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MTR Corporation

COST OF CAPITAL
COST OF CAPITAL (WEIGHTED AVERAGE COST
OF CAPITAL)
The Cost of Capital under this case study refers to the
Weighted Average Cost Of Capital

The cost of capital has always formed an integral part


of business decisions when it comes to the capital
budgeting or investment decisions.
Uses of Cost of Capital.
The cost of capital is used as a discount rate in net
present value calculation and as a target rate of return
for comparing a projects internal rate of return.
The cost of capital helps management is able to
measure the worth of an investment proposal and
thats what we seek to arrive at, in calculating the cost
of capital for MTR Corporation Limited
WEIGHTED AVERAGE COST OF CAPITAL
(WACC)
In calculating the cost of capital of MTR or also know
as The Weighted Average Cost of Capital, Whatever
Cost of Capital is arrived at MTC Corporation expects
its commercial return to be 1-3% above its WACC.
Future investments project should be realise a
Internal Rate of Return 1-3% higher than MTR
Corporations Cost of Capital
In calculating of WACC a few items should be
checked off to aid in the computation.
Formula for computation of WACC
WACC = ((E/V) * Re) + [((D/V) * Rd)*(1-T)]
E = Market value of the company's equity
D = Market value of the company's debt
V = Total Market Value of the company (E + D)
Re = Cost of Equity
Rd = Cost of Debt
T= Tax Rate
Cost of Capital (Debt & Equity)
The Capital Composition for MTR Corporation. (Equity
& Debt)
Tax Rate
COST OF EQUITY
the cost of equity is the return (often expressed as
a rate of return) a firm theoretically pays to its equity
investors, i.e., shareholders, to compensate for the
risk they undertake by investing their capital.
In computing the cost of equity a few underlying
assumptions are to be addressed

The has been no new issue so there would be no need


for underwriting fees of 6%

The Capital Asset Pricing model ( CAPM) is used in


computing the cost of equity
The formula for CAPM
Re=Rf + (Rm-Rf)*
Re=Required rate of return or our cost of equity
Rf=Risk free rate
Rm-Rf=Market risk Premium
=Beta Coefficient unsystematic risk
The assumed risk free rate used was Hong Kong
Exchange fund bond 10-year yield of 2.09% due to the
very large difference in the historical returns of the Hang
Seng relative to U.S. Stocks if it werent so then the
standard U.S. Treasury Bill rate would be used.
The Beta used was 0.74 obtained by regressing the
returns for MTRC against the returns of the Hang Seng
Index.
The market return is based on the Hang Seng, S&P
500 Index and selected data (1983-2012). This
provides an arithmetic Average of Total return of
12.0%. The 12.0% is what is used as the Market
Return.
Thus CAPM would be

=2.09 + (12.0-2.09)*0.74
=9.4234

The cost of equity is thus 9.4234%


COST OF DEBT

Cost of debt refers to the effective rate a company pays on its current
debt. In most cases, this phrase refers to after-tax cost of debt, but it
also refers to a company's cost of debt before taking taxes into
account. The difference in cost of debt before and after taxes lies in
the fact that interest expenses are deductible.
In arriving at the cost of debt 2 methods are worth
mentioning:
1. The Yield-to-maturity approach &
2. Debt rating approach
The following assumptions were used in arriving at
the cost of debt

Cost of issuing bonds was not considered


Assumed all debt fixed
The corporate tax for Hong Kong in 2012 was 16.5%
per further information gathered since the cost of
debt should be after tax because interest on debt is
tax deductible.
Source:https://tradingeconomics.com/hong-
kong/corporate-tax-rate
Yield to Maturity Approach

Yield to maturity (YTM) is the total return anticipated


on a bond if the bond is held until the end of its
lifetime. Yield to maturity is considered a long-
term bond yield, but is expressed as an annual rate. In
other words, it is the internal rate of return of an
investment in a bond if the investor holds the bond
until maturity and if all payments are made as
scheduled.
Formula for YTM Approach
YTM=[ C + (F-P/n)/ F+P/2]
C=Coupon
F=Face Value
P=Price
n=Year to Maturity
Assuming all bonds issued 2012 had the same
conditions the Bonds of US$300M and US$250M
would give a total debt amount of US$550M.

F=US$550M
P=550*0.99175=545.4625
C=2%*550=11
n=5yrs
YTM=[ C + (F-P/n)/ F+P/2]

=11 + (550-545.4625/5)/550+545.4625/2
=11.9075/547.73125=2.174%
Introducing tax of 16.5%
=0.002174(1-0.165)
=1.8153%
Using the Yield to maturity and the Long Term Bond of
debt MTRC is realising a cost of debt of 1.8153%
Using the debt rating approach

The Yield on an AAA debt for MTR Corporation for bonds with
maturity period of April 2017 had a Yield of 1.99% per Schedule
Exhibit 8.
Hence the debt rating approach cost of debt would be
0.0199(1-0.165)
1.6616%
Capital Structure Schedule
Looking at only Looking at all long term
market value of bond debt and short term
debt debt

Equity 176,686.50 176,686.50


Debt 550.00 23,577.00
Total 177,236.50 200,263.50
WACC Using Yield to Maturity cost of equity

=176686.5/177236.5*9.4234 + 550/177236.5*1.8153
=9.39+0.0056
=9.3956%
The WACC when just the Bond Loan amounts are used
is 9.3956%, the reason for such assumption is because
it is assumed by the time projects needed for the
assessment with the cost of capital all short term debts
would be non-existent.
How should MTRC employ its cost of capital

As mentioned earlier on there are numerous ways to apply the cost of


capital of a company but with MTRC its main focus was the
assessment of future investments or projects as to be able to identify
the best hurdle rate for its capital investments. Since the hurdle rate
is the minimum amount a firm is expecting to realise from a project
MTRC should ensure that all projects that come in not only have an
internal rate of return of 9.3956% to equate the current cost of
capital but must have an Internal rate of return of either be 10.3956%
or 12.3956% to satisfy the condition of MTRC meeting its commercial
return by being 1-3% higher than the WACC.