Cost of Capital/CAPM/APT 49

WACC
Practice 6
The following is the capital structure of Saras Ltd. as on 31-12-2022:

Equity Shares - 20,000 Shares of Rs. 100 each 2,000,000

10% Preference Shares of Rs. 100 each 800,000
12% Debentures 1,200,000
4,000,000

The market price of the company’s share is Rs.110 and it is expected that a dividend
of Rs.10 per share would be declared after 1 year. The dividend growth rate is 6%.
 Cost of Capital/CAPM/APT 49A
WACC
Practice 6 (Cont.)
Required:
1. If the company is in a 50% tax bracket, compute the weighted average cost of
capital.
2. Assuming that in order to finance an expansion plan, the company intends to get a
loan of Rs.2 million bearing 14% rate of interest, what will be the company’s revised
weighted average cost of capital? This financing decision is expected to increase
dividend from Rs.10 to Rs.12 per share. However, the market price of equity share is
expected to decline from Rs.110 to 105 per share. The growth rate is expected to stay
at 6% per annum and no change in tax rate is expected.
 Cost of Capital/CAPM/APT 50
WAAC
Practice 6 (Solution)
1) 50% tax bracket

Source After tax cost Calculation

Cost of equity 15.09% ( 10 / 110 ) + 0.06
Cost of preferred shares 10.00%
Cost of debentures 6.00% 12 % X ( 1 – 0.50 )
 Cost of Capital/CAPM/APT 50A
WAAC
Practice 6 (Solution)
Source Amount Weights After tax Cost Weighted Cost
Equity 2,200,0002 52.4% 15.09% 7.907%1
Preference 800,000 19.0% 10.00% 1.900%1
Debentures 1,200,000 28.6% 6.00% 1.716%1
4,200,000 100.0% 11.523%

1) Weight x After tax cost 2) Based on market value

 Cost of Capital/CAPM/APT 51
WAAC
Practice 6 (Solution)
2) Expansion:
Source After tax cost Calculation
Equity 17.43% ( 12 / 105 ) + 0.06
10% Preferred shares 10.00%
12% Debentures 6.00% 12% X ( 1 – 0.50 )
14% Loan 7.00% 14% X ( 1 – 0.50 )
Cost of Capital/CAPM/APT 51A
WAAC
Practice 6 (Solution)

Source Amount Weights After tax Cost Weighted Cost

Equity 2,100,000 34.4% 17.43% 6.00%
Preference Shares 800,000 13.1% 10.00% 1.31%
Debentures 1,200,000 19.7% 6.00% 1.18%
Loan 2,000,000 32.8% 7.00% 2.30%
6,100,000 10.79%
Cost of Capital/CAPM/APT 52

Nike Inc.
 Cost of Capital/CAPM/APT 53
Nike Inc.
Required:
1) Calculate the cost of debt
2) Calculate cost of equity
3) Calculate WACC
 Cost of Capital/CAPM/APT 54
Nike Inc.
Why using 4.3%¹ as cost of debt is incorrect ?

• Based on historical information

• Should be the rate investors require today

1) Cost of debt, p 8
 Cost of Capital/CAPM/APT 55
Nike Inc (Solution)
1. Cost of Debt:
• Coupon: 6.75% (semi annual)
• Current Price: $95.60
➢ 6.75% semi annual = $3.375 every 6 months
➢ Over 1 year = 100 + 3.375 = 103.37 X 1.03375 = $106.86
➢ Interest over one year = 106.86 - 100 = $6.86
➢ Yield = Cost of Debt = Interest /Current Price =
$6.86 / $95.60 = 7.17%
➢ After tax cost of debt = 7.17% X (1 – 0.38) = 4.45%
 Cost of Capital/CAPM/APT 56
Nike Inc (Solution)
2. Cost of Equity:

➢Growth rate = 5.5%

➢Current share price = $42.09
➢Dividends next year = $0.51 ( 0.48 x 1.055)
Ke = ( D1 / Po ) + g

= [ 0.51 / 42.09 ] + 0.055 = 6.70%

 Cost of Capital/CAPM/APT 57
Nike Inc (Solution)
• Weighting:
➢ Debt (Book Value): 5.4 + 855.3 + 435.9 = $1,296.6
Debt (Market Value): $1,296.6 X 0.956 = $1,239.5

