Tutorial 3

Questions

1. What is “cost of capital”? Why does a finance manager need to know this?

The company cost of capital is the expected rate of return that investors require on a
portfolio of all of the company’s outstanding debt and equity. It is the opportunity cost of
capital for investment in the firm as a whole.

From the perspective of a financial manager, cost of capital is the minimum amount of
return that the firms require to pay back to the equity holders and bond holders.

Proper estimate of cost of capital is important for a firm in taking capital budgeting
decisions. Generally, cost of capital is the discount rate used in evaluating the desirability of
the investment project. In the internal rate of return method, the project will be accepted if
it has a rate of return greater than the cost of capital.

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2. Explain the factors that affect beta.

Beta is estimated by regressing the company stock’s excess return against the market’s
excess return.

Beta is affected by:

(i) Nature of the business. Usually, the earnings of a company keep on

fluctuating with time due to the business cycles. The earning may go up in
the growth phase in the business cycle, while the earnings may go down
when a firm is in the contraction phase. Therefore, the company's earnings
are related to the conditions of business. In such circumstances, the
accounting betas usually correlate with the market beta, which is based on
share market returns and not the earnings.

(ii) Financial leverage. Financial leverage is described as the debt portion of the
financial structure of a company. It shows how much debt a company has
taken to run the business. The more the debt, the greater is the risk of the
business organization. So, growth in financial leverage increases the financial
risk. Therefore, this will increase the beta of a companies’ stock as well.

(iii) Operating leverage. Operating leverage is the change in economic earnings

before tax and interest. Having operating leverage makes the companies be
more volatile in terms of management of assets. Firms with a higher
operating lease are risky; consequently, their stocks have a higher beta.
3. Compare and contrast between the two methods of estimating cost of equity. Which is
better? Why?

The CAPM and dividend growth models are widely accepted and used techniques for
determining the cost of equity for companies. However, both models have some merits and
demerits.

(i) The benefits of using the CAPM model to estimate the equity cost are as follows:
It is an easy-to-use model and is a simple method of calculating the required cost.
The formula is as described below.

(ii) It considers systematic risk.

The demerits of the CAPM model are:

It is based on too many assumptions and is often categorized as unrealistic.

The model assumes that all the investors in the market will always hold diversified
portfolios. It means that there would be no firm-specific risk or unsystematic risk. This
assumption is not entirely true.

It uses a risk-free rate (rf) to calculate the cost of equity capital. Unlimited capital cannot be
available at ‘rf’ in a real capital market.

Similarly, the advantages of DDM are:

No level of subjectivity is involved in this model, and the logic behind computing the stock
price by this method is appropriate.

Minority shareholders generally have dividends as the only valuation measure available.

It is reliable for mature companies and entities that pay consistent and regular dividends.

(iii) The demerits of DDM are:

It ignores any kind of risk prevailing in the market.

It can be applied only to a limited type of entity. It is not of any use if the entity does not pay
dividends.

Dividends are considered an irrelevant metric for large shareholders.

Since both models have their specific advantages and disadvantages, it is not possible to
determine which model is better suited for EasyJet without the availability of company-
specific information. In many cases, it has been found that the CAPM model is a better
choice over DDM in that it can be applied even if the company does not have any dividend
payments.
 But if EasyJet is a large-scale, mature company making consistent dividend payments, the
DDM model will also yield accurate results.

4. Discuss the assumptions underlying WACC.

(i) Investment project is small compared to the investing organization

-Therefore, the project should not have a material impact on overall organization
outcomes

(ii) New project has the same business risk as existing business activities
-If the new project has a completely different risk profile and business nature, WACC
may be an inappropriate discount rate since WACC reflects the firm’s current risk
profile

(iii) New project does not change the capital structure of the business
-New project should be financed in the same proportion to reflect current capital
structure and ensure debt-equity ratio
-If the capital structure changes, the firm’s risk profile, Ke and Kd will change.

