UNSW Business School School of Banking and Finance FINS1613: Business Finance 2021 Term 2 Section IV: Cost of Capital n Robert Tumarki r.tumarkin@unsw.edu.au UNSW Business School School of Banking and Finance FINS1613: Business Finance 2021 Term 2 Week 8: Risk, Return, and the Capital Asset Pricing Model The historical record: A rst look The growth in value of $10, 000 invested three major Australian asset classes over the past 30 years (1988 through 2017 Source: www.vanguard.com.au fi ) 3 Risk and return concepts 4 Realised returns De nition The realised return on a security is the percent return change in the security’s value over a particular time period. V aluet+1 V aluet V aluet V aluet+1 = 1 V aluet Return = fi 5 Realised returns Example: Return on a stock over 1 perio You purchased a stock for P0. One period later you received a dividend of Div1 and the stock price was P1 P1 + Div1 P0 1 6 d Return = Realised returns To determine the cumulative return on a security over a multiple time periods, compound the returns for each individual period Assume a stock returns R1 from t=0 to t=1, R2 from t=1 to t=2, and so on. Then the realised return on the stock from t=0 to t=4 is: Return = (1 + R1 ) ⇥ (1 + R2 ) ⇥ (1 + R3 ) ⇥ (1 + R4 ) 1 For stocks, we assume that all dividends are used to purchase new shares in the stock. That is, dividends are reinvested in the stock. (This is identical to the interest reinvestment assumption when compounding.) . 7 Describing realised returns A security’s arithmetic average return for a given timeperiod length (e.g. month, year, etc) is simply the average of the realised returns over several such time-period R̄ = 1 (R1 + R2 + · · · + RT ) T It serves as an estimate of the expected return for a single time-period in the future, assuming that the distribution of returns does not change. s 8 Describing realised returns A security’s geometric average return for a given timeperiod length (e.g. month, year, etc) is simply the geometric average of the realised returns over several such time-period R̄G = ((1 + R1 ) ⇥ (1 + R2 ) ⇥ · · · ⇥ (1 + RT )) 1/T 1 It provides the constant periodic return required to achieve the security’s total realised returns from time-0 to time-T. It is not an estimate of the expected return for a single time-period in the future due to a reinvestment and compounding assumption. s 9 Describing realised returns A stock returned 10% one year and 50% the next. Assume that these two returns are the only possibilities in the future and are equally likely • What is your total return in the stock expressed as a two-year rate and as a one-year rate that assumes reinvestment and compounding • What is the stock’s expected one-year return : ? ? 10 Describing the realised risk in returns A security’s variance and standard deviation both measure the variability in realised returns. Variance is the average squared deviation of realised returns from the average: V ar(R) = 1 T 1 h R1 R̄ 2 + R2 R̄ 2 + · · · + RT R̄ Standard deviation is the square root of the variance: R 11 SD(R) = p = V ar(R) 2 i Using average and standard deviation If we assume that returns are normally distributed… 95% of the time Likelihood 68% of the time -3 -2 -1 0 1 2 3 Standard Deviations … then one can estimate the an interval in which the realised return will fall a given percent of the time. 12 Sample problem A stock has had annual returns of 15%, 30%, and -8%. What is your best estimate of the 95% prediction interval for next year’s return assuming the underlying distribution is normal? 13 Risk and return Don’t forget that risk measures uncertainty after normalising for the expected return • • An investment that will always lose all your money (e.g. the return is always -100%) has no uncertainty An investment that always makes money (e.g. the return will be 150% or 300%) can have a large amount of uncertainty. . . 14 Historical risk and return 15 The historical record: A rst look The growth in value of $10, 000 invested three major Australian asset classes over the past 30 years (1988 through 2017 Source: www.vanguard.com.au fi ) 16 The historical record: A second look In the U.S., a similar pattern emerges from 1926 - 2005 Asset class Average annual return Standard deviation Small company stocks 17.4% 32.9% Large company stocks 12.3% 20.2% Long-term corporate bonds 6.2% 8.5% Long-term government bonds 5.5% 5.7% U.S. Treasury bills 3.8% 3.1% 17 Risk premium De nition The reward for bearing risk. Measured as the excess return on a risky asset over the risk-free rate, which is the rate of return on a risk-less investment. Risk premium = Return on risky asset fi 18 Risk f ree rate Historical risk premiums Investment Average return Risk premium Australian shares 9.8% 3.6% Australian bonds 8.3% 2.1% Cash 6.2% 0.0 Observation: Stocks, which are relatively risky, have higher returns than bonds, which are relatively safe. 19 Portfolios and individual stocks = Portfolio Observation: Portfolios, which are relatively low risk, can perform as well as individual securities, which have relatively high risk. Source: Fundamentals of Corporate Finance, Pearson Objective We would like a model that is compatible with two observations about historical returns • • Asset class returns increase with risk over the long-term (stocks outperform bonds, which outperform cash) Portfolios can provide similar performance to individual securities, despite having lower risk. It is not obvious how these two observations can co-exist as they seem to imply different relationships between risk and returns. : . 21 Thought exercise 22 A simple stock Imagine there is a stock that once you invest immediately is worth either $2 or $0. What is this stock worth ? 23 A LOT of stocks Imagine there are an in nite number of stocks. Each is worth either $2 or $0 immediately after you have implemented your entire investment strategy. Knowing the nal value of one stock does not tell you anything about the nal value of another stock What are these stocks worth? Assume you are very wealthy and can buy as many stocks as you like fi fi . . fi 24 A LOT of stocks? Imagine there are an in nite number of stocks. Each is worth either $2 or $0 immediately after you have implemented your entire investment strategy. Knowing the value of one stock tells you the value of every other stock. For example, if one stock is worth $2, then all stocks are worth $2. What are these stocks worth? Assume you are very wealthy and can buy as many stocks as you like fi . 25 Observation Recall the return equation Return = V aluet+1 V aluet 1 It shows that if you x the nal value of an asset, then … A factor that alters the initial value in uences returns A factor that does not change the initial value has no impact on returns . fl fi : 26 fi • • Observation Recall the return equation Return = P ricet+1 P ricet 1 It shows that if you x the nal price of an asset, then … A factor that alters the initial price in uences returns A factor that does not change the initial price has no impact on returns . fl fi : 27 fi • • Lessons • Investors generally do not like uncertainty. This is often stated as investors are riskaverse • There are two types of risk • • - Risk that is unique to a security can be eliminated by buying many securities Risk that is common to all securities can not be eliminated Risk-averse investors will ignore risk that can be eliminated in securities. This risk does not affect prices or returns. Risk-averse investors will price securities with risk that can not be eliminated less than the expected payoff. Risk-averse investors will demand that securities containing risk that can not be eliminated provide a positive return (relative to the expected payoff ). . . . . 28 Portfolios, risk, and diversi cation fi 29 Types of risk There are two types of risk.. • Systematic risk: Risk that is linked across outcomes. Also called common risk. • Unsystematic risk: Risks that bear no relationship to each other. Also called independent, diversi able, or idiosyncratic risk. fi . 30 Historical risk premiums Investment Average return Risk premium Australian shares 9.8% 3.6% Australian bonds 8.3% 2.1% Cash 6.2% 0.0 Do both systematic and unsystematic risks earn risk-premiums? Source: www.vanguard.com.au 31 Portfolio De nition A portfolio is a collection of securities. It is de ned by: (i) the securities that are in the portfolio and (ii) the amount invested in each security. It is possible to have negative amounts invested in a security. Examples include borrowing cash and shorting stocks. fi fi 32 Portfolio sample problem One year ago, you invested $30,000 in stock A and $20,000 in stock B. Today stock A is worth $45,000 and stock B is worth $15,000. What is the return on your portfolio ? 33 Analysing portfolio return calculations The key equation for computing portfolio returns follows from basic properties of arithmetic (A1 + B1 ) (A0 + B0 ) A0 + B 0 (A1 A0 ) + (B1 B0 ) = A0 + B 0 RP = = = A0 (A1A0A0 ) + B0 (B1B0B0 ) A0 + B 0 A0 B0 RA + RB A0 + B 0 A0 + B 0 Retur The return on a security in the portfolio. Weight The percent of the initial investment in a security. : n 34 Portfolio return De nition The return of a portfolio is a weighted average of the returns of the individual securities, where the portfolio weight (wj) is the value of the investment in asset j as a percent of the total portfolio value RP = w A ⇥ RA + w B ⇥ RB + . . . . fi 35 Portfolio sample problem One year ago, you invested $30,000 in stock A and $20,000 in stock B. Over that year, stock A returned 50% and stock B lost 25%. What was the return on your portfolio ? 