Flashcards in week 7 Deck (30)
Why would we use a property fund’s weighted average cost of capital to assess an investment opportunity?
The rationale for discounting property cash flows by the WACC is that a property earning this rate will be able to cover interest payments and pay the required return on equity.
If the calculated NPV, using the WACC as the discount rate, is positive the property investment will earn a sufficient return to satisfy the claims of both debt and equity holders
When using the weighted average cost of capital to assess an investment, how do we account for interest costs in the cash-flows?
We do not subtract interest costs from the cash flows when using the WACC to discount the future cash flows of an investment. This is because the interest costs are captured in the cost of debt in the WACC formula.
How do we accommodate the following costs when deriving the weighted average cost of capital?
i) An ongoing management fee of 0.6%.
ii) A capital raising has a one-off cost of $600,000 to finance an investment.
i) Include the management fee into the WACC rate. See table 13.1 example of how this is done.
ii) A one-off cost can be included in the cash flows. In this case the capital
Margot Property Company is listed on the ASX. You have the following information:
• Share price: $12.25
• Number shares on issue: 50 million
• Cost of equity: 11.2%
• Outstanding debentures: $1.02 billion, with a yield of 6.3%
• Corporate tax rate: 30%
Calculate Margot’s after-tax WACC
kd = 6.3%
ke = 11.2%
D = $1.02 billion
E = $12.25 x 50 million = $612.5 million
V = $1.02b + $612.5m = $1,632.5 million
D/V = $1,020m/$1,632.5m = 0.625
E/V = $612.5m/$1,632.5m = 0.375
Tc = 0.3
WACC=k= k_d (1-T_c )(D/V)+k_e (E/V)=6.3%(1-0.3)(0.625)+11.2%(0.375)=6.96%
Define the theory ‘clientele effect’. How does this theory impact on the level of debt a property fund may include in its capital structure?
The clientele effect theory suggests that specific investors are attracted to different fund/company policies, and that when a fund/company changes its policy, investors will adjust their unit/share accordingly. As a result of this adjustment, the unit/share price will move up or down.
Under this theory, managers will attempt to achieve a particular capital structure that will attract a certain type of investor. For example, managers may take on higher leverage to generate a higher return on equity to attract an investor who is prepared to accept a higher level risk for a higher return.
Macbeth Property Group has the following capital structure:
Debt: $140 million
Equity: $200 million
The cost of debt is 7.5% and the cost of equity is 9.8%, calculate the WACC.
kd = 7.5%
ke = 9.8%
D = $140 million
E = $200 million
V = $140m + $200m = $340 million
D/V = $140m/$340m = 0.412
E/V = $200m/$340m = 0.588
WACC=k= k_d (D/V)+k_e (E/V)=7.5%(0.412)+9.8%(0.588)=8.85%
In most large property funds, ownership and management are separated. What are the main implications of this separation?
The separation of ownership and management typically leads to agency problems, where the managers (the agent) does not necessarily act in the best interest of the owners (unit holders). Managers may prefer to consume private perks or make other decisions for their private benefit—rather than maximise unit holder wealth.
a. Modigliani and Miller’s theorem assumes perfect financial markets, with no distorting taxes or other imperfections.
b. Modigliani and Miller’s theorem says that the cost of equity increases with borrowing and that the increase is proportional to D/V, the ratio of debt to firm value.
b) FALSE – the cost of equity increases with the ratio D/E.
c. Modigliani and Miller’s theorem assumes that increased borrowing does not affect the interest rate on the firm's debt.
c) FALSE - the formula ke = ku + (D/E)(ku - kd) does not imply that kd is constant as borrowing increases.
define peaking order theory
The pecking order theory suggests that managers prefer to finance an acquisition with first retained earnings, second debt and finally equity
Oracle REIT has a current debt-to-asset ratio of 30%. Within their debt covenant, they have a maximum loan to value ratio of 45%. How far do Oracle’s property values have to decline before they are in breach of their covenant?
Current D/V = 0.3
Max Dm/V = 0.45
Define the ‘hedging principle’. What are two risks that a property fund faces if the hedging principle is not followed?
Hedging principle: the cash-flow-generating characteristics of an asset should be matched with the maturity of the source of financing used for its acquisition.
A property fund that does not attempt to match maturity of a cash-flow-generating asset with the maturity of the source of financing opens themselves up to liquidity risk and interest rate risk.
Liquidity risk is the risk the fund may not be able to renegotiate a new loan at maturity of the current loan (or roll-over of existing loan).
Interest rate risk is the risk that interest rates increase when the existing loan matures and they have to pay a higher rate
contrast debt and equity
Companies like to issue Debt because of the tax advantages. Interest payments are tax deductible. Debt also allows a company or business to retain ownership, unlike equity. Additionally, in times of low interest rates, debt is abundant and easy to access.
Equity is more expensive than debt, especially when interest rates are low. However, unlike debt, equity does not need to be paid back if earnings decline. On the other hand, equity represents a claim on the future earnings of the company as a part owner.
what is the WACC
The WACC is a calculation of a firm's cost to borrow money in which each category of capital is proportionately weighted. All sources of capital within the capital stack are included here which include stocks, bonds etc. and any other long-term debt, are included in a WACC calculation.
