04.04.2016 F3 Exam Techniques Webinar
04.04.2016 F3 Exam Techniques Webinar
04.04.2016 F3 Exam Techniques Webinar
1.1 Introduction
A business raises funds from its investors (both equity and debt investors) and uses those funds to try to
generate returns. These investors are therefore taking a RISK by trusting that the business will spend
their money wisely. Consequently, investors require a return to compensate them for taking this risk. This
is what we call the “investors’ required return” or if just looking at the shareholders’ position the
“shareholders’ required return”.
This required return should be viewed as the MINIMUM return that a business should look to generate
from projects if it is to add value to investors. Consider a simple example from your everyday lives. If you
borrow money from a bank at an interest rate of 8% and use that money to buy some investments that
only generate you a 6% return you will be out of pocket!
A Financial Manager will need to be able to estimate what return the company’s investors want overall so
they can judge whether the project they are looking into is going to offer a sufficiently high return to add
value to the shareholders.
The Financial Manager will actually be concerned with what the overall cost of the finance to the
company is after taking into account any tax relief available on the finance source (i.e. tax relief on
interest). This is then known as the weighted average cost of capital, WACC to the business if there is
more than one finance source.
TP has $200m of finance from investors in total, consisting of 60% ($120m) equity and 40% ($80m) debt.
The equity investors’ required return is 10% whereas the debt investors only require a return of 5% since
their risk is lower (e.g. the debt is secured).
Estimate the overall average investors’ required return and hence the WACC (ignore taxation).
SOLUTION
The overall average cost of TP’s capital can be found by taking a simple weighted average of the costs of
the two sources as follows:
WACC = {10% × 60%} + {5% × 40%} = 8%
This cost of capital can then be used as the discount rate (hurdle rate) for appraising potential projects
using NPV analysis
The main purpose of the section that follows is to demonstrate how the above calculation can be
performed in more complex scenarios where you may have to calculate the cost of capital to a company.
The following formula is given in the exam for this purpose but basically just does what we did above to
get to 8%. Sometimes this is referred to as the “traditional WACC formula”.
VE VD
WACC = k eg [V ] + k d [1 − t] [V ]
E +VD E +VD
Where,
keg = cost of equity in a geared company
kd = cost of debt (after tax)
VE = market value of equity
VD = market value of debt
It is acceptable to use the book value (statement of financial position value) of debt and equity if there is
insufficient information in the question to be able to estimate the market value.
1
Note
If a company has more than two sources of finance (quite likely in practice) and each has a separate cost
then the above formula would be extended. For example, if there were preference shares as well the
formula would become:
𝑉𝐸 𝑉𝐷 𝑉𝑃
𝑊𝐴𝐶𝐶 = 𝑘𝑒𝑔 [𝑉 ] + 𝑘𝑑 [1 − 𝑡] [𝑉 ] + 𝑘𝑃 [𝑉 ]
𝐸 +𝑉𝐷 +𝑉𝑃 𝐸 +𝑉𝐷 +𝑉𝑃 𝐸 +𝑉𝐷 +𝑉𝑃
It is currently 1st Feb 2016 and SCS Co is financed with a mixture of equity and debt. It has just paid a
dividend of 45 cents on its 4.5 million ordinary shares which have a market value of $5.25. The constant
dividend growth rate is 6%. The 7% redeemable debt currently has a market value of 97% cum-interest
and is due to be redeemed at par on 31st Jan 2020. The after tax cost to the company of this redeemable
debt has correctly been calculated as 7.9%. The corporation tax rate is 30%. An extract from SCS's
statement of financial position shows the following.
$
Debt 10,000,000
Shareholders’ funds 19,450,000
What is the WACC for SCS Co?
SOLUTION
Step 1 - If we first consider the cost and market value of the ordinary shares
Step 2 – Now consider the cost and market value of the debt
2
1.1.2 Uses of the WACC
The WACC can be used as the hurdle rate (cost of capital/discount rate) for appraising future projects
(subject to the conditions below). A project that offers a return that is higher than the WACC is worth
doing (i.e. positive NPV) since it generates an amount in excess of that which would be necessary to
repay the finance providers.
