P4 Chapter 03 WACC

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P4 Chapter 3 Content
1 WACC
2 Cost of Equity
3 Cost of Debt
4 How do lenders set their interest rate
5 The use of WACC as discount rate
6 Analysis of Comprehensive Example
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Chapter Summary
Cost of Equity
• CAPM
• DVM
• M+M
The Weighted
Average Cost
of Capital
Cost of Debt
When can WACC
• Irredeemable
be used as a dis-
• Redeemable
counted rate?
• Credit Spreads

1.WACC
 Definition: WACC is derived by finding a firm's cost of equity an

d cost of debt and averaging them according to the market valu
e of each source of finance.
 The formula for calculating WACC is given on the exam formul
a sheet as :
 Ve   Vd 
WACC   
 e 
k  kd (1  T )
Ve  Vd  Ve  Vd 
 Ve and Vd are market values of equity and debt respectively.
 ke and kd are returns required by the equity holders and the debt hol
ders respectively.
 T is the corporate tax rate
 ke is the cost of equity
 kd (1-T) is the cost of debt
2.The cost of equity
 Three main methods of calculating ke are:

 the Capital Asset Pricing Model (CAPM)
 the Dividend Valuation Model (DVM)
 Modigliani and Miller's Proposition 2 formula
 CAPM
 Definition:The CAPM derives a required return for an investor by

relating return to the level of systematic resk faced by an investor.
 Assumption:All investors are well diversified ,so only systematic r

isk is relevant. Unsystematic risk is reduced by diversified portfolio.

 CAPM
 Formula: ke  R f   i ( E ( Rm )  R f )
 where:
Rf= risk free rate
E(Rm)= expected return on the market
N.B. E(Rm)- Rf is called the equity risk premium
βi=beta factor=systematic risk of the firm or project compared
to market
 A beta>1 indicates average risk, while beta<1 means relative

ly low risk.

 Which Beta facor to use？

 If the firm's current beta factor cannot be derived easily, a proxy bet
a may be used.
 A proxy beta is usually found by identifying a quoted company with

a similar business risk profile and using its beta. However, when sel
ecting an appropriate beta from a similar company, account has to
be taken of the gearing ratios invloved.
 The beta values for companies reflect both:
 business risk (resulting from operations)
 finance risk (resulting from their individual level of gearing)

 Which Beta facor to use？

 There are therefore two types of beta:
 "Asset" or "ungeared" beta, βa ,which reflects purely the system
atic risk of the business area.
 "Equity" or "geared" beta, βe ,which reflects the systematic risk o
f the business area and the company specific gearing ratio.
 In the exam, you will often have to degear the proxy equity beta and
then regear to reflect the gearing position of the company.
 The formula to regear and degear betas is :
 V   V (1  T ) 
a   e
e    d d 

 e d
V V ( 1  T )   e d
V  V (1  T ) 
 However, βd is often assumed to be zero, because of the low risk of
being a debt holder, so the following equation is more generally use
d.  V 
a   e
e 

 e d
V V ( 1  T ) 
 APT(Arbitrage pricing theory) is an alternative pricing model to CA

PM. It attempts to explain the risk -return relationship using several di
ndependent factors rather than a single index.
 Differences: CAPM is a single index model in that the expected retur
n from a security is a function of only one factor. However APT is a m
ultiindex model in that the expected return from a security is a linear f
unction of several independent factors.
 Assumptions:
 Each factor must be independent of the other factors.
 The process of arbitrage would ensure that two assets offering ide
ntical returns and risks will sell for the same price.
 Disadv: difficult to determine and specifiy different factors; difficult to
determine how to weigh those variables.

 DVM: The value of the company/share is the present value of the ex

pected future dividends discounted at the shareholders' required rate
of return.
 Assuming a constant growth rate in dividends,g:
where D0=current level of dividend P0  D0 (1  g ) /( ke  g )

P0=current share price
g= estimated growth rate
 How to derive g in the DVM formula?

 Extrapolating based on past dividend patterns
 Assuming growth is dependent on the level of earnings retained in

the business.

 Extrapolating based on past dividend patterns

1
 
D0  D0  n
gn  1    1
Dividend (nyrsago)  Dividend ( nyrsago ) 
 where n=number of yrs of dividend growth
 This method can only be used if:

 recent dividend pattern is considered typical
 historical pattern is expected to continue
 As a result, this method will usually only be appropriate to pred

ict growth rates over the short term.

 Gordon's growth model
 Assumption:growth is primarily due to the reinvestment of retaine

d earnings.
 Formula: g  r *b
where: b=earnings retention rate
r=rate of return to equity
 what is r ? r=ARR=PAT/Opening shareholders' funds
 Assumption for r ?
 it ignores the level of investment in intangible assets
 in the long run, the return on new investment tends to the cost
of equity.
 Modigliani and Miller's Proposition 2 formula

 Formula:
V
ke  kei  (1  T )( kei  kd )( d )
Ve
where:
Ve and Vd are the market values of equity and debt respectively.
kd is the (pre-tax) return required by the debt holders
T is the corporation tax rate
kei is the cost of equity in an equivalent ungeared firm
ke is the cost of equity in the geared firm

3.The cost of debt
 Methods of calculating cost of debt:
 Using DVM to estimate cost of debt

 Irredeemable debt
kd (1  T )  I (1  T ) / MV
Where
I= the annual interest paid
T= corporation tax rate
MV= the current bond price
 Redeemable debt
kd(1-T)=the internal rate of return(IRR) of the bond price, the inte

rest (net of tax) and the redemption payment

3.The cost of debt
 Pre tax cost of debt(or yield to the debt holder)

 Irredeemable debt: the pre tax cost of debt is I/MV
 Redeemable debt: the pre tax cost of debt is the IRR of the bon
d price, the GROSS interest, and the redemption payment.
 Using the CAPM to calculate cost of debt

The risk on debt is usually relatively low, so the debt beta is often
zero. BUT if the debt beta is not zero(for example if the company's
credit rating shows that it has a credit spread greater than zero), th
e CAPM can be used to derive kd as follows:
k d  R f   debt ( E ( Rm )  R f )
3.The cost of debt

 Credit spread (Default risk premium)
 The credit spread is a measure of the credit risk associated wit
h a company. Credit spreads are generally calculated by a cred
it rating agency.
 Formula: kd=(Risk free rate + Credit spread)(1-T)
 Assessment of creditworthiness
• The magnitude and strength of the company's cash flows
• The size of the debt relative to the asset value of the firm
• The volatility of the firm's asset value
• The length of time the debt has to run
 Yield on corporate bond= Yield on equivalent treasury bond
+credit spread
3.The cost of debt
 Application of Macauley duration to debt

 e.g. Tyminski Co has some 10% coupon bonds in issue. They are r
edeemable at par in 5 yrs, and are trading at $97.25%. The yield (p
re tax cost of debt) is 10.743%.The Macaulay Duration is calculated
as follows:
 PV of each future receipt from the bond (using pre tax cost of debt
as discount rate):
$ T1 T2 T3 T4 T5
PV@10.743% 9.03 8.15 7.36 6.66 66.05
Sum of (time to maturity*PV of receipt=404.30
Duration= 404.30/97.25= 4.157 yrs
 The longer the Macauley Duration, the more volatile the bond
3.The cost of debt

 Benefits:
 Duration allows bonds of different maturities and coupon rates t
o be compared.
 If a portfolio of bonds is constructed based on weighted average
duration, it is possible to identify the change in value of the portf
olio as interest rates change.
 Managers may be able to reduce interest rate risk by changing t
he overall duration of the bond portfolio.

3.The cost of debt

 Limitations:
 it assumes a linear relationship between interest rates and bon
d prices. In reality, the relationship is likely to be curilinear. The
more convex the relationship between interest rates and bond p
rice, the more inaccurate duration is for measuring interest rate
sensitivity.
 Bonds which are due to be reddemed at a later date are more p
rice-sensitive to interest rate changes , and therefore are riskier.
Actural Relationship
Bond
value
Relationship predicted by
duration
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4.How do lenders set their interest rates?
 How do lenders set their interest rates?
 Overview of the method

 The basic idea is that the lender will assess the likelihood (usin
g normal distribution theory) of the firm's cash flows falling to a l
evel which is lower than the required interest payment in the co
ming year.
 If it looks likely that the firm will have to default, the interest rate
will be set at a high level to compensate the lender for this risk.


 Normal distribution theory
 The figure from the normal distribution table gives the size of an
area( shaded on the diagram) between the man and a point z st
andard deviations away.
mean
 Example of a simple normal distribution
The height of adult males is normally distributed with a mean of 17
4cm and a standard deviation of 5cm. What is the probability of a
man being shorter than 168cm?


 Normal distribution theory
 Solution
168cm is 7cm away from the mean
This represents7/5=1.4 standard deviations
From tables, 0.4192 of the normal curve lies between the mean an
d 1.40 standard deviations.
Hence, the probability of a man being shorter than 168cm is 0.5-0.
4192=0.0808

 Illustration of how do lenders set their interest rates

Villa Co has 2m of debt, on which it pays annual interest of 6%
The company's operating cash flow in the coming year is forecast to b

e 140,000 and currently the company has12,000 cash on deposit.
Required:
Given that the annual volatility( standard deviation) of the compa

ny's cashflows(measured over the last 5 years) has been 25%, cal
culate the probability that Billa Co will default on its interest pay
ment within the next year(assuming that the company has no oth
er lines of credit available)

 Illustration of how do lenders set their interest rates

Solution:
 The key here is that Villa Co will have expected cash of 140,000+12,000=15
2,000,and its interest commitment will be 6% on 2m, i.e.120,000
 We should calculate the probability that the cash available will fall by 152,00
0-120,000=32,000 over the next year. So, if the annual CF is normally distri
buted, the standard deviation of 25%*140,000=35,000
 Thus, fall of 32,000 represent 32000/35000=0.92 standard deviations
 From the normal distribution tables, the area between the man and 0.91 sta
ndard deviations=0.3186
 So, there must be a 0.5-0.31860=0.1814 chance of the cashflow being insuf

ficient to meet the interest payment.

5.The use of WACC as a discount rate
 The use of WACC as a discounte rate in project appraisal is ap

propriate, if both:
 the new project has the same level of business risk as the existing
operations. (if business risk changes ,required returns of sharehold
ers will change to compensate them for the new level of risk,and he
nce WACC will change)
 undertaking the new project will not alter the firm's gearing (financia
l risk)

Analysis of Example
Levante Co is a large unlisted company which has identified a new project

for which it will need to increase its long term borrowings from $250 million
to $400 million. This amount will cover a significant proportion of the total
cost of the project and the rest of the funds will come from cash held by the
company.
The current $250 million unsubordinated borrowing is in the form of a 4%
bond which is trading at $98.71 per $100 and is due to be redeemed at par
in three years. The issued bond has a credit rating of AA. The new
borrowing will also be raised in the form of a traded bond with a par value of
$100 per unit. It is anticipated that the new project will generate sufficient
cash flows to be able to redeem the new bond at $100 par value per unit in
five years. It can be assumed that coupons on both bonds are paid annually.

Analysis of Example
Both bonds would be ranked equally for payment in the event of default and
the directors expect that as a result of the new issue, the credit rating for
both bonds will fall to A. The directors are considering the following two
alternative options when issuing the new bond:
(i) Issue the new bond at a fixed coupon of 5% but at a premium or discount,
whichever is appropriate to ensure full take up of the bond; or
(ii) Issue the new bond at a coupon rate where the issue price of the new
bond will be $100 per unit and equal to its par value.
The following extracts are provided on the current government bond yield
curve and yield spreads for the sector in which Levante Co operates:

Analysis of Example
Required
(a) Calculate the expected percentage fall in the market value of the existing
bond if Levante Co's bond credit rating falls from AA to A. (3 marks)
(b) Advise the directors on the financial implications of choosing each of the
two options when issuing the new bond. Support the advice with appropriate
calculations. (8 marks)
(c) Among the criteria used by credit agencies for establishing a company's
credit rating are the following: industry risk, earnings protection, financial
flexibility and evaluation of the company's management.
Briefly explain each criterion and suggest factors that could be used to
assess it. (8 marks)

Analysis of Example
(d)The following information is available for the expected situation after the
proposed bond issue.
Total assets = $1,050m
Monthly net income = $25m
Annual profit before interest and tax = $450m
Standard deviation of earnings = 8%
Assume the new bond is issued with a 5% coupon.
Use the Kaplan-Urwitz model for unquoted companies to predict whether the
credit rating will be AAA, AA or A. (6 marks)

Analysis of Example

Solution of Example

Solution of Example

Solution of Example

Solution of Example
Advice to directors
If a coupon of 5% was chosen then the bond would be issued at a discount
of approximately 4.28%.Rather than having to issue 1.5 million $100 units
in order to raise the required $150 million, the company would have to
issue ($150 million/95.718) 1,567,103 $100 units. When the bonds come to
be redeemed in five years' time, Levante will have to pay an additional
$6,710,300 to redeem the extra 67,103 units.
However a higher coupon rate of 6% means that Levante will have to pay
an additional $1,500,000 interest each year for the next five years.
The choice depends on whether the directors feel that that project's profit
will be sufficient to cover the additional redemption charges in five years'
time. If they are reasonably confident that profits will be sufficient then they
should choose the lower coupon rate bond. If they wish to spread the cost
rather than paying it in one lump sum then the higher coupon rate should
be chosen.
Solution of Example
(c) Industry risk

Industry risk refers to the strength of the industry within the country and ho
w resilient it is to changes in the country's economy. Industry risk could be a
ssessed using such factors as the impact of economic forces on industry pe
rformance, the cyclical nature of the industry (and the extent of the peaks a
nd troughs) and the extent to which industry demand is affected by economi
c forces.
Earnings protection
Earnings protection refers to how well the industry will be able to protect its
earnings in the wake of changes in the economy. This could be assessed u
sing such factors as diversity of the customer base, sources of future earnin
gs growth and profit margins and return on capital.