Most often used internally by a company to ascertain if investing in a new Project will be financially viable when contrasting it against the cost of capital.
what does the wacc tell you
WACC is the average of the costs of these types of financing, each of which is weighted by its proportionate use in a given situation. By taking a weighted average in this way, we can determine how much interest a company owes for each dollar it finances.
The higher the WACC the less likely a company is deriving a profit (creating value). This is due to the fact is must overcome more expensive borrowing costs to make a profit.
what does wacc formula variable represent
explain wacc and NPV
Formula can be expanded to include any number of finance sources that have different costs.
WACC useful for evaluating property acquisitions when capital is raised from multiple sources
Rationale: discounting future cash flows from an investment by the WACC can tell us if the project is earning enough to provide the minimum return to equity and debt holders
If the NPV is positive → project is generating return greater than WACC. Therefore generating a positive return for E & D investors
WACC often referred to as the ‘hurdle rate
If the expected return < WACC then…
Management to consider different mix of debt and equity
Sell the poorest performing property or asset (eg. Borrow less)
Do not go ahead with the investment
Important to remember, the total cash flows from the property are discounted by the WACC, we do not subtract interest costs from the cash flows.
This is because the cost of debt is incorporated into the WACC
Otherwise we would be double discounting
what is the clientel affect
Clientele effect” argues managers choose debt levels to attract particular types of investors, i.e. investors with appetite for risk will look to invest in PFs with higher leverage
Modigliani & Miller (1958) argue about debt levels
argue that changing debt levels has no impact of the value of the firm.
Firm value is independent of capital structure because the WACC remains constant as financial leverage changes.
The use of additional debt or financial leverage appears to be cheaper for firm but increases the risk that unit holders have to bear.
As a result, the rate of return on equity increases to compensate unit holders for this additional risk. Nonetheless, the increase in unit holder’s required rate of return is exactly offset by the increase in risk
As such, the overall WACC remains constant and hence firm value remains constant.
explain max debt levels
Australian law does not stipulate a max debt level for trusts to be eligible for tax transparency
Trust deeds often specify a max debt level, but generally above the target level. Therefore the max debt level is often seen as a guide
Particular funds have customary debt levels, if trust moves above this level investors and analysts will view this with suspicion and the units may be repriced accordingly
a tax shield for debt
Interest payments are tax deductible, either:
Directly by a company, or
Calculating taxable income for unit holders in a property trust
When a company pays fully franked dividends, the shareholder pays the same amount of tax whether the company borrows or shareholder borrows.
Therefore, dividend imputation has the effect of taxing company profits at the tax rate of the shareholder
exemptions of tax shield debt
If earnings are retained to grow the company, less tax relief is obtained if the company borrows, rather than the shareholder with a higher marginal tax rate
If a company makes tax losses, shareholders can not claim the loss to offset other income
explain agency theory
Agency theory suggests managers may act to serve their own interests rather than security holders
The consequent losses and costs of monitoring managers is called agency costs (independent boards etc. paid to monitor)
Agency issues can lead to managers choosing between debt & equity to strengthen their own positions
Issuing of debt surrenders less control to outsiders than does equity
Issuing of more units/shares gives voting rights to security holders, who may choose to exercise some control over the fund
Managers whose remuneration is dependent on the value of assets under management have incentive to borrow to increase the size of the fund
Managers who wish to take on financial risks of which equity holders would not approve may use innovative debt instruments that are not fully disclosed in the financial statements.
explain retained earnings and peaking order theory
Funds with retained earnings allow managers control over acquisition/project decisions and are not subject to the scrutiny of the capital markets
Pecking order theory suggest that managers first choose to finance projects first with retained earnings, second debt & last equity.
The higher the scrutiny by the capital market, the greater the influence pecking order theory has on managers.
factors to consider in deriving the wacc
Interest rates & equity returns should reflect the costs in the future, not the past.
If project only goes ahead if capital is raised, interest rates to reflect what lenders are currently offering, return on equity based on rate that will attract sufficient investors
Costs of raising capital should be incorporated in to the cash flows. Alternatively you can adjust rates to reflect the costs
If project only goes ahead if capital is raised, weights should reflect each source of capital.
Use market values for all sources of capital, avoid using book values
decling property values formula
Second event that exposes financial risks for PFs is debt maturity occurring before the project matures
explain this and hedging principle
In theory managers should match the life of the investment with the duration of the funding.
Hedging principle: the cash-flow-generating characteristics of an asset should be matched with the maturity of the source of financing used for its acquisition
The problems that may arise when the hedging principle is not followed, i.e. debt matures early can be referred to as liquidity risk
Some A-REITs have relied on short-term debt to fund acquisitions and developments
Public property syndicates have used debt with shorter maturities than the life of the syndicate
These risks were highlighted by the onset of the GFC, many PFs were more concerned with the risk of higher interest rates than liquidity risk (the risk of refunding
AB Jenkins is a listed property development company. The
company has a weighted average cost of capital (WACC) of 6.8%.
Explain why AB Jenkins should use their WACC to assess an
AB Jenkins should use the WACC to assess an investment because it is the minimum return
required to cover interest payments and pay the required return to equity holders.
The WACC is a hurdle rate, in that the investment must generate a return over the hurdle rate
(minimum required rate).
When using the WACC as the discount rate, if the NPV is positive it means the investment will
earn a sufficient return to satisfy the claims of both debt and equity holder