Note
If a project is being financed with a specific source of finance (e.g. a bank loan), then the exam question
might suggest using the cost of the bank loan as the discount rate to appraise the project. This is wrong
since it ignores the impact that the project and the loan are having on the other finance providers
(particularly the shareholders).
Projects generally should be considered to be financed out of the overall pool of funds that the company
has and so a WACC is likely to be a more appropriate discount rate as this considers returns required to
all finance providers.
3
2 Capital Structure
You may be required to estimate a relevant cost of capital (cost of equity or WACC) for a business
valuation and consequently might need to identify risk levels in relation to a business you are trying to
value.
4
Total
portfolio
risk
Unsystematic risk
(unique risk)
Systematic risk
(market risk)
As you have seen the β factor is the measure of risk facing the investor which when put into the CAPM
indicates the required return of that investor (i.e. for equity investors this is Ke ).
If you already have a diversified portfolio of investments or are a company with diversified shareholders
you can estimate the beta factor for the portfolio/company by working out a weighted average beta
based on what proportion of the portfolio/company each investment makes up. This is shown in the
following illustration.
Steve currently has a diversified portfolio of investments worth $60,000 with an overall β of 1.3. He is
considering investing a further $40,000 in Wacky, a company with a current β of 1.5. The risk free rate is
currently 6% and the return on the market is 14%.
Estimate the risk and required return of the new portfolio including Wacky.
SOLUTION
Since Steve is a diversified investor the estimated risk of the portfolio can be calculated by simply using a
weighted average of the β factors within the overall portfolio.
Steve will have a total investment of $100,000 of which 60% comes from his existing portfolio and 40%
would be Wacky.
∴ Risk(β)of new portfolio = (0.6 × 1.3) + (0.4 × 1.5) = 𝟏. 𝟑𝟖
The required return can then be calculated by using this new β in the CAPM.
k e (required return) = R f + [R m − R f ]β = 6% + [14% − 6%]1.38 = 𝟏𝟕. 𝟎𝟒%
5
Tax (30%) (30,000) (18,000) (24,000) (12,000)
Potential dividends 70,000 ↓40% 42,000 56,000 ↓50% 28,000
The simple illustration shows that a company with debt (Geared Co) has potential dividends that are
more volatile than the company with no debt (Ungeared Co). This occurs because the interest payments
are fixed regardless of operating performance.
The conclusion is that,
Note on terminology
You may sometimes see a geared β called an equity β and an ungeared β called an asset β.
To help visualise this consider the following diagram.
keu
𝑉𝐷
Gearing 𝐸𝑉𝐸
Alternatively, points on the cost of equity line can be found using the following formula (given in exam)
directly:
𝑉𝐷 (1−𝑡)
𝑘𝑒𝑔 = 𝑘𝑒𝑢 + [𝑘𝑒𝑢 − 𝑘𝑑 ] 𝑉𝐸
Note that βd refers to a debt beta. Debt betas are normally assumed to be zero (unless told otherwise in
a question). If a debt beta is zero it simply means that the company can be assumed to be able to borrow
at the risk free rate.
6
ILLUSTRATION 2.2: BETA FACTORS
PBB is considering an investment in the mobile phone market, a market that is different to its current
operations. PBB is an all equity funded business and wishes to remain so.
Phones5Me is a listed mobile phone business with a published beta (this will be a geared beta) of 1.6 and
𝐷
an existing gearing ratio (𝐷+𝐸) of 25%.
What cost of capital would it be appropriate for PBB to use in order to appraise this investment if the risk
free rate is 5% and the return on the market is 12%?
Taxation is at 30% and assume all corporate debt is risk free (i.e. debt beta is zero).
SOLUTION
Typically we would need to find a WACC, however be careful here since PBB is an all equity funded
business it will not have any debt and hence the WACC = Cost of equity ungeared = Keu.
∴ we will need to find the ungeared cost of equity.
There are always two ways of finding the cost of equity, DGM or CAPM. Here we have no dividend
information but we do have beta factors so we can safely assume the CAPM is required.
