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cost of capital,

part 2 RELEVANT to ACCA QUALIFICATION papers f9 and P4

of equity be used as the discount rate with which to appraise capital

required by shareholders). Can this measurement of a company’s cost

project appraisal 1 – pure equity finance PROJECT APPRAISAL 2 – SAME BUSINESS ACTIVITIES,

So now we have two ways of estimating the cost of A MIX OF FUNDS AND CONSTANT GEARING

investments? Yes it can, but only if certain conditions are met.

THere are two ways of estimating the cost of equity (the return

equity (the return required by shareholders). Can Let us look at appraising a project which uses a

this measurement of a company’s cost of equity mix of funds, but where those funds are raised

be used as the discount rate with which to appraise so as to maintain the company’s gearing ratio.

capital investments? Yes it can, but only if certain Remember, where there is a mix of funds, the funds

conditions are met: are regarded as going into a pool of finance and

1 A new investment can be appraised using the a project is appraised with reference to the cost

cost of equity only if equity alone is being used of that pool of finance. That cost is the weighted

to fund the new investment. If a mix of funds is average cost of capital (WACC). As a preliminary

being used to fund a new investment, then the to this discussion, we need briefly to revise how

investment should be appraised using the cost of gearing can affect the various costs of capital,

the mix of funds, not just the cost of equity. particularly the WACC. The three possibilities are

2 The gearing does not change. If the gearing set out in Example 1.

changes, the cost of equity will change and its

current value would no longer be applicable. EXAMPLE 1

3 The nature of the business is unchanged. The ke = cost of equity; kd = pre-tax cost of debt; Vd =

new project must be ‘more of the same’ so market value debt; Ve = market value equity. T is the

that the risk arising from business activities is tax rate.

unchanged. If the business risk did change, once

again the old cost of equity would no longer

be applicable. Cost %

Conventional

These conditions are very restrictive and would theory of

apply only when an all-equity company issued cost capital

more equity to do more of the same type of ke and gearing

activity. Our approach needs to be developed if we

are going to be able to appraise projects in more WACC

general environments.

In particular, we have to be able to deal with more

general sources of finance, not just pure equity, and

it would also be good if we could deal with projects

which have different risk characteristics from kd

existing activities.

Gearing = Vd/Ve

student accountant 11/2009

02

Studying Papers F9 or P4?

Performance objectives 15 and 16 are linked

download part 1 here pdf

Modigliani Conventional theory

and Miller When there is only equity, the WACC starts at the

without tax cost of equity. As the more expensive equity finance

ke is replaced by cheaper debt finance, the WACC

decreases. However, as gearing increases further,

WACC both debt holders and equity shareholders will

perceive more risk, and their required returns both

increase. Inevitably, WACC must increase at some

point. This theory predicts that there is an optimum

kd gearing ratio at which WACC is minimised.

Gearing = Vd/Ve M&M were able to demonstrate that as gearing

increases, the increase in the cost of equity

Cost % precisely offsets the effect of more cheap debt so

Modigliani and that the WACC remains constant.

Miller with tax

Modigliani and Miller (M&M) with tax

ke Debt, because of tax relief on interest, becomes

unassailably cheap as a source of finance. It

becomes so cheap that even though the cost of

equity increases, the balance of the effects is to

keep reducing the WACC.

WACC (Note: the M&M diagrams shown in Example 1

hold only for moderate levels of gearing. At very

kd (1-T) high levels of gearing, other costs come into play

and the WACC can be shown to increase again –

Gearing = Vd/Ve looking rather like the conventional theory.)

lower than the cost of equity (Ke). This is because

debt is inherently less risky than equity (debt has

constant interest; interest is paid before dividends;

debt is often secured on assets; on liquidation

creditors are repaid before equity shareholders). In the

third version, cost of debt is further reduced because

in an environment with corporation tax, interest

payments enjoy tax relief.

03 technical

The new funds being put into the new project are subject to the risk inherent

Different business activities will have different risk characteristics and hence

In that project, and so should be discounted at a rate which reflects that risk.

any business carrying on those activities will have a different beta factor.