36 Portfolio risk example Returns Stock A Stock B Portfolio January 1.00% -0.93% 0.04% February -14.00% -7.16% -10.58% March -18.00% 0.23% -8.88% April -1.00% 3.07% 1.04% May -10.00% -3.27% -6.63% June -13.00% -11.26% -12.13% July -4.00% 10.70% 3.35% August 12.00% -8.27% 1.87% September 19.00% 5.56% 12.28% October -20.00% 20.12% 0.06% November 0.00% 9.86% 4.93% December -11.00% 5.70% -2.65% Average -4.92% 2.03% -1.44% St Dev 11.34% 8.65% 6.80% Correlation -9.40% Portfolio risk A portfolio containing two assets has a variance given by 2 p = !a2 2 a + !b2 2 b + 2⇢a,b !a !b a b 8 > !a = Porfolio weight of asset a > > > > > <!b = Porfolio weight of asset b where b = Standard deviation of asset b > > > > b = Standard deviation of asset b > > :⇢ = Correlation of assets a and b a,b : 38 Computing portfolio risk What is the standard deviation of a portfolio with 40% allocated to Stock A and 60% allocated to Stock B? Stock A has a standard deviation of 25%, Stock B has a standard deviation of 50%, and the correlation coef cient for the two stocks is 0.3. fi 39 Principle of diversi cation Total unsystematic risk decreases as assets are added to a portfolio 40 20 Unsystematic Risk 10 Systematic Risk 0 0 250 500 Number of Securities 40 fi Standard Deviation (%) 30 750 1,000 Principle of diversi cation De nition As (i) different types of securities are added to a portfolio and (ii) the average size of each position shrinks, the amount of unsystematic risk in the portfolio declines to zero and only systematic risk remains Unsystematic risk is essentially eliminated by diversi cation, so a relatively large portfolio only has systematic risk. fi . fi fi 41 Systematic return principle 42 Risk and return There are two types of risk.. • Systematic risk: Risk that is linked across outcomes. Also called common risk. • Unsystematic risk: Risks that bear no relationship to each other. Also called independent, idiosyncratic, or diversi able risk ... but only one type earns a risk-premium. • Investors must be rewarded for bearing systematic risk, otherwise no one would own risky assets • As systematic risk increases, expected returns increase. fi . . . 43 The systematic risk principle De nition The risk premium of a security is determined by its systematic risk and does not depend on its diversi able (unsystematic) risk. Only systematic risk has earns a risk premium. The risk premium for diversi able risk is zero; investors are not compensated for holding unsystematic risk. fi fi fi 44 The Capital Asset Pricing Model (CAPM) 45 Risk premium De nition The reward for bearing risk. Measured as the excess return on a risky asset over the risk-free rate, which is the rate of return on a riskless investment (for example, treasury bills). Risk premium = Return on risky asset fi 46 Risk f ree rate Historical risk premiums Historical averages Investment Systema c Risk Unsystema c Risk Expected Return Risk Premium Stock A 3x equity risk Medium ? ? Australian equities Equity risk None 9.8% 3.6% Stock B 0.5x equity risk High ? ? Risk-free None None 6.2% 0.0% (All Ordinaries) ti ti 47 Capital Asset Pricing Model (CAPM) Expected return of a security is linear in its ‘beta Expected return The expected rate of return on security i. It is the expected return in the market on investments with equivalent risk to the risk associated with the security. E[ri,t ] = rf + i Beta Measures the sensitivity of security i to market movements. Captures relative systematic risk. ⇥ M arket Risk P remium Market Risk Premiu The average return market participants demand for bearing the market’s systematic risk. It re ects the average risk aversion of all market participants. Risk-free retur The return on a riskless security. M arket Risk P remium = E(rm ) rf where E(rm) is the expected return on the market. ’ fl m n 48 Capital Asset Pricing Model (CAPM) Key implications of the CAPM • Investors are compensated for holding systematic risk in form of higher returns. • The size of the compensation depends on the market risk premium • The market risk premium is increasing in • • the volatility of the market portfoli the risk aversion of average investor : o : . 49 Beta De nition The level of systematic risk in any asset relative to that of the “market”. By de nition, the market has a beta of 1 and the risk-free asset has a beta of 0 In principle, the “market” contains every asset in the economy (every stock, bond, property, etc). In practice, the “market” is often chosen to be a stock market index (e.g. Australian All Ordinaries, S&P 500). fi . fi 50 Implications of the CAPM The excess return on a security is its return over the risk free rate. The CAPM implies that the excess return of security i is proportional to its systematic risk (beta): E[ri,t ] rf = i ⇥ M arket Risk P remium This implies that all security’s (e.g. security i and security j) have the same excess return-to-risk ratio: E[ri,t ] rf = M arket Risk P remium = i E[rj,t ] j 51 rf Estimating beta The CAPM implies a relationship that can be used to estimate beta. Using the relationship between security and market excess returns (from the previous slides): E[ri,t ] rf = i = i ⇥ M arket Risk P remium ⇥ (E [rm,t ] rf ) This implies that one can use observed data to estimate beta: ri,t rf = i ⇥ (rm,t 52 rf ) Estimating beta Beta is generally found as the slope of the best tting linear regression line between security excess returns (vertical axis) and the market excess returns (horizontal axis). An example for Apple is shown below Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – 9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition fi : 53 CAPM example Assume the risk-free rate is 3.5% and the market-risk premium is 5%. • What is the expected return for a stock with β=1.07 Assume the expected return on a stock with β=0.69 is 12% and the risk-free rate is 2.0% • What is the expected market return? From the Capital Asset Pricing Model (CAPM) : ? . 54 Betas for selected industries Low betas suggest an asset’s returns are relatively insensitive to market movements… Industry Beta Industry Beta Apparel 0.82 Computer 1.19 Banks 0.57 Cable TV 1.15 Business & Consumer Services 0.94 Drugs (Biotech) 1.28 Education 0.87 Homebuilding 1.07 Food Wholesalers 0.69 Internet 1.15 Hospitals 0.74 Precious Metals 1.19 Power 0.81 Retail 1.11 Restaurant/Dining 0.78 Semiconductor 1.36 Tobacco 0.71 Telecom Equipment 1.16 …Assets with high betas have returns that are relatively sensitive to market movements. Source: Aswath Damodaran (http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datacurrent.html) s 55 Security Market Line (SML) De nition The SML plots the expected return on a security as a function of its beta. It implies that a security’s expected return linearly depends on systematic risk (beta). Expected Return Expected Return E[ri,t ] = rf + i ⇥ M arket Risk P remium E[rm ] rf 0 1 Beta( Beta (β) ) fi 56 Security Market Line (SML) De nition The SML plots the expected return on a security as a function of its beta. Expected Return Expected Return E[ri,t ] = rf + i ⇥ M arket Risk P remium E[rm ] Securities (portfolios) with Betas less than 1 are expected to return less than the market. rf 0 1 Beta( Beta (β) ) fi 57 Security Market Line (SML) De nition The SML plots the expected return on a security as a function of its beta. Expected Return Expected Return E[ri,t ] = rf + i ⇥ M arket Risk P remium E[rm ] rf 0 1 Beta( Beta (β) ) fi 58 Securities (portfolios) with Betas greater than 1 are expected to return more than the market. Portfolios and individual stocks = Portfolio Observation: Portfolios, which are relatively low risk, can perform as well as individual securities, which have relatively high risk. Source: Fundamentals of Corporate Finance, Pearson CAPM and Portfolios A portfolio’s expected return is RP = w A ⇥ RA + w B ⇥ RB + . . . … and must also satisfy the CAPM P ⇥ M arket Risk P remium 60 … E[rP,t ] = rf + CAPM and Portfolios The derivation of a portfolio’s beta follows from substitution RP = w A ⇥ RA + w B ⇥ RB + . . . E[rP,t ] = rf + P ⇥ M arket Risk P remium : 61 CAPM and Portfolios The CAPM can be applied to portfolios by setting beta equal to the weighted average of the individual securities’ betas E[rP,t ] = rf + P ⇥ M arket Risk P remium wher P = wA ⇥ A + wB ⇥ B + ... : e 62 Portfolio example What is the expected return on the following portfolio assuming a risk-free rate of 5% and a 7% risk-premium. Asset Shares Price Value 2,300 0.392 901.6 ANZ Banking 43 26.940 1.40 BHP Billiton 85 31.010 1.04 “The Market” 1 5986.10 3,500 1 Myer Risk-free asset Portfolio 63 Weight Beta 1.67 Expected Return Objective The CAPM is compatible with two observations about historical returns: • Stocks outperform bonds, which outperform cash. Stocks have higher systematic risk than bonds. • Portfolios can provide similar performance to individual securities, despite having lower risk. Portfolios can have lower total risk, but the same systematic risk as individual securities. 