(iv) Pooling assumption

-Assumes that the project is funded by pool of financing sources already
incorporated into WACC
-Individual financers do not adjust their required rate of return to match each
project

5. Can a company’s overall cost of capital be used for businesses operating in diversified
business sectors? Discuss.

Problems
1. Your firm is planning to invest in an automated packaging plant. Harry Inc. is an all-equity
firm that specializes in this business. Suppose Harry’s equity beta is 0.85, the risk-free rate is
4% and the market risk premium is 5%. If your firm’s project is all equity financed, estimate
its cost of capital.

Risk free rate= default risk / stable / minimum return of any investments
Cost of capital = pay to bondholders / shareholders (cost of financing)

CAPM= 0.04 + 0.85 (0.05)

= 0.0825
= 8.25%

2. Your firm is considering expanding its product division. You identify PG as a firm with
comparable investment. Suppose PG’s equity has a market capitalization of RM144 billion
and a beta of 0.57. PG also has RM37 billion AA-rated debt outstanding (stable, not sensitive
to the movement of the market), with an average yield of 3.1%. Estimate the cost of capital
of your firm’s investment given a risk-free rate of 3% and a market-risk premium of 5%.

Average yield= cost of debt (cost that company incurred to pay its bondholders)
Market capitalization= market value of the firm

Beta of equity= 0.57 (144B / 144B + 37B) + 0 (37B / 144B + 37B)

= 4.53%

CAPM= 0.03 + 0.453 (0.05)

= 5.265%

WACC= 5.265% (144B / (144B + 37B) + 3.1% (37B / 144B + 37B)

= 4.82%

3. X Co is identical in all operating and risk characteristics to Y Co, except that X Co is all equity
financed and Y Co is financed by equity valued at RM2.1m and debt valued at RM0.9m based
on market values. X Co and Y Co. operate in a country where no tax is payable. The interest
paid on Y Co’s debt is RM72,000 per annum, and it pays a dividend to shareholders of
RM378,000 per annum. X Co pays an annual dividend of RM450,000.

a. Calculate the value of X Co.

Similar risk
Value of X = Value of Y

Company X (all equity company)

Equity value= RM3,000,000
Annual dividend
= RM450,000

Company Y
 Equity value= RM2,100,000
Debt value= RM900,000 million
Dividend payment = RM378,000
Interest payment= RM72,000

Value of levered company= 2.1 million + 0.9 million

= 3 million

b. Calculate the cost of capital for X Co.

D1
Dividend growth model = +g
Po
= 450,000 / 2,100,000
= 15%

Growth rate did not provide = 0%

c. Calculate the cost of equity for Y Co, and the cost of debt for Y Co.

Cost of debt= total interest / Value of debt

Cost of debt of company X= 72,000 / 900,000 x 100%
= 0.08

Cost of equity= total dividend / Value of equity x 100%

=378,000 / 2,100,000 x 100%
= 18%

Alternative
Cost of equity= Ke + (Ke – Kd) * D/E * (1-t)
= 0.15 + (0.15 – 0.08) x 900,000 / 2,100,000 * (1-0)
= 18%

d. Calculate the weighted average cost of capital for Y Co.

WACC= 18% (2,100,000 / 900,000 + 2,100,000) + 8% (900,000 / 3,000,000

= 15%

4. X Co is identical in all operating and risk characteristics to Y Co, except that X Co is financed
only by equity valued at RM3m whereas Y Co has debt valued at RM0.9m (based on market
 value as part of its capital structure. X Co ad Y Co operate in a country where tax is payable
at 33%. The interest paid on Y Co’s debt is RM72,000 per annum, and it pays a dividend to
shareholders of RM378,000 per annum. X Co pays an annual dividend of RM450,000.
a. Calculate the value of equity of Y Co.

b. Calculate the cost of capital for X Co.

c. Calculate the cost of equity for Y Co, and the cost of debt for Y Co.

d. Calculate the weighted average cost of capital for Y Co.

-tax

-whether the cost of debt will go up or not

-and why?

-tax deduction can claim – interest payment

-better understand how to compute WACC