Investment Analysis Lecture: 13 Course Code: MBF702

Outline RECAP OBJECTIVES OF SECUIRTY VALUATION AND COST OF CAPITAL WEIGHTED AVERAGE COST OF CAPITAL ESTIMATING INPUTS : DISCOUNT RATES SECUIRTY VALUATION AND COST OF CAPITAL DIVIDEND VALUATION MODEL COST OF EQUITY COST OF PREFERENCE SHARES

Objectives To develop a model for the valuation of shares and bonds. To use this model to estimate the cost of equity and the cost of debt. To consider further practical influences on the valuation of securities.

Weighted average cost of capital (WACC) The cost of capital for investors is the return that investors require from their investment. Companies must be able to make a sufficient return from their own capital investments to pay the returns required by their shareholders and holders of debt capital. The cost of capital for investors therefore establishes a cost of capital for companies. For each company there is a cost of equity. This is the return required by its shareholders, in the form of dividends or share price growth There is a cost for each item of debt finance. This is the yield required by the lender or bond investor

Weighted average cost of capital (WACC) Expected return is what the debt holders and shareholders expect from the company. This is the cost of capital and in turn the required rate – i.e. Weighted Average Cost of Capital (WACC) Where, Ke = Cost of equityE = Market Value of equityKd = Cost of Debt (always post tax) D = Market value of Debt In case of a new project, the required rate of return for a company is the Marginal Cost of Capital (MCC)

Elements of cost of capital

Weighted average cost of capital (WACC) When there are preference shares, there is also a cost of preference share capital, which is the dividend yield required by the shareholders. The cost of capital for a company is the return that it must make on its investments so that it can afford to pay its investors the returns that they require. The cost of capital for investors and the cost of capital for companies should theoretically be the same. However, they are different because of the differing tax positions of investors and companies.

Weighted average cost of capital (WACC) The cost of capital for investors is measured as a pre-tax cost of capital. This is a return ignoring taxation. The weighted average cost of capital is the average cost of all the sources of capital that a company uses. This average is weighted, to allow for the relative proportions of the different types of capital in the company’s capital structure.

WACC and capital investment appraisal One approach to the evaluation of capital investments by companies is that all their investment projects should be expected to provide a return equal to or in excess of the WACC. If all their investment projects earn a return in excess of the WACC, the company will earn sufficient returns overall to meet the cost of its capital and provide its investors with the returns they require. This principle is often applied in practice. The general rule is that when capital investment projects are evaluated using the NPV method, the cost of capital to be used is the WACC. This is on the assumption that the capital project will not alter the risk profile of the company’s investments and the risk with the new project is similar to the risks with the rest of the company’s business operations.

WACC and capital investment appraisal The principle is often applied when the financing for a new capital investment changes the company’s WACC. On the assumption that the capital project will not alter the risk profile of the company’s investments, the NPV of the new project should be calculated using the new WACC that will exist after the project has been undertaken and financed. An alternative approach to the evaluation of capital investment projects, which does not use these assumptions, is the adjusted present value method or APV method.

Comparing the cost of equity and the cost of debt For investors and for companies, the cost of their equity is always higher than the cost of their debt capital. This is because equity investment in a company is always more risky than investment in the debt capital of the same company. In addition, from a company’s perspective, the cost of debt is also reduced by the tax relief on interest payments. This makes debt finance even lower than the cost of equity. The effect of more debt capital, and higher financial gearing, on the WACC is considered in more detail later.

Security valuation and cost of capital

Estimating Inputs: Discount Rates Critical ingredient in discounted cash flow valuation. Errors in estimating the discount rate or mismatching cash flows and discount rates can lead to serious errors in valuation. At an intuitive level, the discount rate used should be consistent with both the riskiness and the type of cash flow being discounted. –Equity versus Firm: If the cash flows being discounted are cash flows to equity, the appropriate discount rate is a cost of equity. If the cash flows are cash flows to the firm, the appropriate discount rate is the cost of capital. –Currency: The currency in which the cash flows are estimated should also be the currency in which the discount rate is estimated. –Nominal versus Real: If the cash flows being discounted are nominal cash flows (i.e., reflect expected inflation), the discount rate should be nominal

WHAT GOES INTO THE DISCOUNT RATE? The discount rate should reflect the cost of capital or the cost of funds used to finance the business. An investment is not acceptable unless it generates a return sufficient to cover the cost of funds.

DIVIDEND VALUATION MODEL The theoretical model The dividend valuation model states that: “the market value of a share or other security is equal to the present value of the future expected cash flows from the security discounted at the investor's required rate of return”. In terms of a formula for a share valuation this can be expressed as follows:

DIVIDEND VALUATION MODEL The theoretical model As per the model, the present value of all future CASH dividend expected shareholder required rate of return would give the market value of equity. Ex-div market value is the market value assuming that a dividend has just been paid.

DIVIDEND VALUATION MODEL The theoretical model The model then becomes: If the dividend is assumed to be constant this is a perpetuity that simplifies to: