WACC 19 Flashcards
what is WACC
It is the average cost of raising finance for a business, taking into account both debt and equity capital.
The importance of the weighted average cost of capital
The weighted average cost of capital (WACC) is important because it is used to evaluate the feasibility of investment projects. It represents the minimum rate of return that a company must earn on its investments to satisfy its investors and creditors.\
By using WACC as the discount rate in net present value calculations, a company can determine whether an investment project will generate enough cash flows to cover its costs and provide a return that meets or exceeds the required rate of return
In addition, WACC can be used to determine the optimal capital structure for a company by balancing
the costs and benefits of debt and equity financing.
In this chapter, we usually deal with market values. Thus ‘gearing’ could also be defined as:
market value of debt /
market value of debt market value of equity
or
market value of debt/
market value of equity
(where the market value of the equities and debt (bonds) would be the number of each issued
multiplied by the market price of each)
The cost of debt and the cost of equity
It is the net cost of debt that appears in the formula, where:
It is the net cost of debt that appears in the formula, where:
net cost of debt = gross cost of debt × (1 – t)
where t is the rate of corporation tax.
Interest payments on debt finance are tax deductible. They appear before the tax line on the
statement of profit or loss.
Question
A company’s dividend yield is 3% and the gross redemption yield on its debt is 6%. Discuss the
expected rate of return for an equity investor and the rate of return for a bond investor
Solution
The rate of return for a bond investor is relatively clear; it is the redemption yield on the bond,
namely 6%.
The expected return for equity investors can’t be determined from the information given, as this
is equal to dividend yield plus capital growth.
The equity shareholders are accepting a greater risk than the bond investors, and must therefore
be expecting a return greater than 6%. This greater return must be expected in the form of
capital growth through retained earnings and increasing dividends.CB1-19: WACC Page 5
The Actuarial Education Company © IFE: 2019 Examinations
The term ‘cost of equity’ is the return that the managers of the company have to provide to keep
equity capital providers happy, and in a fair world is equal to the expected return on equity
This is the essence of a weighted cost of capital calculation example.
Example
Suppose that Growmore plc has:
debt with a market value of £100m trading at a gross redemption yield (GRY) of 5% in the
market
£100m market value of equity with analysis suggesting equity investors expecting 10% pa
from their investment.
Growmore’s weighted cost of capital, assuming no tax is paid, is 7.5% pa (ie weighted average of
the cost of equity and the gross cost of debt). If the company can earn 7.5% pa return on its
assets, it can give a 5% pa return to the loan capital providers and a 10% pa return to the equity
capital providers.
This is the essence of a weighted cost of capital calculation.
Question
Explain what is meant by ‘exploiting arbitrage possibilities’.
Solution
Arbitrage is the buying and selling of financial assets in order to make a risk-free profit from
known pricing anomalies.
The MM model predicts that for companies with the same business risk and the same earnings,
the WACC is the same, regardless of gearing.
Let us now consider the effect of gearing on the return on equity.
The following graph shows the rates of return on debt and equity for a single company as its
gearing ratio increases.
Modigliani and Miller argued that the WACC remains constant as gearing increases. As gearing
increases, the cost of equity increases by just enough to offset the increasing proportion of the
cheaper debt.
A more highly geared structure offers a higher return on equity, but it also offers a higher risk.
These two features cancel out to leave the price of the shares, the value of the company and the
WACC unchanged.
Additionally we can argue that increasing the gearing within a company only gives the
shareholders the same increase in returns that they could have achieved themselves by
borrowing money from a bank and buying more shares. So gearing up a company adds no value,
because shareholders can increase their own risk by borrowing money from a bank and buying
more shares.
This thinking was further developed by the Capital Asset Pricing Model (CAPM) which
attempts to provide a coherent framework for understanding the interaction of risk and
return.
Question
Suppose Growmore plc (from page 5) raises a further £50 million of debt finance in order to buy
back shares with a value of £50 million.
Explain the impact on Growmore’s WACC.
Solution
The obvious conclusion would be that the weighted cost of capital would fall, because the
company is now financed by £150 million of 5% debt and £50 million of 10% equity.
However, according to MM, this argument is flawed because the required return of equity
investors would not remain constant if the company structure were changed in this way.
The company is now much more highly geared and the returns to equity investors are likely to be
much more volatile. In fact so much more, that the equity investors will require a return of 15%
in order to hold the shares.
According to MM, the cost of capital is unchanged, being a mixture of £150 million of debt capital
providers requiring 5% pa and £50 million of equity capital providers requiring a return of 15% pa,
the weighted average of which is 7.5% pa.
