Cost of Capital and Returns to Providers of Finance 2BUS0197 – Financial Management Cost of Capital and Returns to Providers of Finance Lecture 7 Dr Francesca Gagliardi

Learning outcomes By the end of the session students should be able to: Calculate the costs of different sources of finance used by a company Calculate the weighted average cost of capital Understand how to apply the cost of capital in investment appraisal Appreciate the reasons for preferring market values to book values

Knowledge development In the past weeks we have looked at short- and long-term financing sources that are available to companies We have analysed how investment appraisal methods can be applied to make capital investment decisions We have also discussed the risk-return trade-off faced by investors Today we go a step further and discuss how the level of risk of different financing sources affects their required rate of return, hence a company’s cost of capital

Why focus on cost of capital? The cost of capital is the rate of return required on invested funds Companies should seek to raise capital by the cheapest and most efficient methods Minimisation of the average cost of capital will increase the net present value of a company’s projects, hence its market value To minimise the cost of capital: Information on the costs associated to the available different sources of finance is needed Knowledge of how to combine different sources of finance to reach an optimal capital structure is required All providers of finance require returns. The required return will reflect the risk of the investment and the returns of alternatives.

Calculating the cost of capital A company’s cost of capital can be used as: A discount rate in investment appraisal A benchmark for company performance Calculating a company’s cost of capital can be difficult and time consuming To calculate the weighted average cost of capital, need first to find the cost of capital of each source of long-term finance used by a company

Ordinary shares In previous lectures we have seen that equity finance can be raised either by issuing new ordinary shares or by using retained earnings The cost of equity can be calculated using the dividend growth model as: where: Ke = cost of equity D0 = current dividend g = the expected growth rate of dividends P0 = the current ex-dividend share price

Ordinary shares The cost of equity can also be found from the CAPM: Rj = Rf + βj (Rm - Rf) where: Rm = return of the market Rf = risk-free rate of return (Rm – Rf) = equity risk premium βj = beta value of ordinary share CAPM allows shareholders to determine their required rate of return, based on the risk-free rate of return plus an equity risk premium

Retained earnings It is a mistake to consider retained earnings as a free source of finance Retained earnings have an opportunity cost, which is equal to the cost of equity If retained earnings were returned to shareholders they could have achieved a return equal to the cost of equity through personal reinvestment The cost of retained earnings can be found in the same way as the cost of equity

Preference shares Dividend paid on preference shares is usually constant The cost of preference shares is found by dividing the preference dividend by the ex dividend market price: where: Kps = cost of preference shares P0 = current ex dividend preference share price Dp = preference dividend Preference shares are normally irredeemable (i.e. they do not have to be repaid by the company after the term for which the preference shares have been issued). Preference dividends are not tax-deducible because they are a distribution of after tax profits

Kid(after-tax) = Kid(1 – CT) Irredeemable bonds Like preference shares, bonds involve a constant annual payment in perpetuity Kid = cost of irredeemable bonds I = annual interest payment P0 = current ex interest market price Interest is tax-deductible. The after-tax cost of debt is: Kid(after-tax) = Kid(1 – CT) CT = corporation taxation rate

Example 10% irredeemable bonds Ex interest market price: £72 Corporation tax: 30% Kid (before tax) = 10/72 = 13.9% Kid (after tax) = 13.9 x (1 - 0.3) = 9.7%

Redeemable bonds Redeemable bonds involve several fixed interest payments plus redemption value. The after-tax cost of debt is: I = interest payment RV = redemption value Kd = cost of debt capital n = number of years to maturity CT = corporation tax rate The before-tax cost of debt is found by using I instead of I(1-CT) Kd estimated through linear interpolation or Hawanini-Vora (1992) model

Convertible bonds To calculate the cost of debt need first to determine whether conversion is likely to occur Conversion not expected: bond treated as redeemable debt Conversion expected: cost of capital found by linear interpolation and a modified version on the redeemable bond valuation model Use number of years to conversion (not to redemption) Use future conversion value (CV) instead of redemption value An after-tax cost of debt is appropriate only if the company is in a profitable position, i.e. has taxable profits against which to set its interest payments

Bank borrowings Bank borrowings are not traded and have no market value that interest can be related to The cost of bank borrowings can be proxied by the average interest paid: interest paid in a period divided by average borrowings for that period Alternatively, the cost of traded debt issued by a company may be used as a best approximation Appropriate adjustments to allow for tax-deducibility of interest payments are needed

The relationship between the costs of different sources of finance The cost of each finance source is linked to the risk faced by each supplier of finance Equity finance: highest level of risk faced by investors, hence most expensive source of finance The cost of preference shares is less than the cost of ordinary shares as the former are less risky and rank higher in the creditor hierarchy Debt finance: generally no uncertainty on interest payments. Debt further up the creditor hierarchy. Hence, the cost of debt less is than the cost of equity Whether bank debts are cheaper than bonds depends on the relative costs of obtaining a bank loan and issuing bonds, the amount of debt and the length of period over which debt is raised Risk of equity finance due to uncertainty on dividend payments and capital gains, and ranking of ordinary shares at the bottom of the creditor hierarchy

