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Assessment Criteria
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Introduction
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Required rate of return
REQUIRED RATE OF RETURN (RRR)
o What investors expect to earn on investments with
equivalent risk
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Cost of capital
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Cost of capital (2)
Remember! the objective of financial management is to maximize
shareholder wealth
To do this, company must invest in projects and investments that will add
value to the company and ultimately maximize shareholders wealth
Two sources can be used to finance projects and investments: (E) + (D)
= (V or total value of the firm)
Equity (E)
Debt (D)
See example 7.1 P130 131 + additional example in presentation
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Definitions of Cost of Capital P131
1. Rate of return a company must earn on its investments to ensure that the minimum requirements of
the providers of capital are met
2. Breakeven point where the proceeds of a project are exactly enough to pay the providers of capital
OR both equal to each other
3. Collective charge of all the providers of finance for every one Rand invested in the company
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Class example
Opportunity to invest R2 500 in an asset that will yield
returns one year from today
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Class example
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Class example
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Calculation of cost of capital (2)
Future projects funded by future funds
o Calculate future cost of funding over long term
o Historic cost of funds is irrelevant
o Cost of capital is the cost of obtaining similar funding today
for use in the future
o Ask yourself
What will the cost be of obtaining similar loan today for
future use?
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Calculation of cost of capital (3)
Evaluate capital projects
o Long-term nature
o Funded with long-term funds if not, can create cash
flow shortages
o Identify permanent sources of finance
Sources available for future use in the long term
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Calculation of cost of capital (4)
Calculating cost of capital:
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Cost of equity: Ordinary Shares
Various methods available in practice
CFM11B1 we use:
Adjusting the risk-free rate
Equity shareholders arrive at required return by taking basic rate
and adjusting for the risk-profile of the company
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Cost of equity: Ordinary Shares
Cost of equity = risk free rate + risk premium
Risk-free rate
Return on government bonds (example: R208 maturing in
2021)
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Cost of equity: Ordinary Shares
Cost of equity = risk free rate + risk premium
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Cost of equity: Example
Lions Limited has 10 000 shares at a par value of R10 each.
The return on R208 government bonds is 10.79% at present.
Due to the recent war in the Middle East the risk in global markets is perceived
as high and a premium of 8% is considered appropriate.
The company has a fairly low business risk and financial risk. A further
premium of 5% is considered appropriate.
Required:
Calculate the cost of equity.
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Cost of equity: Example solution
The cost of equity capital is:
Risk-free % + Risk premium %
10.79% + (8% + 5%)
23.79%
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Cost of preference shares
TVM calculation
Identify future cash flows
PMT = Dividends paid (% of par value x number of shares)
Identify current market value and redeemable value
PV =no of shares at current market value
FV = no of shares at par value
Solve for I/Y
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Cost of preference shares: Example
Required:
Calculate the cost of preference shares
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Cost of preference shares: Example solution
P/Y 1
FV -40 000 (20 000 x R2)
PMT -4 000 (20 000 x R2 x 10%)
N 4
PV 30 000 (20 000 x R1.50)
I/Y ? 19.58%
Required return on similar instruments issued today
NB! 10% dividend is historic rate, not cost of capital
RRR of preference shares (19.58%) is lower than RRR of ordinary shares
(23.79%) because lower risk!
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Cost of debt: Example
Lions Limited has a loan of R60 000 on their balance sheet
This is the price at which the loan can be fully repaid today
The loan is repayable in 4 installments of R20 000 each, at the end
of each year
The tax rate is 30%.
Required:
Calculate the cost of debt
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Cost of debt: Example solution
P/Y 1
PV 60 000
PMT -20 000
FV 0
N 4
I/Y 12.59%
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Weighted average cost of capital (WACC)
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Cost of Capital Part 2
Decision making
Which Cost of Capital (Capital source) to use?
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Weighted Average Cost of Capital (WACC)
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Optimum Capital Structure
Company will have optimal/target capital structure (This is given to
you in CFM1B)
Debt : Equity mix at which shareholder wealth is maximized
CFM11B1:
Assume company is operating at optimal capital structure
Reflected by book value of sources on statement of financial position
Usually best to use market values but read question!
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Optimum Capital Structure
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Example 7.3 WACC
Example 7.3 P137 - Yankee Limited has a target capital
structure of 50 : 50 (50% debt + 50% equity)
They are considering an investment in Project A with a return
of 16%
To fund this they will use a 12% after tax loan
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WACC
Project B comes up with a 20% return
To bring target capital structure back they will issue
ordinary shares at a cost of 22%
REJECT!
Reason: Return not sufficient to meet the requirements
of the shareholders
Summary
Accept Project A (16% return)
Reject Project B (20% return)
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WACC
How is it possible that a project yielding 20% return is rejected in
favour of a project yielding 16%?
WRONG DECISION
Measuring projects against individual sources of capital will lead
to incorrect decisions
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WACC
Weighted cost of capital for Yankee Limited is 17%
(50% 12%) + (50% 22%) = 17 %
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WEIGHTED AVERAGE COST OF CAPITAL
WACC
Ordinary Preference
Debt
Equity Shares
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WEIGHTED AVERAGE COST OF CAPITAL
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WEIGHTED AVERAGE COST OF CAPITAL
After-
tax Value Weighting Contribution
Component
cost (R) (%) (%)
(%)
Ordinary shares K V V/V total K x V/V total
Preference shares Kp Vp Vp/V total Kp x Vp/V total
Debt Kd Vd Vd/V total Kd x Vd/V total
V total 100% WACC
Step
Step 2: Step 3:
1:
Example 1: Cats Limited
The information in the table below has been provided to you with regards to
Cats Ltd.
Required:
Calculate the weighted average cost of capital.
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Example 1: Cats Limited
Step 2:
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Cats Limited (3)
Step 3:
Step 3:
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Example 1: Cats Limited
Cats Limited needs to earn at least 16.56% on its investments to
satisfy all the providers of capital proportionately to their interest
in the project.
WACC = 16.56%
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Example 2: Dogs Limited
Dogs Limited has a capital structure as follows:
Equity: 100 000 shares valued at R5 per share. Equity
shareholders require 18% return for similar shares.
12% Preference shares: 200 000 of R2. The preference
shareholders require 12% return on similar investments.
Debt: R100 000 at a fixed interest of 9% before tax. (tax is 28%)
Required:
Calculate Dogs Limiteds weighted average cost of capital
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Example 2: Dogs Limited
Step
# 9% -28% tax = 6.48% after tax 1:
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Example 2: Dogs Limited
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Example 2: Dogs Limited
Dogs Limited needs to earn at least 14.45% on its investments to
satisfy all the providers of capital proportionately to their interest
in the project.
WACC = 14.45%
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Class question 1: Rabbit Limited
Rabbit Limited has a capital structure as follows:
Equity: 1 000 000 shares trading at R 1.54 per share. Equity
shareholders require 22% return for similar shares.
12% Preference shares: 200 000 of R2. The required rate of
return is 16%.
Debt: R300 000 at a fixed interest of 11% before tax. (tax is 28%)
Required
Calculate Rabbit Limiteds weighted average cost of capital
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Class question 2: Pony Limited
Pony Limited has a capital structure as follows:
Equity: Equity shareholders require 20% return for similar shares.
14% Preference shares. The required rate of return is 13%.
Debt: fixed interest of 11% before tax. (tax is 28%)
The capital structure of the company is 50% equity, 20% pref
shares and 30% debt.
Required
Calculate Pony Limiteds weighted average cost of capital.
NOTE: You do not have to have a rand value for capital if you have
the individual weighting.
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Homework
Tutorial questions
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