Question
Suppose Growmore plc’s existing and new debt are likely to trade on a level of (say) 6% GRY to
compensate for the higher risk of default attaching to the company’s debt. The equity holders
have also increased their required return (to 15%) to reflect the greater risk of default and the
greater volatility of the highly geared company. Determine the new WACC.
The cost of capital for the company would now be:
(150x6% +50 *15%)/200
=8.25%
WACC
ie higher than before!
Therefore, in practice, an increase in gearing, beyond the company’s debt capacity, could increase
the company’s WACC.
Conclusion
Putting the above arguments together suggests that increasing the level of debt in the business
will initially reduce the
WACC as the company takes advantage of the lower cost of debt and the
tax relief on debt finance
However, as debt finance increases, both equity holders and debt holders will require a higher
rate of return. There will be a point at which the costs of increasing the gearing begin to
outweigh the benefits and the WACC begins to increase, ie there will be an optimal capital
structure.
Question
Discuss the validity of the following statement:
‘Many investors shy away from equity investment because the risks involved are too high,
therefore the expected return from equities is higher than that from debt.’
Soluti
Solution
This statement is correct.
If an investment in equities is more risky than an investment in bonds, but offers the same
expected return, then rational investors will not buy equities. If investors do not buy equities the
prices will fall. Eventually, at much lower prices, equity investments will offer a much better
prospect, and a higher expected return (ie they become ‘cheaper’).
At this level the equity and bond markets are in equilibrium, offering a trade-off between risk and
return.
Cost of Equity:
The cost of equity represents the opportunity cost of capital, which is the rate that shareholders .
forego by investing in a project rather than alternative securities
Investors expect to be rewarded for the additional risk they take on by investing in .
equity
The cost of equity takes into account the supply and demand considerations in the market and the preference of investors for
steady returns or higher volatility.
Validity of the Statement:
The statement “Many investors shy away from equity investment because the risks involved are too high, therefore the expected return from equities is higher than that from debt” is valid.
If equities are riskier than bonds but offer the same expected return, rational investors would choose bonds instead.
As investors avoid equities, prices would fall, making equity investments more attractive and offering higher expected returns.
Equilibrium is reached when the risk and return trade-off of equities is in balance with the market demand.
The formula for Cost of Equity:
The conventional approach to calculating the cost of equity is:
Cost of Equity = Risk-free rate + Equity risk premium.
The risk-free rate is the return required from a risk-free asset, such as government bonds.
The equity risk premium is the additional reward demanded by equity holders to compensate for the additional risk associated with holding shares instead of risk-free bonds.
More sophisticated versions of the formula may incorporate different risk premiums for different types of equity investments based on their associated risks.
Evidence and Choice of Historical Period:
Historical rates of return on securities, often represented by market indices or bundles of representative securities, are used to
analyze the performance.
Equities have generally outperformed fixed-interest investments over the long term, but there can be ________and ________considerations.
volatility and inflation-adjusted considerations.
A ______and _________period of historical data is preferable, although subsets of data may be appropriate if the nature of constituents in the portfolio has changed.
A long and homogenous period of historical data is preferable
____________, such as_________returns, can enhance the analysis but requires careful interpretation to eliminate bias and statistical factors.
Frequency of data collection, such as monthly or annual returns, can enhance the analysis but requires careful interpretation to eliminate bias and statistical factors.
Real and Nominal Rates:
> Analyzing real rates (adjusted for inflation) removes heterogeneity, while the risk-free rate can be defined on a nominal basis.
The inflation risk premium, which compensates for uncertain inflation rates, is an important consideration.
Historical data can be decomposed into the risk-free rate and the risk premium to estimate the future required opportunity cost.
Practitioners may adjust the risk premium based on their views about the relevance of past experience to future conditions.
Typical Results:
The Barclays Equity Gilt study in the UK provides accessible information on historic returns.
> The study calculates the historic return on equity as 5% real, assuming a risk-free real rate of 1.5-3%, suggesting an equity risk premium of 2-3.5%.
Different calculations, such as the geometric mean and arithmetic mean, can lead to variations in apparent returns.
It’s important to understand the principles and avoid excessive focus on mathematical accuracy when dealing with risk and uncertainty.
Remember, it’s crucial to grasp the principles and apply judgment consistently when
Remember, it’s crucial to grasp the principles and apply judgment consistently when determining the cost of equity. Accuracy is important, but it’s the ranking of projects rather than precise pricing that matters.