Calculating the weighted average cost of capital (WACC) The costs of individual sources of finance are weighted according to their relative importance as sources of finance E = value of equity D = value of debt Ke = cost of equity Kd = cost of debt E/(E+D) is the proportion of equity D/(E+D) is the proportion of debt CT = taxation rate The equation will expand in proportion to the number of different sources of finance used by a company

Market value or book value weighting? Book values are historical and are obtained from a company’s accounts Book values rarely reflect the current required rate of return of providers of finance Example: an ordinary share with a nominal value of 25p has a market value of £1.76 Book values will underestimate the impact of the cost of equity on the average cost of capital, hence unprofitable projects will be accepted Market values reflect current requirements and can be obtained from financial press and databases

Class activity Source of finance Cost Market value (£000) Equity Ke = 16.9% 633.6 Preference shares Kp = 13.4% 33.5 Irredeemable debt Kid = 9.7% 68.4 Redeemable debt Krd = 8.7% 76.0 Bank loans Kbl = 8.8% 60.0 871.5 Note: the relative costs of the different sources reflect their relative risks, i.e. the risk-return hierarchy of financial securities Required: in groups of four calculate the WACC

Solution

Average and marginal cost of capital So far we have looked at how to calculate the cost of capital on an average basis by using book values or market values The cost of capital can also be calculated on a marginal basis, as the cost of the next increment of capital raised

Average and marginal cost of capital AC MC Quantity of capital

Average or marginal cost of capital? The marginal cost of capital should be preferred but it is difficult to allocate particular funding to a specific project WACC can be used if the following are satisfied: The business risk of an investment project is similar to the business risk of a company’s current operations Incremental finance is raised in proportions that preserve the existing capital structure The required return of existing finance sources is not affected by a new investment project

Practical problems with WACC Calculating the cost of particular sources of finance may not be straightforward Ordinary shares of private companies Solution: use the cost of equity for a listed company, with similar characteristics and add a premium to reflect the higher risk of the private company Market value of bonds Solution: find the market value of a bond issued by another company, with similar maturity, risk and interest rate, and use this market value as a proxy The accuracy of the calculated cost of capital depends on the reliability of the models used

Practical problems with WACC Which sources of finance should be included in the WACC calculation? Finance sources used to fund the long-term investments of a company should be included in the calculation of WACC What about a bank overdraft used on an ongoing basis? The difficulty of finding the market value of securities impacts on the weightings applied Both market and book values are used in practice Debt finance raised in foreign currencies needs to be converted WACC is not constant: changes in the market value of securities and in macroeconomic conditions affect a company’s average cost of capital

WACC in the real world Companies pay attention to the value of WACC In recent years WACC received attention also from national regulatory bodies to determine what is considered to be a ‘fair’ level of profit Several companies claimed that the cost of capital calculated by the regulatory body underestimated their true cost of capital

Gearing The term refers to the amount of debt finance a company uses relative to its equity finance Gearing ratios assess financial risk: Debt/equity ratio: long-term debt / shareholders’ funds Capital gearing: long-term debt / capital employed (i.e. D+E) Market values preferred to book values The nature of the industry in which a company operates is a major factor in determining what the market considers to be an appropriate level of gearing Typically, the lower the business risk the higher the gearing

Implications of high gearing Increased volatility of equity returns arises with high gearing since interest must be paid before paying returns to shareholders Increased risk of bankruptcy also occurs Stock exchange credibility falls as investors learn about company’s financial position Short-termism moves managers’ focus away from maximisation of shareholder wealth

Summary Today we looked at: How to calculate the cost of different sources of finance How to calculate the WACC Average vs. marginal cost of capital Main issues arising from WACC

Readings Textbook Research papers Watson, D., Head, A. (2009). Corporate Finance. Principles & Practice, 5th Ed., FT Prentice Hall – Chapter 9 Research papers Miller, R. A. (2009), The Weighted Average Cost of Capital is not Quite Right, The Quarterly Review of Economics and Finance, Vol. 49, 3, pp. 128-138 Bade, B. (2009), Comment on “The Weighted Average Cost of Capital is not Quite Right”, The Quarterly Review of Economics and Finance, Vol. 49, 4, pp. 1476-1480 McGowan, C.B., Tessema, A., Collier, H.W. (2004), A Comparison of the Weighted Average Cost of Capital for Multinational Corporations: The Case of the Automobile Industry Versus the Soft Drink Industry, The Journal of Current Research in Global Business, Vol. 6, 9, pp.82-88

Your tutorial activity for next week During the seminar you will be expected to work on: Q1 p.298; Q3 p.299 (5th ed) Q1 p.278; Q3 p.279 (4th ed) To prepare for the seminar you should answer the following practice questions: Q3,4,5,9 p.295-6 (5th ed) Q3,4,5,10 p.274-5 (4th ed)