➢ Equity (Market Value) =

271.5 mil shares X $42.09 = $11,427.4
➢ Percentage:
o Debt = 1,239.5 / (1,239.5 + 11,427.4) = 9.8%
o Equity = 11,427.4 / (1,239.5 + 11,427.4) = 90.2%
100.0%
 Cost of Capital/CAPM/APT 58
Nike Inc (Solution)

WACC = (4.45% X 9.8%) + (6.70% X 90.2%) = 6.48%

Weighted Average Cost of Capital/CAPM/APT 59

What is risk?
Weighted Average Cost of Capital/CAPM/APT 61
Risk
• Risk is a measure of volatility
• If you got what you had anticipated, is there any risk?
• Important differences among various risk sources
• News stories....some specific, some general
• Announcement about interest rates or GNP....specific or general?
• Stories about the affairs of a rival company...specific or general?
Weighted Average Cost of Capital/CAPM/APT 62

• Risk resulting from information/news can be divided into two categories:

➢ General portion / systematic portion or systematic risk
➢ Remaining portion or specific or unsystematic risk

• Systematic = any risk that affects a large number of assets (sometime

referred to as market risk)
➢ e.g general economic conditions eg GNP, inflation etc

• Specific/unsystematic = a risk that specifically affects a single asset or a

small group of assets
➢ e.g. announcement of a small oil discovery by a company
Weighted Average Cost of Capital/CAPM/APT 63

• Distinction between systematic vs unsystematic is never this

exact

➢ Even a minor event may have an impact on the world

➢ We know it when we see it

Weighted Average Cost of Capital/CAPM/APT 64

• Total risk = market/systematic + specific/unsystematic

• The unsystematic risk on company A eg Boeing’s shares is unrelated to the

unsystematic risk of , say, Unilever’s shares

• The risk that Unilever’s shares will go up or down because of a discovery or a

failure to discover by Unilever’s R&D Department ....will it affect Boeing’s
shares?

• Unsystematic risk of Boeing and Unilever’s shares..... unrelated/uncorrelated

Weighted Average Cost of Capital/CAPM/APT 65
• What happens if we combine the shares of Unilever with another company’s
shares in a portfolio?
➢ Unsystematic/specific risk uncorrelated....it can offset each other.
Weighted Average Cost of Capital/CAPM/APT 66
RISK

➢ Unsystematic/specific risk of portfolio < unsystematic/specific

risk of a single share....Diversification

➢ Add a second security?

➢ Add a third security?

Weighted Average Cost of Capital/CAPM/APT 67
RISK
• What happens when we add a fourth, a fifth or a sixth
share?

• Combine an infinite number of shares...what happens to the

unsystematic/specific risk of the portfolio?

It will disappear
Weighted Average Cost of Capital/CAPM/APT 68
RISK
• What happens to the portfolio’s systematic/market risk when we
add a second share?
➢ Inflation turns out to be higher than anticipated
o Both (ie all) shares will decline
Weighted Average Cost of Capital/CAPM/APT 69
RISK

• Same result ...three shares, four shares ...infinite shares

➢ Bad news for the economy will impact all shares negatively

• Unlike unsystematic /specific , systematic/market risk cannot be

diversified away
Weighted Average Cost of Capital/CAPM/APT 70
DIVERSIFICATION
• Total risk of a portfolio steadily falls with diversification

• Diversification does not allow total risk to go to zero. Why?