64 UNSW Business School School of Banking and Finance FINS1613: Business Finance 2021 Term 2 Week 9: Capital Structure and the Cost of Capital Cost of capital 66 Expected returns and discount rates The analysis of risk and return shows that • The expected return premium on any asset is proportional to its systematic risk As a consequence, a rm trying to attract investors must • Offer investments that meet the return expectations of the markets. That is, a project must have a positive NPV when discounted at the appropriate expected return • Providing returns is a necessary cost to the company for accessing investor capital. . . : : fi 67 Cost of capital De nition The required rate of return a company must offer investors for a project to compensate them for risk. Consequently, it is the discount rate a company should use when valuing projects. fi 68 Preliminaries 69 Valuation: Parts and their whole Consider a nancial source (e.g. rm or project) that distributes the cash ows generated across different nancial securitie Source Asset A Asset B There are two possible methods to value the entire nancial source • Value assets A and B individual at their respective discount rates and then add the values • Value the source at an appropriate discount rate. This distinction is relevant. Only the securities of a rm (e.g. debt and equity) are directly valued in nancial market.s fl : fi s fi fi fi fi fi . 70 Valuing the parts to value the whole Total cash ow Source Cash ows to each security Asset A Asset B Discount rates rA rB Values VA + fl fl 71 VB = ValueSource Valuing the whole Total cash ow Source Cash ows to each security Discount rates Values rSource ValueSource fl fl 72 Valuing the parts to value the whole Total cash ow Source Source Cash ows to each security Asset A Asset B Discount rates rA rB rSource Values VA VB ValueSource + Is there a relationship between the individual discount rates and the source discount rate? fl fl 73 Example Imagine an asset that yields cash ows in 1 period and never again. • • Security A receives $6.25, and has a cost of capital of 25%. Security B receives $11, and has a cost of capital of 10% What is the value of each security when valued independently? What is the asset’s total value? . fl 74 Example Imagine an asset that yields cash ows in 1 period and never again. • • Security A receives $6.25, and has a cost of capital of 25%. Security B receives $11, and has a cost of capital of 10% If you built a portfolio of securities a and b, what is the weighted average cost of capital (WACC) What is the value of the total cash ow at the WACC? . fl fl ? 75 Weighted average cost of capital (WACC) 76 The analysis of risk and return shows that • The return on a portfolio is a weighted average of the returns of the securities in the portfolio As a consequence, an investor that purchased all the securities receiving cash ows from an asset could • Value this asset using the weighted average of the expected returns of the rm’s securities, where the weights are based on the purchase price (market value). fi : : 77 . fl Portfolios and discount rates Portfolios and discount rates The analysis of risk and return shows that • The return on a portfolio is a weighted average of the returns of the securities in the portfolio As a consequence, a rm trying to attract investors must • Offer a return equal to the weighted average of the expected returns of the asset’s securities • The weights must be based on market values, as these are the value used by investors. : : fi . . 78 Weighted Average Cost of Capital (WACC) De nition The weighted average of an asset’s costs of capital for each security used in nancing. Weights are the fractional amounts of each security’s total market value. Example: rW ACC ✓ ◆ ✓ ◆ ✓ ◆ Cost of Cost of Cost of =wE ⇥ + wP ⇥ + wD ⇥ Ordinary Shares P ref erence Shares Debt fi fi 79 Levered and unlevered rms De nition A rm without debt is called an unlevered rm, while a rm with debt outstanding is called a levered rm. The weighted average cost of capital for an unlevered rm is just the cost of equity. fi fi fi fi fi fi fi 80 The WACC method values assets by discounting cash ows at the weighted average cost of capital • This gives the total market value of all the rm’s securities when applied to the total rm cash ow. • This gives an NPV when applied to project The WACC method implicitly assumes that the relative market values of the underlying securities do not change over time. fl fi s . 81 fl fi Applications Project discount rates 82 Weighted average cost of capital provides an important insight on discount rates • Cash ows should be discounted using an cost of capital that re ects the appropriate risk in the cash ows • Securities are discounted using the cost of capital for the risk in the security’s cash ows • Assets are discounted using the “average” cost of capital of the underlying securities; this represents the average risk in the total asset cash ow fl . fl . fl fl 83 . fl Insight from WACC Project-speci c discount rates Imagine two rms, each with a single project Firm A: Has a low-systematic risk project with a discount rate of 5%. It requires $15 million up front and generates $1 million per year in perpetuity. Firm B: Has a high-systematic risk project with a discount rate of 15%. It requires $25 million up front and generates $3 million per year in perpetuity Should the rms invest in these projects? . . fi fi fi 84 Project-speci c discount rates Imagine a single rm with two projects Project A: This is identical to that from Firm A. It has low-systematic risk, requires $15 million up front, and generates $1 million per year in perpetuity. Project B: This is identical to that from Firm B. It has high-systematic risk project, requires $25 million up front, and generates $3 million per year in perpetuity The rm has on-average moderate systematic risk, with a discount rate of 10%. • • Should the rm invest in these projects? Would the rms invest in these projects if it uses a single 10% discount rate? . . fi fi fi fi fi 85 Project-speci c Discount Rates Firms should use a discount rate that is appropriate for each project A rm that uses an “average” discount rate instead of project-speci c discount rates • May not invest in positive NPV low-risk projects and may invest in negative NPV highrisk projects • As a consequence of these investment decisions, rms using a single, “average” discount rates for all projects may become riskier over time. . fi fi fi . : fi 86 Implementation: Costs of Debt and Equity 87 CAPM limitations In principle, the CAPM can be used to nd the cost of capital for any asset or security • This implies the CAPM can be used to value both equity and debt. In practice, asset and security values must be current, with reliable market values, to estimate the CAPM • Many debt securities and preference shares do not trade frequently and listed prices may be outdated or stale. Estimated CAPM betas may be unreliable • Ordinary shares, which trade frequently, are generally valued using the CAPM. . fi . . 88 Cost of debt Debt payments are tax deductible. As a result, rms that makes a debt payment do not bear the “full” cost of the debt. Example: A rm that borrows $10,000 at 10% interest per year with a tax rate of 30%: Item Equa on Value Interest expense -rD × $10,000 -$1,000 Tax savings rD × Tax Rate ×$10,000 $300 Effective after-tax interest expense rD × (1-Tax Rate) ×$10,000 -$700 fi fi ti 89 There are two possible ways to ensure the tax-deductibility of interest payments enters into the valuation • Compute “levered” cash ows by adjusting for tax savings. Discount “levered” cash ows using the observed, pre-tax cost of deb • Ignore the impact of interest tax savings. Instead, adjust the cost of debt for the tax savings. Discount the “unlevered” cash ows at the after-tax cost of debt. In nance, we use the second option as this separates the analysis of the project from the analysis of the choice of nancing. t fi fl : fl 90 fi fl Cost of debt Cost of debt Debt payments are tax deductible. As a result, rms that makes a debt payment do not bear the “full” cost of the debt. Example: A rm that borrows $10,000 at 10% interest per year with a tax rate of 30%: Item Equa on Value Interest expense -rD × $10,000 -$1,000 Tax savings rD × Tax Rate ×$10,000 $300 Effective after-tax interest expense rD × (1-Tax Rate) ×$10,000 -$700 The after tax cost of debt should re ect the tax bene ts: rD × (1-Tax Rate) fi fi fl fi ti 91 Cost of debt De nition The cost of debt used in WACC computations re ects the tax bene ts of debt. The debt’s yield to maturity is the expected return on debt required by investors. Thus, the after tax cost of debt to a rm is Cost of Debt = rD (1 TC ) where rD is the yield to maturity and TC is the rm’s tax rate. fi fl fi : fi fi 92 Cost of preference shares Preference shareholders typically have a xed dividend. The price of a preference share can, therefore, be reliably estimated using a constant growth dividend discount model P0 = Rearranging this equation provides that the cost of a preference share rP = Div1 +g P0 . 93 . • Div1 rP g fi • Cost of preference shares De nition The cost of preference shares used in WACC computations re ects the expected return demanded by investors. As preference shares often have speci ed dividends, the cost of preference shares is typically found using a constant growth dividend discount model rP = Div1 +g P0 where P0 is the current price, Div1 is the expected dividend, and g is the dividend growth rate. : fl fi fi 94 Cost of ordinary shares The Capital Asset Pricing Model (CAPM) is most often used to determine the cost of ordinary shares Expected return The expected rate of return on security i. It is the expected return in the market on investments with equivalent risk to the risk associated with the security. rE,i = rf + i Beta Measures the sensitivity of security i to market movements. Captures relative systematic risk. ⇥ M arket Risk P remium Market Risk Premiu The average return market participants demand for bearing the market’s systematic risk. It re ects the average risk aversion of all market participants. Risk-free retur The return on a riskless security. M arket Risk P remium = E(rm ) rf where E(rm) is the expected return on the market. fl : m n 95 Cost of ordinary shares Applying the CAPM requires several estimates 1. A risk-free rate 2. A market risk premium 3. An appropriate Beta, re ecting the risk in the project. : fl . . 