Solution of Example
(c) Financial flexibility

Financial flexibility refers to the ease with which companies can raise fina
nce in order to pursue profitable investment opportunities. This could be a
ssessed by evaluating future financial needs, the range of alternative sou
rces of finance available, the company's relationship with its bank and an
y debt covenants that may restrict operations.
Evaluation of the company's management
This refers to how well management is managing the company and plann
ing for its future. This could be assessed by looking at the company's pla
nning, controls, financing policies and strategies; merger an acquisition p
erformance and record of achievement in financial results; the overall qua
lity of management and succession planning.

Solution of Example
(d) Here:
F = 1,050
π = (25 × 12)/1,050 = 0.286
S=0
L = 400/1,050 = 0.381
Interest = (250 × 0.04) + (150 × 0.05) = 17.5
C = 450/17.5 = 25.7
б = 0.08
Y = 4.41 + (0.0014 × 1,050) + (6.4 × 0.286) – 0 – (2.72 × 0.381) + (0.006
× 25.7) – (0.53 × 0.08)
Y = 4.41 + 1.47 + 1.830 – 1.036 + 0.154 – 0.042 = 6.79
The Kaplan-Urwitz model predicts that the credit rating will be AAA.

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P4 Chapter 03 WACC

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4 How do lenders set their interest rate

5 The use of WACC as discount rate

6 Analysis of Comprehensive Example

ACCAspace 中国ACCA特许公认会计师教育平台 Copyright © ACCAspace.com 2

ACCAspace 中国ACCA特许公认会计师教育平台 Copyright © ACCAspace.com 3

 Definition: WACC is derived by finding a firm's cost of equity an

 Three main methods of calculating ke are:

 the Dividend Valuation Model (DVM)

 Modigliani and Miller's Proposition 2 formula

 Definition:The CAPM derives a required return for an investor by

 Assumption:All investors are well diversified ,so only systematic r

ACCAspace 中国ACCA特许公认会计师教育平台 Copyright © ACCAspace.com 5

E(Rm)= expected return on the market

N.B. E(Rm)- Rf is called the equity risk premium

βi=beta factor=systematic risk of the firm or project compared

 A beta>1 indicates average risk, while beta<1 means relative

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 Which Beta facor to use？

 A proxy beta is usually found by identifying a quoted company with

 The beta values for companies reflect both:

 business risk (resulting from operations)

 finance risk (resulting from their individual level of gearing)

ACCAspace 中国ACCA特许公认会计师教育平台 Copyright © ACCAspace.com 7

 Which Beta facor to use？

 APT(Arbitrage pricing theory) is an alternative pricing model to CA

ACCAspace 中国ACCA特许公认会计师教育平台 Copyright © ACCAspace.com 9

 DVM: The value of the company/share is the present value of the ex

 Assuming a constant growth rate in dividends,g:

where D0=current level of dividend P0  D0 (1  g ) /( ke  g )

g= estimated growth rate

 How to derive g in the DVM formula?

 Assuming growth is dependent on the level of earnings retained in

ACCAspace 中国ACCA特许公认会计师教育平台 Copyright © ACCAspace.com 10

 Extrapolating based on past dividend patterns

 where n=number of yrs of dividend growth

 This method can only be used if:

 historical pattern is expected to continue

 As a result, this method will usually only be appropriate to pred

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 Gordon's growth model

 Assumption:growth is primarily due to the reinvestment of retaine

r=rate of return to equity

 what is r ? r=ARR=PAT/Opening shareholders' funds

 Modigliani and Miller's Proposition 2 formula

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 Methods of calculating cost of debt:

 Using DVM to estimate cost of debt

I= the annual interest paid

T= corporation tax rate

MV= the current bond price

kd(1-T)=the internal rate of return(IRR) of the bond price, the inte

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 Methods of calculating cost of debt:

 Pre tax cost of debt(or yield to the debt holder)

 Using the CAPM to calculate cost of debt

 Methods of calculating cost of debt:

 Application of Macauley duration to debt

 Application of Macauley duration to debt

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 Application of Macauley duration to debt

 How do lenders set their interest rates?