• Systematic/market risk is left untouched...it just does not decrease

through diversification
Weighted Average Cost of Capital/CAPM/APT 71
DIVERSIFICATION
• To diversify away unsystematic/specific risk....need
diversification

• The more shares in a portfolio, the lesser the risk

• Best to hold...weighted portfolio of all existing shares ie

market portfolio
Weighted Average Cost of Capital/CAPM/APT 72
DIVERSIFICATION

• Broad-based index like S&P500 as a proxy

• Holder of market portfolio has

➢ no unsystematic/specific risk
➢ only systematic/market risk to worry about
 Weighted Average Cost of Capital/CAPM/APT 73
DIVERSIFICATION
Everybody holds a market portfolio

• To maximize diversification
• To minimize risk
• As unsystematic / specific risk can be diversified away, market only
cares about systematic / market risk
• No reward for undertaking unsystematic / specific risk
Weighted Average Cost of Capital/CAPM/APT 74
Systematic/Market risk

• Systematic/market risk is measured by β, beta

• β is a measure of a stock's volatility in relation to the overall

market
Weighted Average Cost of Capital/CAPM/APT 79
• Shares with negative β
➢ Hedges or insurance policies
➢ Do well when market does poorly and vice versa
➢ Adding a negative β share to a well diversified portfolio reduces risk

• Examples of β
➢ Unilever 0.16
➢ P&G 0.43
➢ Facebook 1.16
➢ Tesla 2.03
Weighted Average Cost of Capital/CAPM/APT 80
Capital Asset Pricing Model (CAPM)
• Expected return on a share
➢ Risk free rate + some compensation for the risk inherent in the
market portfolio
E(R) = RF + (Responsiveness X Risk premium)

E(R) = RF + β X [E(RM) - RF]

 Weighted Average Cost of Capital/CAPM/APT 81
Capital Asset Pricing Model (CAPM)
E (R) = Rƒ + β [ E(RM) - Rƒ ]
where:
Rƒ = Risk free rate
E(RM) = Expected market return

E (R) = Risk free rate + β ( Market risk premium )

Weighted Average Cost of Capital/CAPM/APT 82

Capital Asset Pricing Model (CAPM)

• Risk premium in the future = average risk premium in the past

• Average historical worldwide equity risk premium = 6.9%

➢ Future equity risk premium could be higher or lower
Weighted Average Cost of Capital/CAPM/APT 83

CAPM: E(R) = RF + β [E(RM) - RF]

• β = 0 ie E(R) = RF....Why?

• β = 1 ie E(R) = RM....Why?
Weighted Average Cost of Capital/CAPM/APT 84

Practice 7
A share of Jawad Enterprises has a beta of 1.5 and that of Fawad Enterprises has a
beta of 0.7. The risk free rate is assumed to be 3% and the difference between the
expected return on the market and the risk free rate is assumed to be 8%.

What are the expected returns of the two shares?

Weighted Average Cost of Capital/CAPM/APT 85

Practice 7 (Solution)

Jawad E(R) = 3% + (1.5 X 8%) = 15.0%

Fawad E(R) = 3% + (0.7 X 8%) = 8.6%

Weighted Average Cost of Capital/CAPM/APT 86

Nike Inc (Revisited)

• US Treasury 20-year = 5.74%

• Beta = 0.69
• Market Premium = 5.90%

Cost of Equity = 5.74% + 0.69 (5.90%) = 5.74% + 4.07% = 9.8%

Weighted Average Cost of Capital/CAPM/APT 87

Nike Inc (Revisited)

• After tax cost of debt = 7.17% X (1 – 0.38) = 4.45%
• Cost of Equity (DDM) = ( D1 / Po ) + g = 6.70%
• Cost of Equity (CAPM) = 9.8%
• Weighting: Debt: 9.8% Equity: 90.2%

WACC (DDM) = 4.45% X 9.8% + 6.70% X 90.2% = 6.48%

WACC (CAPM) = 4.45% X 9.8% + 9.80% X 90.2% = 9.28%
 Weighted Average Cost of Capital/CAPM/APT 88
Nike Inc (Revisited)
• DDM (6.48%) vs CAPM (9.28%) ….which appears more reliable?
• DDM: Cost of debt (7.17%) is higher than cost of equity (6.70%)

Not possible
• Better to use EPS growth (as proxy for company’s growth) than dividend
growth
• DDM better suited for stable growth companies with constant and
predictable growth rate in dividends
Weighted Average Cost of Capital/CAPM/APT 89

Royal Mail
Weighted Average Cost of Capital/CAPM/APT 90
Royal Mail
Required:

1) Calculate the cost of the capital for Royal Mail

2) Calculate the cost of capital for Comparables ( Exhibit 9 )