PQ ICAEW focus
A weighty issue
Rob Stephens explains how to calculate weighted average cost of capital
A
s a topic, students can struggle
with WACC more than they
possibly should. The important
fact to remember is that we are simply
calculating the average cost of a
business’s long-term finance (as a
percentage). So, if we imagine a
company is funded by borrowing and
equity in equal proportions, and if the
finance cost of each is 5% and 10%
respectively, it should hopefully be logical
to conclude that the (weighted) average
cost of capital is 7.5%. We shall return to
this calculation later but at this stage we
need to understand how to calculate the
costs of the individual capital types,
namely borrowing (debt) and equity.
Cost of equity.
Dividend Model: There are two models
we can use to calculate a cost of equity.
The first of these, dividend model,
expresses the finance cost as the cost of
paying dividends as a percentage of the
share price. So, assuming a share was
worth £2 and a company pays a constant
annual dividend of 20p, we could
conclude that the company has to
provide a 10% return to shareholders to
keep them satisfied (cost of equity). This
can be written as Ke = do/Po.
In reality dividends are not paid at a
constant rate year on year. The following
mathematical model allows us to recalculate
the cost of equity where dividends are
assumed to grow (g) at a constant annual
rate:
Ke = (do(1+g)/Po) + g
Assuming a share price of £2, a dividend
just paid of 20p (do), and an assumed
dividend growth rate of 5%,
Ke = (20(1.05)/200) + 0.05 = 0.155 (15.5%).
Capital Asset Pricing Model (CAPM): While
we shall not explore this model in detail at
this time, it is worth noting that while the
dividend model calculates a cost of equity by
expressing dividend costs as a percentage of
share price, CAPM measures the return
we would need to offer shareholders (Ke)
to compensate them for the degree of risk
(market/systematic) they are taking by
holding that particular share.
By attributing a risk factor (called a
beta) of 1 to the stock market on average,
the technique involves calculating the risk
factor of individual shares and then
assessing how much return each share
ought to be providing to shareholders (Ke)
given the risk attributable to that share.
For illustration purposes, imagine if one
could earn 5% by investing in government
securities that we assume are subject to
no risk (a risk-free investment) and 10%
by spreading funds across all shares on
the stock market. If we were now told that
a share carried a risk factor (beta) of 1.2,
the model would suggest that this share
should provide a minimum of 5%
(because that could be earned by anyone,
taking no risk). In addition, if earning an
extra 5% (10%-5%) is possible by taking
on a risk factor of 1, CAPM would argue
that a share with a risk factor of 1.2 should
earn an extra (1.2 x 5%) 6%. Thus
Ke = Rf + ß(Rm-Rf)
where Rf = risk-free rate of return, Rm =
return on stock market as a whole, ß =
beta (risk factor).
In our illustration
Ke = 5% + 1.2(10%-5%) = 11%
In a future article we will take a look
at the cost of debt and the WACC
calculation. PQ
• Rob Stephens is a Partner at First
Intuition Reading
PQ your health
Food for
thought
Health eating can help you pass
your exams, says Nicki Cresswell
B
usy trainee accountants often eat
notoriously badly – endless coffee at
their desk, a takeaway on the way
home as they switch from a working day to a
night of revision, or even just a random
succession of hastily scoffed crisps and
chocolate bars.
But taking a little time and effort to
manage your diet has a whole range
of benefits, and not just for
your waistline. Watching
what you eat can help
you to boost your brain
24
function, support your immune system and
reduce stress. And it can be done on a budget.
The first thing to do is have an awareness of
the basics by learning a few fundamental diet
‘numbers’. These are some of the important ones
and there are also links at the bottom of this
feature where you can find more information:
• Work out your current body mass index (BMI)
and find out what it should be. Your BMI is the
best guide to your ideal weight in relation to your
body shape.
• Eat five portions of fruit or vegetables every
day. Not only is this healthy in itself but will help
to steer you towards a generally much improved
diet.
• Men should keep their alcohol consumption
below 3-4 units and women under 2-3 a day –
and you should aim for at least two alcohol-free
days every week.
• Keep your caffeine intake below 300mg per
day. A single cup of filter coffee contains
around 100mg while tea has 40mg
and a can of cola around
the same.
• Have an idea what
your cholesterol and
blood pressure should be
and monitor them under
the guidance of your
doctor.
A useful additional diet skill is being able to
identify which foods can help you to maximise
your brain power. While miracles are unlikely,
eating the right foods is proven to improve your
memory and help you to think more clearly –
pretty useful skills for trainee accountants. These
foods include oily fish, nuts and seeds, tomatoes,
blueberries and blackberries.
Knowing your way around these diet basics
will help you not just through the process of
training to be an accountant but for the rest of
your life. PQ
Useful links.
❖ Why five a day?
http://www.nhs.uk/Livewell/5ADAY/Pages/Why5ADAY.aspx
❖ What constitutes five a day?
http://www.nhs.uk/Livewell/5ADAY/Pages/Whatcounts.aspx
❖ Eating healthily on a budget
http://www.nhs.uk/Livewell/5ADAY/Pages/
Tencheapways.aspx
❖ How to calculate your BMI
www.nhs.uk/Tools/Pages/Healthyweightcalculator.aspx
❖ More about brain foods
http://www.bbcgoodfood.com/content/wellbeing/features/
boost-brainpower/1/
• Nicki Cresswell, training and events coordinator, Chartered Accountants Benevolent
Association. Call 01788 556366 for more
details or see www.caba.org.uk
PQ Magazine February 2012