ×kp
Where: (E/V) is the proportion of equity finance (D/V) is the proportion of debt finance (Dp/V) is the proportion of preference share holders ke is the return required by equity holders kd is the return required by debt holders kp is the return required by preference share holders tc is the tax rate
24
WACC
• The WACC for a firm reflects the risk and the target capital structure to finance the firm’s existing assets as a whole. • WACC is the return that the firm must earn on its existing assets to maintain the value of its shares. • WACC is the appropriate discount rate to use for cash flows that are similar in risk to the firm.
example: textbook p.450
25
Example—Weighted Average Cost of Capital
Zeus Ltd has 78.26 million ordinary shares on issue with a book value of $22.40 per share and a current market price of $58 per share. The market value of equity is therefore $4.54 billion. Zeus has an estimated beta of 0.90. Treasury bills currently yield 4.5 per cent and the market risk premium is assumed to be 7.94 per cent. Company tax is 30 per cent.
26
Example—Weighted Average Cost of Capital (continued)
The firm has four debt issues outstanding:
Bond 1 2 3 4
Coupon 6.375% 7.250% 7.635% 7.600% Total
Book Value $499m $495m $200m $296m $1 490m
Market Value $501m $463m $221m $289m $1 474m
Yield to Maturity 6.32% 7.83% 6.76% 7.82%
27
Example—Cost of Equity (SML Approach)
RE R f E RM R f 4.5% 0.90 7.94% 11.65%
28
Example—Cost of Debt
Bond 1 2 3 4 Market Value $501m $463m $221m $289m $1 474m Weight 0.3399 0.3141 0.1499 0.1961 1.0000 Yield to Maturity 6.32% 7.83% 6.76% 7.82% Weighted YTM 2.1482% 2.4594% 1.0133% 1.5335% 7.1544%
The weighted average cost of debt is 7.15 per cent.
29
Example—Capital Structure Weights
• Market value of equity = 78.26 million × $58 = $4.539 billion. • Market value of debt = $1.474 billion.
V $4.539 billion $1.474 billion $6.013 billion D $1.474b 0.245 or 24.5% V $6.013b E $4.539b 0.755 or 75.5% V $6.013b WACC 0.755 0.1165 0.245 0.0715 1 0.30 0.0932 or 9.32%
30
WACC: example
31