1. F9 Financial Management

2. 2 Designed to give you the knowledge and application of: Section F: Estimating the cost of equity F1. Sources of finance and their short-term finance F2. Estimating the cost of equity F6. Impact of cost of capital on investments

3. 3 Learning Outcomes  Relationship between company value and cost of capital. [2]  Discuss the circumstances under which WACC can be used in investment appraisal. [2]  Discuss the advantages of the CAPM over WACC in determining a project-specific cost of capital. [2]  Apply the CAPM in calculating a project-specific discount rate. [2] F6. Impact of cost of capital on investments

4. 4 Relationship between company value and cost of capital Inverse relationship between value of firm and its cost of capital Vice-versa also applicable Leads to Increase in cost of capital Decrease in the value of the firm Return generated from project Should exceed Cost of employing resources to that activity Return company gets from employing new projects Should exceed Cost of resources required for its employment

5. 5 Example Assume a company invests $100,000 in a project and it expects a return of 10% on this investment If the NPV generated by the project is more than 10% then the objective of the company is achieved. Example

6. 6 Cost of capital Investment decision Finance decision Cost of capital  The rate of return is required to reward investors for the level of risk they have accepted.  It is the hurdle rate, which the company’s project needs to generate a return in order to satisfy the providers of that capital.  The cost of capital is the ‘Hurdle Rate’  It is the discount rate used for the calculation the net present value of potential future projects.  If the project’s cash flow generate a positive NPV at the weighted – average cost of capital, the company will have added to its investors wealth.

7. 7 The circumstances under which WACC can be used in investment appraisal WACC Represents overall compensation for the average risk of projects which it may undertake in near future.  Used as discount rate to determine projects NPV considering investment project of ‘average risk’ and maintaining its target debt-equity mix.  WACC, as the discount rate, incorporates the tax shield impact of debt.  The use of the firm’s WACC to evaluate individual projects with different risk characteristics is inappropriate.  A common practice in choosing a discount rate for a project is to apply a WACC that applies to the entire firm, but a higher discount rate may be more appropriate when a project’s risk is higher than the risk of the firm as a whole. Common practice

8. 8 Circumstances under which WACC is used for different project risk profile Approach Divide projects into broad risk classes and use different discount rates Replacement & modernisation projects Can estimate benefits of replacement / modernisation of projects with relative accuracy Investments for expansion of current business Revenue & cost estimates are relatively difficult. Variability of cash flows can be estimated with judgements Diversification into new business Difficulty in estimating cash flows as it shows high variability. Risk classes Low risk projectsMedium risk projectsHigh risk projects Risk and return go hand in hand, i.e. the higher the risk, the higher the return and vice-versa. Hence, the risk factor in higher risk projects should be reflected with a higher discount rate.

9. 9 Advantages of WACC It uses market data and hence there is less room for manipulation by managers It sticks to its target debt – equity mix Disadvantages of WACC Fails to distinguish between projects with different risk characteristics Reflects average risk that can be misleading when deciding on appropriate project Advantages & Disadvantages of WACC

10. 10 The advantages of the CAPM over WACC in determining a project- specific cost of capital  CAPM allows the calculation of risk - adjusted discount rates for use in project appraisal.  It works on the simple idea that investors will require at least a risk - free rate of return when investing in a project.  They will also require a premium to compensate them for the particular risk of the investment.  Since the investors’ required rate of return is exactly the same as the cost of equity to the company, CAPM can be used to calculate the cost of equity. Risk adjusted discounted rate (CAPM) and WACC

11. 11 Apply the CAPM in calculating a project-specific discount rate  CAPM is a method of calculating the return required on an investment, based on an assessment of its risk.  The CAPM assumes that investors hold fully diversified portfolios.  The investors are assumed by the CAPM to want a return on an investment based on its systematic risk alone, rather than on its total risk.  The measure of risk used in the CAPM, which is called ‘beta’, is therefore a measure of systematic risk. CAPM Refer to Example (page 411)

12. 12  The beta is a key parameter in the capital asset pricing model.  The beta takes into account a project’s total systematic risk i.e. the risk arising from the nature of a company’s business (business risk) and the risk arising from the way in which the company finances itself (financial risk).  A firm’s assets are financed by debt and equity.  Therefore, a firm’s asset beta (also called the ungeared beta or unlevered beta) will be equal to the weighted average of the firm’s equity beta (β e ) and debt beta (β d ).  This relationship can be represented as follows: E D β a = β e x --------- + β d x ----------- E + D E + D  The asset beta can also be represented by the following formula which is often used in the calculation of the unlevering of equity betas. E Asset Beta = Equity beta x --------------------- E + D (1 – t) Equity beta = Asset beta x ----------------------- E Where, E is the market value of equity, D is the market value of debt t is the tax rate Asset Beta

13. 13  The ratio of a company's long - term funds with fixed interest to its total capital.  It describe the relationship between the relative proportions of debt and equity finance used by the firm.  The ‘market gearing’ of a company is a measure of the company’s gearing based on its market value of debt and equity  Market gearing can be calculated by using the following formula D --------- E + D Where, D is the market value of debt E is the market value of equity Gearing Example Calculate the market gearing ratio of Spiral Co assuming: 1. it has two million equity shares quoting $1.5 each; and 2. $3.5m of debt with a market value of 80% Answer: Market value of equity (E) = 2,000,000 x 1.5 = 3,000,000 Market value of debt (D) = 3,500,000 x 0.80 = 2,800,000 Using the above formula, market gearing can be calculated as 2,800,000 = ---------------------------------- = 0.48 2,800,000 + 3,000,000

14. 14  Equity betas reflect not only the business risk of a company’s operations, but also the financial risk of a company.  The systematic risk represented by equity betas, therefore, includes both business risk and financial risk.  In a project-specific discount rate, it is necessary to remove the effect of the financial risk or gearing from each of the proxy equity betas in order to find their asset betas, which are betas that reflect business risk alone.  If a company has no gearing, and hence no financial risk, its equity beta and its asset beta are identical.  If the equity beta, the gearing, and the tax rate of the proxy company are known, this amended asset beta formula can be used to calculate the proxy company’s asset beta.  Since this calculation removes the effect of the financial risk or gearing of the proxy company from the proxy beta, it is usually called ‘ungearing the equity beta’.  Similarly, the amended asset beta formula is called the ‘ungearing formula’. Equity Beta  Locate suitable proxy companies.  Determine the equity betas of the proxy companies, their gearings and tax rates.  Ungear the proxy equity betas to obtain asset betas.  Calculate an average asset beta.  Use the CAPM to calculate a project-specific cost of equity. Steps in calculating the project- specific discount rate using CAPM Reference: Taken from student accountant (April 2008) – Project- specific discount rates

15. 15  The base case NPV, is calculated assuming that the project is financed entirely by equity.  It is necessary to calculate the cost of equity in an entirely equity-financed company in the same industry to which the company belongs.  But the comparable companies may have different levels of debt.  Thus, an adjustment needs to be made for the leverage before using the beta of a comparable firm. Identify comparable company in same industry as company Calculate beta of company Calculate equity beta by levering asset beta calculated above Calculate comparable company’s asset beta by adjusting beta for leverage and tax Levering (gearing) and unlevering (degearing) the beta Steps for levering and unlevering beta

16. 16 Recap  Relationship between company value and cost of capital. [2]  Discuss the circumstances under which WACC can be used in investment appraisal. [2]  Discuss the advantages of the CAPM over WACC in determining a project-specific cost of capital. [2]  Apply the CAPM in calculating a project-specific discount rate. [2]

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