96 Cost of ordinary shares 1. What is the risk-free rate • The risk-free rate needs to match the investment horizon for investors and for the project. • • As most projects have long-term horizons, a cash rate is not valid. Most rms use yields on long-term government bonds (10- to 30-years) as a risk-free rate 2. What is the market risk premium • Estimating the market risk premium requires a large amount of historic data. Historic market risk premiums may not be valid going forward • Most rms use a market risk premium between 5.5% and 7%. . ? ? fi fi . 97 Estimating beta Beta is generally found as the slope of the best tting linear regression line between security excess returns (vertical axis) and the market excess returns (horizontal axis). An example for Apple is shown below Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – 9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition : fi 98 Cost of ordinary shares 3. What is the appropriate Beta • • • Beta re ects the systematic risk in the project The historic beta on a rm’s stock may be inappropriate due t - estimation error (noise) average rm risk not being re ective of project risk average rm risk not being re ective of future rm or project risk, and/o other factors Firms generally use Betas based on the average of single-industry (“pure-play”) rms in the same industry as the projec - Averaging many rms minimises estimation error for a single rm and emphasises project risk fi r o fi , fi . ? t fl fl , fi fi . fi fi fl 99 Cost of ordinary shares De nition The cost of ordinary shares used in WACC computations re ects the expected return demanded by investors. It is most often computed using the CAPM rE,i = rf + i ⇥ M arket Risk P remium where rf is a long-term risk-free rate matching the project horizon, the market risk premium is based on historical analysis, and Beta re ects the typical Beta of pure-plays rms in the project’s industry. fi : fl fl fi 100 Weighted Average Cost of Capital (WACC) De nition The weighted average of a project’s costs of capital for each security used in nancing. Weights are the fractional amounts of each security’s total project market value. Typically: rW ACC = wE ⇥ rE + wP ⇥ rP + wD ⇥ rD ⇥ (1 TC ) fi fi 101 Sample problem 102 Sample problem You have the following information about an energy company (solar power) that is evaluating an energy drink project • The rm has debt outstanding with a book value of $4 billion and a market value of $7 billion. The debt has an average yield-to-maturity of 6% and an average coupon rate of 10% • The rm’s preference shares just paid a dividend of $1.50 per share. Dividends are paid annual and are growing at 2% annually. The preference shares have a price of $17. There are 200 million preference shares outstanding • The rm’s ordinary equity has a market capitalisation of $12 billion and a book value of $1 billion. The beta on this equity is 1.2 • Energy company’s have an average beta of 1.14. Beverage company’s have an average beta of 0.91 • • • The risk-free rate is 6.0% and the market risk-premium is 7.0%. The rm’s marginal tax rate is 30% The rm expects to nance the project using securities in proportion to its existing capital structure What is the correct discount rate to use on this project? . . : . . fi . fi fi fi fi fi . 103 Flotation Costs 104 Flotation cost De nition A cost incurred by a company when issuing securities. Common expenses include underwriting, legal, and registration fees. fi 105 Dealing with otation costs There are two commonly used methods to dealing with otation costs • • Include the costs as an initial (t=0) expense for the project Adjust the cost of capital to account for otation costs. Which method is correct? . fl fl fl : 106 Adjusting the cost of capital for otation costs Imagine a rm that pays total otation cost, F, as a proportion to the capital raised. • Instead of receiving P0 for a series of cash ows, the rm receives P0×(1-F). This affects the cost of capital • Example: - The constant growth dividend discount model implies P0 (1 - F) = Div1 rE g The resulting cost of capital is: rE = Div1 +g P0 (1 F ) fl : fi fl fl fi 107 Example Imagine a rm that is raising capital for a project that needs to consider the impact of otation costs. • A “pure-play” rm for the project type has a preference share that trades for $30 based on a dividend in one year of $6 that will grow by 5% annually • The project requires an initial capital expenditure of $150 million. Positive cash ows begin in 1 year with $10 million and grow at 20% in perpetuity. All cash ows will be paid to investors • The rm expects to pay 10% in otation costs What is the project NPV • • When the otation costs are treated as an initial expense? When the cost of capital is adjusted for otation costs? fl fl . . fl fl : . fi fl fi fl fi 108 Example Imagine a rm that is raising capital for a project that needs to consider the impact of otation costs. • A “pure-play” rm for the project type has a preference share that trades for $30 based on a dividend in one year of $6 that will grow by 5% annually • The project requires an initial capital expenditure of $150 million. Positive cash ows begin in 1 year with $10 million and grow at 20% in perpetuity. All cash ows will be paid to investors • The rm expects to pay 10% in otation costs Project NPV when otation costs are treated as an initial expense • To answer, consider - How much money can the rm raise from investors What are the cash ows of the project for the rm? fl . fl : fl ? fi . . fl fi fl : fl fi fi fi 109 Example Imagine a rm that is raising capital for a project that needs to consider the impact of otation costs. • A “pure-play” rm for the project type has a preference share that trades for $30 based on a dividend in one year of $6 that will grow by 5% annually • The project requires an initial capital expenditure of $150 million. Positive cash ows begin in 1 year with $10 million and grow at 20% in perpetuity. All cash ows will be paid to investors • The rm expects to pay 10% in otation costs Project NPV when the cost of capital is adjusted for otation costs. fl . fl fl fl . . fl fi fi fi 110 Dealing with otation costs There are two commonly used methods to dealing with otation costs • • Include the costs as an initial (t=0) expense for the project Adjust the cost of capital to account for otation costs. Adding otation costs as an initial expenses is more accurate; adjusting the cost of capital assumes that the issuance costs are recurrent (ongoing) expenses. . fl fl fl fl : 111 Capital structure determinants 112 Remaining question How do rms choose among the types of nancing when raising capital for projects • Part II implicitly focused on a rm's existing capital structure, when the cost of debt is observed • It is not clear why rm’s decide whether to issue debt or equity. fi fi fi fi ? . 113 Debt-value ratios by industry Debt-value = D D+E Brokerage & Investment Banking Power Auto & Truck Real Estate (General/Diversi ed) Steel Engineering/Construction Food Wholesalers Retail (General) Homebuilding Transportation Electronics (Consumer & Of ce) Why does debt’s percentage of total rm value vary by industry? Chemical (Basic) Entertainment Computers/Peripherals Information Services Computer Services Electronics (General) Healthcare Products Drugs Semiconductor Retail (Online) Software (Internet) 0% 17.5% 35% Source: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/data.html fi fi fi 114 52.5% 70% Raising capital 115 Raising equity Firms typically initially raise capital by selling equity to private investors • Venture capitalists: Professional investors who focus almost exclusively on purchasing shares in young rms • Institutional investors: Invest in nearly all types of assets. May invest in higher risk new rms as a way to get higher returns • Corporate investors: May invest in rms in related industries as part of strategic initiative. . . fi . fi fi 116 Raising equity An initial public offering (IPO) provides a way for a successful young rm to raise additional capital • • • Allows venture capitalists and other seed investors to realise pro ts Founders and other members of the rm can sell shares to extract cash The rm’s founders control of the rm will decrease as other investors now have shares and, consequently, can vote for members of the rm’s board of directors A seasoned equity offering (SEO) occurs when a publicly traded rm sells additional shares. fi . . . fi fi fi fi . fi 117 Raising equity Several unresolved issues around IPOs remain • • Pricing does not appear to serve either the rm or investors: - IPOs are generally underpriced, leading to a increase in price on the rst day Shares generally underperform the market 3 to 5 years from the IPO An IPO’s success does not exclusively depend on the rm’s outlook - IPOs are cyclical. Investors prefer IPOs at some times and prefer other source of capital at others. Even good rms may not have a successful IPO if the market is unreceptive. : . . fi fi fi . fi 118 Raising debt Debt may be either private or public Private debt is nancing that is not publicly traded. • Avoids registration costs with regulators (e.g. Australian Securities and Investment Commission (ASIC) • • It is hard for the purchaser to sell the debt if necessary Examples include bank loans and private placements Public debt is publicly traded Debt securities differ among many dimensions including • Seniority: Determines if the bond is paid before or after other creditors in administration (bankruptcy). • Collateral: Secured debt may be backed by speci c rm assets. Unsecured debt has no such guarantee • Covenants: Restrictions on the rm. May limit the rm’s ability to issue other securities, execute acquisitions, sell assets, or pay dividends. : . fi fi . fi : fi . ) fi . 