Whichever theory you believe, whether there is PROJECT APPRAISAL 3 – DIFFERENT

or isn’t tax, provided the gearing ratio does not BUSINESS ACTIVITIES, A MIX OF FUNDS AND

change the WACC will not change. Therefore, CHANGING GEARING

if a new project consisting of more business Let’s deal with different business activities

activities of the same type is to be funded so as first. Different activities will have different risk

to maintain the present gearing ratio, the current characteristics and hence any business carrying

WACC is the appropriate discount rate to use. on those activities will have a different beta factor.

In the special case of M&M without tax, you can The new funds being put into the new project are

do anything you like with the gearing ratio as the subject to the risk inherent in that project, and so

WACC will remain constant and will be equal to should be discounted at a rate which reflects that

the ungeared cost of equity. risk. The formula:

The condition that gearing is constant does not

have to mean that upon every issue of capital both E(ri) = Rf + ßi(E(rm) - Rf)

debt and equity also have to be issued. That would

be very expensive in terms of transaction costs. predicts the return that equity holders should

What it means is that over the long term the gearing require from a project with a given risk, as

ratio will not change. That would certainly be the measured by the beta factor of that activity.

company’s ambition if it believed it was already at Note that we are doing something quite radical

the optimum gearing ratio and minimum WACC. here: CAPM is allowing us to calculate a risk

Therefore, this year, it might issue equity, the next adjusted return on equity, tailor-made to fit the

debt and so on, so that the gearing and WACC hover characteristics of the project being funded. All

around a constant position. projects consist of capital being supplied, being

invested and therefore being subject to risk, but the

risk is determined by the nature of the project, not

the company undertaking the project. The existing

return on equity of the company that happens to be

the vehicle for the project has become irrelevant.

We can extend this argument as follows. If the

company doing the project is irrelevant there’s no

reason why you can’t view the project as being

undertaken by a new company specially set up for

that project. The way the project is funded is the

way the company is funded and, in particular, the

appropriate discount rate to apply to the project

is the WACC of the company/project, not its cost

of equity – which would take into account only one

component of the funding.

student accountant 11/2009

04

risk by using a beta value appropriate to that risk. The final steps are to adjust

we can calculate the cost of equity component which reflects project

the cost of equity to reflect the gearing and then to calculate the

So we can calculate the cost of equity component ßa = Veße

which reflects project risk by using a beta value Ve + Vd (1 - T)

appropriate to that risk. The final steps are to

adjust the cost of equity to reflect the gearing and What is meant by ßa (the asset beta), and ße (the

then to calculate the appropriate discount rate, the equity beta)?

WACC. The diagrams shown in Example 1 show

(qualitatively) how the rates might move. No matter The asset beta is the beta (a measure of risk)

how reasonable the conventional theory seems, which arises from the assets and the business the

its big drawback is that it makes no quantitative company is engaged in. No heed is paid to the

predictions. However, the Modigliani and Miller gearing. An alternative name for the asset beta is

theory does make quantitative predictions, and the ‘ungeared beta’.

when combined with CAPM theory it allows the beta

factor to be adjusted so that it takes into account The equity beta is the beta which is relevant to

not only business risk but also financial (gearing) the equity shareholders. It takes into account

risk. The formula you need is provided in the the business risk and the financial (gearing) risk

Paper F9 exam formula sheet: because equity shareholders’ risk is affected by

both business risk and financial (gearing) risk.

ßa =

[ Ve

Ve + Vd (1 - T)

ße

[ [

+ Vd (1-T) ßd

Ve + Vd(1 - T) [ An alternative name for the equity beta is the

‘geared beta’.

appropriate discount rate, the WACC.

Ve = market value of equity is no debt), then the two betas are the same. If

Vd= market value of debt there is debt, the asset beta will always be less

T = corporation tax rate than the equity beta because the latter contains an

ßa = the asset beta additional component to account for gearing risk.

ße = the equity beta The formula is extremely useful as it allows us

ßd = the debt beta to predict the beta, and hence the cost of equity,

for any level of gearing. Once you have the cost of

ßd, the debt beta, is nearly always assumed to be equity, it is a straightforward process to calculate

zero, so the formula simplifies to: the WACC and hence discount the project.

