Cost of capital final - CIMA

1 TECHNICAL | cost OF CAPITAL22 CIMA Insider March 2002 wacc attackIan CorneliusThe first part in a series of three articles explaining the many aspects of cost of capital theoryThe cost of capital is a huge subject,incorporating many of the mostfamous and controversial theories infinancial management. Given its breadth, itis tempting to treat it as a series of discretetopics with no common thread. This wouldbe a mistake. The key to unlocking themysteries of the cost of capital is to under-stand how all of these strands come is particularly important for final -levelstudents to gain a global overview of thesubject and to understand how it links withother areas of the a series of three articles I will cover allof the major topics under the cost ofcapital heading namely:lhow to make basic weighted-average costof capital ( wacc ) calculations;lhow different gearing levels affect theWACC ( capital structure theory);lhow to use the capital asset pricing model(CAPM) to calculate the cost of equity;lhow to use the adjusted present value(APV) three articles should be of use to finallevel Financial Strategy (FLFS) students,but those at intermediate level will also findparts in this first article relevant to thesyllabus they are studying.

2 The cost of capital can be thought of asthe minimum return required by providersof finance for investing in an asset, whetherthat is a project, a business unit or an entirecompany. It needs to reflect the capitalstructure used to finance the investment. Assuch, it is likely to include the cost of equityand as an annual percentagereturn, it represents the hurdle rate that acompany s projects must exceed if they areto increase the investors wealth. So the costof capital is used as the discount rate innet present value (NPV) project appraisaltechniques. Projects that earn positive NPVat the cost of capital are accepted becausethey earn more than the investors requiredrate of return and will add to their NPV projects are rejected becausethey reduce the investor s wealth by earningless than their target rate of cost of capital therefore has a pivotalrole to play in corporate finance, formingthe link between the investment decision(what the company should be spendingmoney on) and the finance decision (how itshould be funding that spend).

3 The weighted-average cost of capital ( wacc ) represents the overall cost of capi-tal for a company, incorporating the costs ofequity, debt and preference share capital ,weighted according to the proportion ofeach source of finance within the business. The models used to calculate the cost ofeach source all start from the premise that therequired rate of return is a function of theinvestors expectations of future cash-flowreturns, expressed as a percentage of thecurrent value of their investment. The cost ofequity share capital is calculated using thedividend valuation model. The usualassumption made is that future dividends areexpected to grow at a reasonably even rate. Preference share capital usually pays aconstant dividend each year, so no growthfunction is required. For debt, the futurecash-flow stream is the interest with preference shares, these cash flowsare constant, but, given that a company candeduct interest payments in determiningtaxable profits, it will experience a tax savingon the interest it pays.

4 This tax shieldreduces the cost of debt finance from thecompany s perspective. In practice, the firm s wacc is often usedas the discount rate to appraise new pro-jects. But it is crucial to realise that thisapproach makes three key assumptions:lthat the project has the same businessrisk as existing activities;lthat the project does not change thefinancial structure of the business;lthat the project is financed from a poolof funds .The third assumption is not usually aproblem. Most finance is not project-specific. Projects draw on the company sgeneral pool of finance, which incorporatesfunds from all of the company s financeproviders. The cost of using this pool offinance is, of course, the first two assumptions cause the mainproblems here. The company s wacc reflects the riskiness of its current also reflects the current financial structureand gearing risk. If a new project changeseither of these risk profiles, the wacc becomes an inappropriate discount rate.

5 When considering the effect of differentcapital structures on the wacc , it is impor-tant to focus on the action of two competingforces as the company gears up. The firstforce recognises that debt finance is cheaperthan equity finance. As a firm increases itsgearing, the proportion of this cheapfinance within the capital structure inc-reases. All other things being equal, this willreduce the wacc . The second force focuses on the cost ofequity. As a company gears up, shareholders returns become increasingly volatile, owingto the fixed interest bill that must be repaidbefore they are given their cut. This extra riskincreases their required rate of return. Allother things being equal, this increasing costof equity will increase the overall effect on the wacc dependson the relative size and strength of these twoopposing forces. There are two schools ofthought here. The traditional view of capitalstructure theory, based on observation andintuition, suggests that an optimum capitalstructure exists.

6 This minimises a firm sWACC and therefore maximises its value. Sothe finance decision is as relevant to a firm svalue as the investment 1958 two economists, Merton Millerand Franco Modigliani (M&M), presented aradically different view of capital structuretheory. They suggested that value was about what you do (the investment decision).How you financed it, they argued, wasirrelevant. In their arbitrage proof , theydemonstrated that two firms with identicalinvestments would have the same value,regardless of their gearing. This theory is rock-solid, given theassumptions it makes. In a market with noimperfections, getting obsessed aboutwhere the money comes from is indeedmisguided businesses should focus on theTECHNICAL | cost OF CAPITAL23 March 2002 CIMA Insiderquality of their investment decisions. Theproblem is that the world is not perfect. Inparticular, the presence of taxation givesdebt finance an additional advantage.

7 Because interest is tax-deductible, the useof debt finance gives rise to a tax saving. Soin 1963 M&M republished their model topropose that the value of a geared firm wasthe value of the equivalent ungeared firmplus the present value of any tax shieldgenerated by the use of debt finance. Thissuggested that the optimum gearing levelwas 100 per cent. In the real world, companies do not raisetheir debt-to-equity ratios to such extremelevels. This is because at high levels of gear-ing the costs of financial distress that maylead to liquidation are much more means that the cost of equity and debtincrease significantly at high levels of gear-ing, causing the wacc to traditional view of capital structuretheory, leading through M&M s 1958 and1963 positions, together with the finalcompromise position taking into accountfinancial distress, is summarised in thepanel. It suggests that, given market imper-fections, the wacc is affected by changes inthe gearing level within the is clear that the wacc lies at the heartof finance, linking together the key areas ofthe investment and finance decisions tomeasure whether the business has createdor destroyed value.

8 What is not yet clear ishow the wacc is affected for changes inbusiness risk that is, the fundamentalinherent risk of the sector in which thecompany operates. To grasp this, you needto understand what is arguably the mostfamous financial theory to appear in thepast 40 years: the capital asset pricingmodel (CAPM). This will be the subject ofthe next article in this series. nIan Cornelius is director of ATC svalue creation department andspecialises in final level FinancialStrategy. He has co-written two bookson shareholder value. He can becontacted at theory in developmentThe traditional viewlIncreasing use of cheap debtfinance dominates at low gear-ing, pushing the wacc increasing cost of equitydominates at high gearing,pushing the wacc optimum capital structureexists, minimising the WACCand maximising the firm s I 1958lValue is a function of the invest-ment decision, rather than thefinance identical businesses withdifferent gearing should haveidentical values and gearing up, no force domi-nates.

9 The increased use of debtfinance is balanced exactly byan increasing cost of equity,leaving the wacc a perfect market there is nooptimum gearing level. Com-panies should focus on theinvestment decision II 1963lOnce tax is introduced, debtfinance becomes even cheaper,owing to the tax deductibility ofthe interest becomes the dominantforce. Increasing gearing leadsto reduced wacc and increasedcompany increase in value is the taxshield. To optimise this benefit,firms should gear up to the high-est level compromise viewlAt extreme gearing levels, thecosts of financial distress be-come significant, pushing theWACC back position is now consistentwith the traditional an imperfect world, the taxshield effect and costs of finan-cial distress probably mean thereis an optimum capital structureGearingGearingGearingCostCostCo strerererdrdWACCWACCWACCWACCTa xshieldreDistress