119 Australian bond market: Bonds outstanding Source: Deloitte “The Corporate Bond Report 2018” Australian bond market: Ownership Source: Deloitte “The Corporate Bond Report 2018” Raising equity & debt Underwriters (investment banks) usually manage the process of selling securities to the public • • • • Design securities and the method of sale Market the rm to investors and institutions on a road show Sets the initial price and may provide a guarantee on the amount of capital raised Total fees are materia - Typically range between 5% and 10% of total raised with equity Typically range between 3% and 5% of debt raised with debt. Underwriting fees do not decrease (as a percentage) as the amount of capital raised increases (i.e. there are not signi cant “size” discounts). . . . . fi l . fi 122 Pros and cons of security issuance Equity Pro Debt Dividends are not mandatory No administration (bankruptcy) Low issuance costs No change in control Interest is tax deductible High issuance costs Con Interest payments are required Loss of control Dividends are not tax deductible 123 Administration (bankruptcy) costs Pros and cons of security issuance Equity Debt Taxes Dividends are not tax deductible Interest is tax deductible Administration No administration (bankruptcy) Administration (bankruptcy) costs Dividends are not mandatory Interest payments are required Costs High issuance costs Low issuance costs Other Loss of control No change in control Payouts 124 Real capital markets Capital markets have many “frictions:” • • Taxes create a cash ow bene t for rms that have debt outstanding. • • • Security prices may deviate from the present value of future cash ows Administration is costly for the rm. Bond holders can force the rm to alter strategy, affecting project and values There are many costs affecting the issuance of new securities, securities trading, etc Financing decisions may affect project investment decisions and cash ows. Financing decisions may reveal information about cash ows. . . fl fi fl fl fi fi . fi fl 125 The capital structure problem The rm must decide which combination of debt and equity maximises the value of either a project or the overall rm V alue =P V (Cash f lows) + P V (Interest tax shield) P V (F inancial distress costs) P V (Issuance costs) + P V (Other f actors) This is a complicated problem. We initially simplify the analysis and then add complexity. : fi fi 126 Perfect capital markets: A starting point 127 Perfect capital markets Perfect capital markets do not have friction • • Taxes do not exist. • • • Security prices are fair, re ecting the present value of future cash ows Administration is not costly for the rm. It can negotiate with bond holders and recapitalise without affecting either projects or rm values There are no costs affecting the issuance of new securities, securities trading, etc Financing decisions are independent of project cash ows. We analyse perfect capital markets as a basic framework and starting point. . . fl . fl s fi fi fl 128 Starting business example Imagine you are starting a business that will last for only 1 year • • It requires $20,000 upfront to set up operations After salary and expenses, you expect total free cash ows available to investors to be $30,000, but may range between $25,000 and $35,000 You are considering two possible ways to raise the money to fund operations • • Option 1 is to nance entirely by equity Option II is to nance with both debt and equity. : : fl . . . fi fi 129 An investor may purchase all the securities issued by a rm to nance a project. In perfect capital markets • • Cash ows are independent of the capital structure. - Taxes do not help overall cash ow through tax savings. The rm’s investment decisions are the same irrespective of nancing Security prices re ect the discounted value of the rm cash ows This implies that in perfect capital market • • Project and rm value does not depend on the choice of nancing Weighted average cost of capital (WACC) does not depend on the choice of nancing. fi . . . fi fi fl fi s fi , fl fi fl fi fl 130 fi fi Portfolios and rm values in perfect capital markets Leverage De nition An unlevered rm is one that does not have any debt outstanding. A rm with debt outstanding is considered levered In perfect capital markets, the weighted average cost of capital does not depend on capital structure rW ACC,L = rW ACC,U This means that E D rE,L + rD = rE,U E+D E+D fi . fi : fi 131 Leverage De nition An unlevered rm is one that does not have any debt outstanding. A rm with debt outstanding is considered levered In perfect capital markets, the weighted average cost of capital does not depend on capital structure rW ACC,U = rW ACC,L This means that: Cost of levered equity Cost of unlevered equity rE,L = rE,U + D (rE,U E rD ) Cost of debt Market values o equity and debt fi . fi f : fi 132 Modigliani and Miller (MM) Propositions Modigliani and Miller (MM) provided two important observations (propositions) that are direct consequences of the perfect capital markets assumptions MM Proposition I In perfect capital markets, the total value of a r - is equal to the market value of the free cash ows generated by its assets an is not affected by its choice of capital structure MM Proposition II The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the debt-equity ratio (measured using market values) rE,L = rE,U + D (rE,U E rD ) . d m . fi fl : : 133 Leverage and WACC 50 45 40 Cost of capital (%) 35 Equity cost of capital 30 25 20 15 WACC 10 5 0 0 Debt cost of capital 10 20 30 40 50 60 Debt-value ratio (%) 134 70 80 90 100 Starting business example problem Imagine you are starting a business that will last for only 1 year • • It requires $20,000 upfront to set up operations. After salary and expenses, you expect total free cash ows available to investors to be $30,000, but may range between $25,000 and $35,000 You are considering two possible ways to raise the money to fund operations in perfect capital markets • • Option 1 is to nance entirely by equity. Option II is to nance with both debt and equity What is the NPV of the project if it is nanced entirely by equity? What is the initial price of equity • The correct cost of capital is 15%. The appropriate risk free rate is 5% : . fl . fi . : fi fi ? 135 Starting business example problem Imagine you are starting a business that will last for only 1 year • • It requires $20,000 upfront to set up operations After salary and expenses, you expect total free cash ows available to investors to be $30,000, but may range between $25,000 and $35,000 You are considering two possible ways to raise the money to fund operations in perfect capital markets • • Option 1 is to nance entirely by equity Option II is to nance with both debt and equity What is the NPV of the project if it is nanced by debt and equity? What is the initial price of equity • • The correct cost of capital is 15%. The appropriate risk free rate is 5% You will borrow $10,000 debt in present value terms : . fl . . . fi . . : fi fi ? 136 Starting business example problem How will the realised return on equity vary with the cash ows under both possible capital structures? You are operating in perfect capital markets. Security cash flows FCF Bad $25000 Expected $30000 Good $35000 Unlevered Equity Levered Equity Debt Unlevered Equity Debt 137 fl Scenario Security returns Levered Equity The costs of equity capital and debt capital may change with the rm’s choice of leverage However, in perfect capital markets, any such changes balance such that WACC is constant regardless of leverage. 