05 technical

WACC of the finance. Again, in the Paper F9 exam formula sheet you will find a

In example 2, The appropriate rate at which to evaluate the project is the

To illustrate the use of CAPM in determining a Solution:

discount rate, we will work through the following 1 We have information supplied about a company in

example, Example 2. the right business but with the wrong gearing for

our purposes. To adjust for the gearing we plan

EXAMPLE 2 to have, we must always go through a theoretical

Emway Co is a company engaged in road building. ungeared company in the same business.

Its equity shares have a market value of $200 Again the beta supplied to us will be the beta

million and its 6% irredeemable bonds are valued at measured in the market, so it will be an equity

par, $50m. The company’s beta value is 1.3. Its cost (geared) beta. Were Foodoo to be ungeared, its

of equity is 21.1%. ( Note: this figure is quite high asset beta would be given by:

in the current economic situation and is used for

illustration purposes. Currently, in a real situation, ßa = Ve ße = 7 x 0.9

the cost of equity would be lower.) Ve + Vd (1 - T) 7 + 5 (1 - 0.2)

The company is worried about the recession and

is considering diversifying into supermarkets. It = 0.5727

has investigated listed supermarkets and found

one, Foodoo Co, which quite closely matches its This asset beta (ungeared beta) can now be

plans. Foodoo has a beta of 0.9 and the ratio of the adjusted to reflect the gearing ratio planned in

market value of its equity to its debt is 7:5. Emway the new venture:

plans that its new venture would be financed with a

market value of equity to market value of debt ratio 0.5727 = 1 ße

of 1:1. 1 + 1(1 - 0.2)

The corporation tax rate is 20%. The risk free rate

is 5.5%. The market return is 17.5%. So the planned ße will be 0.5727 x 1.8 = 1.03

What discount rate should be used for the Check that this makes sense. Foodoo has a

evaluation of the new venture? gearing ratio of 7:5, equity to debt, a current beta

of 0.9, and a cost of equity of 16.30 (calculated

from CAPM as 5.5 + 0.9(17.5 - 5.5)). Were

Foodoo ungeared, its beta would be 0.5727, and

its cost of equity would be 12.37 (calculated

from CAPM as 5.5 + 0.5727(17.5 - 5.5)).

ratio of 1:1. This is higher gearing, so the equity

beta must be higher than Foodoo’s 0.9.

student accountant 11/2009

06

in example 2, finally take account of the cheap debt finance that is mixed with

this equity finance by calculating the WACC of 11.33%. this is the rate which

should be used to evaluate the new supermarket project, funded

2 To calculate the return required by the suppliers In terms of the diagram used in Example 1, for

of equity to the new project: Modigliani and Miller with tax, what we have done

for Foodoo’s figures is set out below. We started

Required return = Risk free rate + ß (Return from with information relating to a supermarket with a

market - Risk free rate) gearing ratio of debt:equity of 5:7, and an implied

cost of equity of 16.30%. We strip out the gearing

= 5.5 + 1.03 (17.5 - 5.5) = 17.86% effect to arrive at an ungeared cost of equity of

12.37, then we project this forward to whatever

3 17.86 is the return required by equity holders, level of gearing we want. In this example, this is

but the new venture is being financed by a mix a gearing ratio of 1:1 and this implies a cost of

of debt and equity, and we need to calculate the equity of 17.86%.

cost of capital of this pool of finance. Finally, we take account of the cheap debt finance

that is mixed with this equity finance, by calculating

Note that while Paper F9 does not require students the WACC of 11.33%. This is the rate which should

to undertake calculations of a project-specific be used to evaluate the new supermarket project,

WACC, they are required to understand it from a funded by debt:equity of 1:1.

theoretical perspective.

Cost %

The appropriate rate at which to evaluate the

project is the WACC of the finance. Again, in the

Paper F9 and Paper P4 exam formula sheet you

will find a formula for WACC consisting of equity ke

and irredeemable debt. 17.86

16.30

12.37

Ke = 17.86%

Kd = 6% (from the cost of the debentures already

issued by Emway) WACC

11.33

1+1 1+1

5/7 1/1

by debt:equity of 1:1.

Gearing = MVd/MVe

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