To use the CAPM we will need a beta factor that reflects the business risk of the mobile phone market
but with PBB’s financial risk (i.e. with no debt hence no financial risk).Therefore we need an ungeared
beta. We are given a geared beta for Phones5Me and we will need to “ungear” this.
𝑉𝐸
𝛽𝑢 = 𝛽𝑔 [ ]
𝑉𝐸 +𝑉𝐷 (1−𝑡)
75 75
𝛽𝑢 = 1.6 [75+25(0.7)] = 1.6 [92.5] = 1.297
We now need to put this beta factor into the CAPM to find keu
𝑘𝑒 = 𝑅𝑓 + (𝑅𝑚 − 𝑅𝑓 )𝛽
𝑘𝑒𝑢 = 5% + (12% − 5%)1.297 = 𝟏𝟒. 𝟎𝟖%
ED and GOR are identical businesses in all respects apart from ED being financed entirely by equity and
GOR having a debt:equity ratio of 1:2. ED’s cost of equity is 14% and GOR’s pre-tax cost of debt is 10%.
Tax is payable at 25%.
What is GOR’s cost of equity?
SOLUTION
7
LECTURE EXAMPLE 2.2: GEARING AND UNGEARING BETAS
The board of MN, an unlisted company, needs to derive its cost of equity so that it can carry out a
valuation of the company. The board is aware that the expected return on the market portfolio is 12%
and the current return on a risk-free asset is 5%. The tax rate is 30%.
A similar listed company in the same industry sector to MN has an equity beta of 1.62 and a debt equity
ratio of 1:2. MN’s debt-equity ratio is 1:5. Debt can be assumed to be risk-free.
Calculate MN’s cost of equity to the nearest 0.01%.
SOLUTION
Increase the
level of debt
Suggests it Suggests it
would be a good
idea to use
? would be a good
idea to use less
more debt debt
The question is which one of the two factors dominates (i.e. does the WACC actually go up or down when
the level of debt rises)?
The answer is that it depends on which theory you believe. The F3 syllabus requires a basic awareness of
the following theories;
Traditional theory
Modigliani & Miller (no tax)
Modigliani & Miller (with tax)
8
One fundamental point about the theories is that they agree that lower the WACC is, the higher the NPV
of projects is and hence the higher the market value of the business is (MV of business being the MVdebt
+ MVequity). This is because if you discount the operating cash flows of a business at a lower WACC then
the PV of those cash flows will be higher.
9
2.3.3 M&M (With TAX) – 1963 proposition
𝑽𝑫 [𝟏−𝑻]
𝒌𝒆𝒈 = 𝒌𝒆𝒖 + [(𝒌𝒆𝒖 − 𝒌𝒅 ) ( )]
𝑽𝑬
Value of a company
𝑽𝒈 = 𝑽𝒖 + 𝑻𝑩
10
M&M make a few fairly limiting assumptions including;
Debt is always risk free (big assumption) and hence the cost of debt remains at the risk free rate
regardless of the level of gearing.
Perfect capital markets (perfect information, rational risk averse investors and no transaction
costs).
Individuals and companies can borrow and invest at the same rate.
Investors are indifferent between personal and corporate gearing. In other words investors do not
mind whether they invest in a company that has some debt or they borrow money personally to
invest in an all equity funded business.
Green Man operates in the wallpaper design industry, where most of the customers are large hotels. The
Managing Director has identified an opportunity to diversify into the manufacturing of cranes for the
construction industry by buying a Crane manufacturer, Dweeb Ltd, that has the same level of gearing as
Green Man currently has.
Green Man’s gearing is currently represented by a D:E ratio of 2:5.
Green Man currently has a WACC of 14% and a published beta of 1.1. Nacre is a listed crane
manufacturer with a beta factor of 1.8 and a D:E ratio of 3:4. The average stock market return over
recent years has been 10% and the risk free rate is 4%.
Assuming that both Green Man, Dweeb Ltd and Nacre can borrow at the risk free rate (i.e. the 𝛽𝑑 = 0)
what would be a suitable WACC for Green Man to use when valuing Dweeb Ltd. The tax rate is 30%.
SOLUTION
11