138 . fi Lessons from perfect capital markets Tax bene ts of debt A next step : fi 139 Nearly perfect capital markets “Nearly perfect” capital markets have one friction — taxes • • Taxes create a cash ow bene t for rms that have debt outstanding. • • • Security prices are fair, re ecting the present value of future cash ows Administration is not costly for the rm. It can negotiate with bond holders and recapitalise without affecting either projects or rm values There are no costs affecting the issuance of new securities, securities trading, etc Financing decisions are independent of project cash ows. . . fl : . fl fi fi fi fi fl fl 140 Woolworths’ 2012 ($ milllions) Interest payments to bond holders reduce the rm’s tax burden Actual (levered) Hypothetical (unlevered) EBIT 3919.60 3919.60 Interest expense -318.30 0.00 Income before tax 3601.30 3919.60 -1080.39 -1175.88 2520.91 2743.72 Taxes Net profit … resulting in greater total cash ows available to investors Actual (levered) Interest paid to debt holders Hypothetical (unlevered) 318.30 0.00 Income available to equity holders 2520.91 2743.72 Total available to investors 2839.21 2743.72 … . fi fl 141 Aside: WACC with debt and taxes Recall from earlier that the weighted average cost of capital uses the after tax cost of debt rW ACC = E D rE + rD (1 E+D E+D TC ) Rearranging suggests tha rW ACC = E D rE + rD E+D E+D | {z } P re tax W ACC D rD ⇥ T C E+D | {z } Reduction f rom tax shield This “reduction” is valid for a given capital structure. It is not particularly helpful for a rm determining its capital structure as the costs of debt and equity may change with leverage. fi t 142 Debt, taxes, and rm value The total value of a levered rm is greater than that of a rm without leverage due to the tax savings (shield) of debt payments VL = VU + P V (Interest tax shield) fi : fi fi 143 Estimating the present value of the tax shield Valuing the tax shield would require projecting all the interest payments made to bond holders for the life of the rm. This is complicated because of • • • • Changing debt levels in a rm over tim Changing interest rates over tim A marginal tax rate that varies over tim Default risk leading to unpaid interes A crude simpli cation is that the market value of current debt outstanding re ects the present value of perpetual interest payments D = P V (Interest payments) As the tax shield is just the tax rate multiplied by the interest payments, the present value of the tax shield with a constant tax rate TC is P V (Interest tax shield) = P V (TC ⇥ Interest payments) = TC ⇥ D fl : : : e e t e fi fi fi 144 The costs of equity capital and debt capital may change with the rm’s choice of leverage The tax shield bene ts of debt increase with leverage Without any material disadvantages of debt, all rms and project should be nanced exclusively (or nearly exclusively) with debt. fi . fi . fi 145 fi fi Lessons from tax bene ts of debt Trade-off Theory A nal step : fi 146 Real capital markets Capital markets have many “frictions:” • • Taxes create a cash ow bene t for rms that have debt outstanding. • • • Security prices may deviate from the present value of future cash ows Administration is costly for the rm. Bond holders can force the rm to alter strategy, affecting project and values There are many costs affecting the issuance of new securities, securities trading, etc Financing decisions may affect project investment decisions and cash ows. Financing decisions may reveal information about cash ows. . . fl fi fl fl fi fi . fi fl 147 Administration and nancial distress A rm that has trouble meeting its debt obligations is in nancial distress. This may lead to administration (bankruptcy). Administration (bankruptcy) has signi cant direct costs • • • Professional services (accounting, legal, investment banking, appraisal, auction, etc… • Average direct costs are 3-4% of rm value. Costs are greater in rms with complicated businesse Costs can be greater for rms with a large number of creditors as it may be dif cult to reach an agreement suitable to all partie Financial distress and administration have indirect costs that affect the ability of the business to operate: • • • • • Loss of revenues as customers fear a company may not be able to ful l its promise Loss of suppliers who worry they may never get pai Dif culty hiring and retaining employee Sale of assets to meet debt payments impairs the rm’s future operation Costs can be 10-20% of rm value ) s fi s fi : fi s d fi fi fi s s fi fi fi fi fi fi 148 Trade-off theory De nition The total value of a levered rm equals the value of the rm without leverage plus the present value of the tax savings from debt, less the present value of nancial distress costs: VL = VU + P V (Interest tax shield) P V (F inancial distress costs) Trade-off theory implies that rms choose an optimal capital structure to maximise the value of the rms. fi fi fi fi fi fi 149 Trade-off theory: Optimal leverage and firm value No financial distress costs Low distress costs V Firm value Low V High High distress costs V U D High Value of debt D Low Estimating nancial distress costs An all-equity nanced rm has a current share price of $17 and 15 million shares outstanding. The rm announces it will lower its corporate taxes by borrowing $160 million of perpetual debt and repurchasing shares. The rm pays taxes at 30%. If the price per share rises to $19 after the announcement, what is the present value of nancial distress costs ? fi fi fi fi fi fi 151 The costs of equity capital and debt capital may change with the rm’s choice of leverage The tax shield bene ts of debt and the costs of nancial distress both increase with leverage Firms should balance the bene ts and costs of debt to nd an optimal amount of leverage The approach can be adapted to account for other costs of debt, equity, and other securities. fi fi fi . . . 152 fi fi Lessons from trade-off theory A practical method 153 A practical method One common approach to estimate a WACC for any prospective amount of leverage • • Estimate a cost of debt based on the rm’s ability to make interest payments Determine a “levered” beta for the ordinary equity that accounts for leverage and the “unlevered” risk of the project/ r This approach ignores many factors (e.g. distress costs), but provides guidance for rms that wish to change their capital structure. fi fi m fi : 154 Estimating a cost of debt • A simple method is to estimate the interest coverage ratio (EBIT/Interest expense) Interest coverage ratio ≥ 8.5 6.5 5.5 4.25 3 2.5 2.25 2 1.75 1.5 1.25 0.8 0.65 0.2 Rating Credit spread 8.50 6.50 5.50 4.25 3.00 2.50 2.25 2.00 1.75 1.50 1.25 0.80 0.65 0.20 Aaa/AAA Aa2/AA A1/A+ A2/A A3/ABaa2/BBB Ba1/BB+ Ba2/BB B1/B+ B2/B B3/BCaa/CCC Ca2/CC C2/C D2/D 0.60% 0.80% 1.00% 1.10% 1.25% 1.60% 2.50% 3.00% 3.75% 4.50% 5.50% 6.50% 8.00% 10.50% 14.00% More sophisticated approaches exist. 155 : • ≤ Leveraging beta A value with leverage follows from the de nition of the tax shield VL = EL + D = VU + P V (Interest tax shield) = VU + TC ⇥ D Portfolio beta is a weighted average. Treating each side as separate portfolios D VL D = +D D = VU + E,L E,L E,L E,L VU VL E,U E,U + TC ⇥ D VL + TC ⇥ D D D VU D (1 TC ) ⇥ E,U D EL EL EL + D T C D D = (1 TC ) ⇥ E,U D EL EL ✓ ◆ D D = 1+ (1 TC ) E,U (1 TC ) ⇥ EL EL = D 156 : EL E,L fi EL VL Leveraging beta Beta with leverage depends on the beta of unlevered equity, the beta of debt, and the marginal tax rate E,L = ✓ D 1+ (1 EL TC ) ◆ E,U (1 TC ) ⇥ D EL D In the special case where the beta of debt is zero (βD=0) E,L = ✓ D 1+ (1 EL TC ) ◆ E,U D/E is called the debt-to-equity ratio. : : 157 Estimating a cost of equity Estimating a levered cost of equity for a project or rm is a multiple step process 1. Find a set of single industry (pure play) rms 2. Estimate the beta for these rms. This is a levered beta 3. Compute the unlevered cost of equity for each rm based on each rm’s debt-toequity ratio and tax rate 4. Average the unlevered cost of equity to estimate the project/ rm cost of unlevered equity 5. Compute the levered cost of equity for the project or rm using the estimate from step 4 and the appropriate tax rate. fi fi fi fi . fi . fi fi . : . 158 Leverage and the cost of capital with taxes One common approach to estimate a WACC for any prospective amount of leverage • • Estimate a cost of debt based on the rm’s ability to make interest payments Determine a “levered” beta for the ordinary equity that accounts for leverage and the “unlevered” risk of the project/ r Note that this approach has a few internal inconsistencies • Debt provides yields above the risk-free rate, but is generally considered risk-less when leveraging beta • The nal rm valuation may deviate from the leverage assumptions (i.e. assuming $100m in debt with 20% a debt-value ratio yields a WACC that gives a rm value above $500 million). One should verify that the nal valuation supports the leverage assumptions. fi : fi fi m fi . : fi fi 159 Example A rm is considering recapitalising by issuing debt to repurchase equity • • • It currently has $5 billion of debt and $8 billion of equity outstanding Its pre-tax cost of debt is 8%, its current beta is 0.5, and it pays taxes at 30% The risk-free rate is 4% and the market risk premium is 6% What will be the cost of common equity if it issues $4 billion of debt and the issue does not change the total rm market capitalisation? . : . . fi fi 160 UNSW Business School School of Banking and Finance FINS1613: Business Finance 2021 Term 2 Week 10: Payout Policy and Course Summary Payout Policy 162 A rm with positive free cash ows must decided whether to retain the cash ows or distribute them to investors Free cash ow Retain Invest in new projects Distribute Increase cash reserves Pay dividends Repurchase shares Investors ultimately would like the rm to make the decision that best increases the value of their investment. : fl fi fl 163 fi fl Cash distributions Reinvestment 164 The ef cient markets hypothesis suggests that competition eliminates positive NPV trading opportunities until all information is in security prices • Expectations about cash ows and discount rates are determined by information known to investors • Security trading and the forces of supply and demand ensures that information is re ected in security prices • Security prices are the best estimate of the discounted value of expected future cash ows. . . fl . fi fi 165 fl fl Ef cient capital markets Ef cient capital markets Public, easily interpretable information • Known to all investors who can determine how the information affects cash ows and discount rate • Should be re ected in security prices due to security trading and the forces of supply and deman • Examples include news reports, nancial statements, press reports, etc Private or dif cult to interpret information • Investors may be able to use private information to trade pro tably. However, trading will cause prices to shift until the information is re ected in security prices • Dif cult to interpret information may slowly enter security prices allowing temporary pro table trading opportunities. fl . … fi fl : : fi s fi fl d fi fi fi 166 Reinvestment example problem Consider two rms that are trying to decide if they should pay cash to investors or reinvest in new projects. Assume all positive cash ows begin at t=1 and have a 10% cost of capital Firm A • • • Cash balance of $1 billion Current projects generates $250 million in perpetuity Has a new project that requires $1 billion today and generates cash ows of $150 million in perpetuity. This project has not been announced and is not yet priced to market participants Firm B • • • Cash balance of $1 billion Current projects generate $1 billion in perpetuity Has a project that requires $1 billion today and generates cash ows of $500 million in perpetuity. This project has not been announced and is not yet priced to market participants . . fl . fl . . fl . . fi : : 167 Reinvestment When a rm reinvests cash in a positive NPV project • • Investors recognise the effect of the decision on cash ow • • The NPV accrues to the rm’s current owner Supply and demand ensure that the security prices adjust to re ect the fair value of the cash ows (assuming capital markets are ef cient) The rm’s current owners bene t in the form of abnormal security returns above the risk-adjusted cost of capital Firms should always reinvest cash ows in positive NPV projects; this is the best option to increase the value of ownership. : fl s fl fi s fi fl fi fi fl fi 168 Reinvestment A rm should always use available free cash ows to invest in positive NPV projects. Afterwards, it may choose to either • Retain cash ows and purchase nancial assets so as to have money when positiveNPV investments arise • Payout cash ows to investors : fl fi fl fl fi 169 Cash reserves 170 Perfect capital markets Perfect capital markets do not have friction • • Taxes do not exist. • • • Security prices are fair, re ecting the present value of future cash ows Administration is not costly for the rm. It can negotiate with bond holders and recapitalise without affecting either projects or rm values There are no costs affecting the issuance of new securities, securities trading, etc Financing decisions are independent of project cash ows. . . fl . fl s fi fi fl 171 Cash reserves and payout in perfect capital markets After reinvesting in all positive NPV projects, a rm is trying to decide if it should (i) distribute the remaining cash reserve to investors or (ii) invest on behalf of investors and then distribute. In perfect capital markets, how are investors best served Retain: Firm Cash Invest in nancial asset Realise returns Investors Distribute Distribute: Firm Cash Investors Distribute Invest in nancial asset Realise returns fi ? fi fi 172 Retention and payout in perfect capital markets Modigliani and Miller (MM) provide yet an important observation that is a direct consequences of the perfect capital markets assumption MM payout irrelevance In perfect capital markets, if a rm invests excess cash ows in nancial securities, the choice of payout versus retention is irrelevant and does not affect the initial value of the rm In perfect capital, all investments have zero NPV and payouts are untaxed. It does not matter whether a rm or its owners purchase securities. . fi . fi fl fi fi : 173 Cash reserves and payout with taxes After reinvesting in all positive NPV projects, a rm is trying to decide if it should (i) distribute the remaining cash reserve to investors or (ii) invest on behalf of investors and then distribute. For simplicity, assume that both dividends and capital gains are taxed at Ti for investors and Tc for corporations. Are investors better off if the rm retains or distributes cash? Retain: Firm $1 + r(1 $1 Invest in nancial asset Cash ($1 + r(1 Distribute: $1 Firm Cash Investors Distribute and pay taxes $1 ⇥ (1 Invest in nancial asset fi fi s TC )) ⇥ (1 TI ) Realise returns and pay taxes $1 ⇥ (1 TI ) 174 fi Realise return and pay taxes Distribute and pay taxes Investors fi TC ) TI ) ⇥ (1 + r(1 TI )) After reinvesting in all positive NPV projects, a rm is trying to decide if it should distribute the remaining cash reserve to investors. The rm • • Cash reserves are $100 million • If it retains cash, the will invest in the a risk-free asset yielding 3%. Investors that receive distributed cash are expected to invest in the risk-free asset • In one year, there is a 50% chance that a research and development will yield a project that requires $103 million upfront and generates $25 million per year starting at t=2 in perpetuity at a 10% discount rate. • Issuance costs are 10% of capital raised Current projects generates $250 million starting at t=1 in perpetuity at a cost of capital of 5% Ignoring taxes and assuming that we can use the 50% probability to determine rm value, are investors better off if the rm retains or distributes cash? : . fi fi fi . . 175 . fi Cash reserves for future projects example problem Cash reserves for future projects example problem Today One Year Firm’s existing projects Firm’s existing projects Retain: Firm Cash Firm Cash 50% probability Use cash to fund project 50% probability Risk free investment Distribute: Firm’s existing projects Firm’s existing projects Raise capital to fund project Distribution Investor Cash Risk free investment 176 Investor Cash 50% probability Imperfect capital markets Firms may choose to retain cash for several factors • Taxes: Firm should invest on behalf of shareholders if the rm pays a lower marginal tax rate than shareholders • Future shortfalls: Firms may retain cash to fund future projects, avoiding issuance costs. Extra cash also provides a cushion against nancial distress However, there are costs of having excess cash Agency costs: Firms may use excess cash inef ciently (e.g. money-losing pet projects, executive perks, or overpaying for acquisitions) . … fi . fi fi 177 . • Cash reserves When a rm retains cash to build cash reserves • • Investors recognise the effect of the decision on cash ow • The rm’s current owners bene t may bene t from a reduction in expected future issuance and distress costs, but can suffer from increased agency costs Supply and demand ensure that the security prices adjust to re ect the fair value of the cash ows (assuming capital markets are ef cient) Firms may build cash reserves in real capital markets, but should consider the costs and bene ts of doing so. fl s : fl fi fi fi fi fi fl fi 178 Payouts: Dividends and repurchases in perfect capital markets 179 Distribution If a rm distributes cash to investors • Investors receive cash through either a dividend or share repurchase and must pay taxe • • Investors must nd new investment • The rm’s current owners do not earn abnormal returns New investments return on average the risk-adjusted cost of capital (assuming capital markets are ef cient Distributions are the only way for rms to return cash to investors. Investors must then determine what to do with the money received. : s fi ) fi fi fi fi s 180 Taxes on dividends and capital gains Distributions Pay dividends Repurchase shares 181 Dividend timeline } Dividend “value” Price Time Declaration Ex-dividend Record Payment Important dates for dividend payments - Declaration date: Board authorises dividend and rm is obligated to pay Ex-dividend and record date: To receive a dividend, the share must be purchased before the ex-dividend date and still owned on the record date. Stock price adjusts when investors are eligible to receive the dividend — the exdividend date Payable (distribution) date: Date payment is received by shareholders. . fi : . 182 Dividends and repurchases Example problem A rm has $20 million in cash available for payouts and projects that have a present value of $48 million. There are 10 million shares outstanding Option 1: If the rm pays announces it pay the cash as a dividend, what is the value of the investment before the ex-dividend date? After the ex-dividend date ? . : fi fi 183 Repurchase timeline Price Time Repurchase Announcement Repurchase Important dates for share repurchases - Announcement: Company announces it will conduct repurchases, but is not obligated to do so Repurchases: Generally occur over a period of time. These should not the affect stock price. : . 184 Dividends and repurchases Example problem A rm has $20 million in cash available for payouts and projects that have a present value of $48 million. There are 10 million shares outstanding Option 2: If the rm uses the cash to repurchase shares, how many shares does it purchase? What is the price of a share after the repurchase? Does it make a difference if you sell the shares in perfect capital markets? . : fi fi 185 Dividends and repurchases Example problem A rm has $20 million in cash available for payouts and projects that have a present value of $48 million. There are 10 million shares outstanding Pay dividends Repurchase shares 7.0588 million current shareholders 10 million shareholders - - Stock worth $4.80 Stock worth $6.8 2.9412 million former shareholders Cash worth $2.00 - Cash worth $6.80 . : : : : 0 fi 186 Dividends and repurchases In perfect capital markets • The share price drops by the amount of the dividend when the share begins to trade ex-dividend • A share repurchase through a stock exchange that is available to all shareholders (open market repurchase) has no effect on the share price. : . 187 Payout policy in perfect capital markets Modigliani and Miller (MM) provided an important observation that is a direct consequences of the perfect capital markets assumption MM dividend irrelevance In perfect capital markets, holding xed the investment policy of a rm, the rm’s choice of dividend policy is irrelevant and does not affect the share price Firm value ultimately derives from free cash ows. In perfect capital markets, it does not matter whether payouts are through dividends or share repurchases. fi . fi . fl fi : 188 Payouts: Dividends and repurchases with personal taxes 189 Taxes on dividends and capital gains Distributions Pay dividends Repurchase shares Dividends Repurchases • Treated as income, taxed at marginal tax rat • Selling shareholders pay taxes at the capital gain rat • May have franking credit in imputation tax system. “Double taxation” in classical tax system. • No difference between imputation and classical tax systems e e : : 190 Franking credit De nition A tax credit transfer to shareholders for the amount of tax the company has paid in an imputation tax system. The franking credit is used by shareholders to reduce his or her own tax liability, with any excess paid back as a refund. Only available to resident tax payers in Australia. fi 191 Dividend taxation and tax systems Dividend taxation depends on the tax system Classical: Personal tax based on after-tax dividends to a shareholder Imputation: Personal tax based on pre-tax net pro t with a credit for corporate tax. Tax system Classic Imputation Classic Imputation Classic Imputation Company tax rate 30% 30% 30% Marginal personal tax rate 45% 30% 15% Company Net profit before tax 1.000 1.000 1.000 1.000 1.000 1.000 Corporate tax -0.300 -0.300 -0.300 -0.300 -0.300 -0.300 Net profit after tax 0.700 0.700 0.700 0.700 0.700 0.700 Shareholder Dividend before tax 0.700 0.700 0.700 0.700 0.700 0.700 Taxable income 0.700 1.000 0.700 1.000 0.700 1.000 Personal tax -0.315 -0.450 -0.210 -0.300 -0.105 -0.150 Franking credit 0.300 0.300 0.300 Tax payable -0.315 -0.150 -0.210 0.000 -0.105 0.150 Income after tax 0.385 0.550 0.490 0.700 0.595 0.850 . : 192 fi • • Capital gain taxation and share holding period Capital gain taxation depends on the length of time a share is held Less than one year: Taxes based on marginal tax rate (Australia) More than one year: Taxes based on half marginal rate (Australia). Holding period < 1 year Capital gain rate > 1 year < 1 year 45% > 1 year < 1 year 30% > 1 year 15% Shareholder Gain on sale of share 0.700 0.700 ⨉½ 0.700 0.700 0.700 0.700 Taxable component 0.700 0.350 0.700 0.350 0.700 0.350 Capital gain tax -0.315 -0.158 -0.210 -0.105 -0.105 -0.053 Income after tax 0.385 0.543 0.490 0.595 0.595 0.648 Note: Tax regimes vary worldwide. In the U.S., short-term gains (<1 year) taxed as income, most long-term gains (>1 year) taxed at about 20%. : 193 . • • Dividends versus capital gains The income for the investor after taxes depends on • • • Method of distribution: Dividends vs. repurchase Tax system: Imputation vs. classica Length of time the shares are hel Comparing the systems — capital gain equal to marginal personal tax rates: Tax system Classic Imputation Classic Imputation Classic Imputation Company tax rate 30% 30% 30% Marginal personal tax rate 45% 30% 15% Capital gain rate 45% 30% 15% Amount received by investor on $0.70 distribution Dividends 0.385 0.550 0.490 0.700 0.595 0.850 Repurchase (> 1yr) 0.543 0.543 0.595 0.595 0.648 0.648 Note: This comparison assumes the marginal personal tax rate and the capital gain rate are equal. This is just for illustrative purposes. Rates vary globally. : s l d 194 Dividends versus capital gains Optimal payout policy suggests rms should maximise the money received by investors. This suggests payment by • Dividends: When the personal tax payable on dividends is less than the personal tax payable on capital gains • Repurchases: When the personal tax payable on dividends is more than the personal tax payable on capital gains Payout policies appear to re ect investor preferences • Relatively low taxes on dividends induced by Australia’s switch to the imputation system in 1987 led to increased dividend payments • Relatively low capital gain rates in the U.S. have led to increased share repurchases. : . … fi fl . . 195 Payouts: Dividend and repurchase signalling 196 Imperfect capital markets Payout policy will also be in uenced by investor perceptions. Firm “smooth” dividends, setting them at a level they expect to maintain, because • • Investors may prefer stable dividend Management may prefer to set dividends as a target fraction of earning Dividend signalling suggests changes to dividend policy provide information to investors • • Dividend cuts suggests earnings will be lower in the future Dividend increases suggest the rm can afford greater future payout Share repurchases are not as credible a signal as dividends • Repurchases are less informative about future earnings as repurchases are set infrequently and rms do not maintain regular repurchases schedule • Repurchases suggest the rm is under-valued as management will not buy overpriced shares : s s : s s fl fi fi fi : 197 Note: Dividend imputation and the cost of equity 198 Imputation and the cost of equity capital Dividend franking credits create a tax bene t for shareholders • This is similar to how rm’s realise cash ow bene ts from the tax deductibility of interest payments • The imputation adjusted cost of equity is the standard cost of equity multiplied by a scaling factor: rE,I = rE ⇥ ✓ 1 1 TC TC (1 F ⇥ ✓) ◆ where: TC is the corporate tax rate, F is the percent of available franking credits rms distribute, and is the market value of a franking credit : fi fi fi fl fi . 𝛳 199 Imputation and WACC The imputation adjusted WACC ◆ TC =wE ⇥ rE ⇥ 1 TC (1 F ⇥ ✓) ✓ ◆ 1 TC + w P ⇥ rP ⇥ 1 TC (1 F ⇥ ✓) + wD ⇥ rD ⇥ (1 200 : rW ACC ✓ 1 TC ) Imputation and the cost of equity capital Studies estimate that in Australia • Firms pay approximately 70% of available franking credits (F=0.70) (Hathaway and Of cer (2004) for ATO) • Estimates of the market value of a franking credit differ widely. Available studies provide estimates of between 0 and 0.81 • Using F=0.7, =0.55, andTC=0.3 suggests that the imputation corrected cost of equity is about 86% of the standard cost of equity. . : 𝛳 fi 𝛳 201 Imputation and the cost of equity capital Market practice does not adjust for the value of franking credits • 85% of those surveyed in Australia by Truong, Partington, and Peat (2008) do no adjust the cost of equity for franking credits1 • • • Leads to incorrectly high discount rates being used when valuing project and rms Suggests rms may attach negative values to positive NPV project Firms may not invest in positive NPV projects as a result 1 Truong, G., Partington, G., and Peat, M, Cost-of-capital estimation and capital-budgeting practice in Australia, Australian Journal of Management, 2008, 33 (1), 95 -121. fi : s fi 202 Putting it all together: Free cash ow models fl 203 Discounted free cash ow model (Project) Discounted free cash ow models are the workhorse models in project valuation 1. Determine pro forma incremental earnings, capital expenditures, depreciation, working capital needs, and salvage for a project (Cash Flows: Topic 6) 2. Compute free cash ows (Cash ows: Topic 6) 3. Determine the debt-equity mix and corresponding weighted average cost of capital that captures the appropriate risk of the project cash ows (Cost of capital: Topic 8) - Debt:Yield to maturity (Loans and Bonds: Topic 3) - Equity: Use CAPM with levered beta appropriate for project risk (Equity: Topic 4, Risk & Return/CAPM: Topic 7 - Preference shares: Implied discount rate from dividend growth model (Equity: Topic 4 4. Compute a net present value and decide if the project is worth pursuing (Financial Mathematics: Topic 2, Investment decision rules: Topic 5 5. Determine cash retention and payout policy (Payout policy: Topic 9) fl ) fl fl ) fl fl : ) 204 Discounted free cash ow model (Firm) Discounted free cash ow models are also the workhorse models in rm valuation 1. Determine pro forma incremental earnings, capital expenditures, depreciation, working capital, and salvage for the rm (Cash Flows: Topic 6) 2. Compute free cash ows (Cash ows: Topic 6) 3. Determine the debt-equity mix and corresponding weighted average cost of capital that captures the appropriate risk of the total rm cash ows (Cost of capital: Topic 8) - Debt:Yield to maturity (Loans and Bonds: Topic 3 - Equity: Use CAPM with levered beta appropriate for rm risk (Equity: Topic 4, Risk & Return/CAPM: Topic 7) - Preference shares: Implied discount rate from dividend growth model (Equity: Topic 4) 4. Compute a net present value, which is the enterprise value of the rm (Financial Mathematics: Topic 2, Investment decision rules: Topic 5) fi fi fl fi ) fi fl fl fi fl fl : 205 Free cash ow model (Firm) Once the enterprise value has been obtained the total market value of the rm’s securities can be calculated M arket V alue Equity + M arket V alue Debt = Enterprise V alue + Cash This is often used to “price” shares, where an investor determines their own value of the shares: P rice per share = Enterprise V alue + Cash M arket V alue Debt N umber of Shares Outstanding : fl 206