Fin management materials / 1 P4AFM-Session02_j08

SESSION 02 – SECURITY VALUATION AND THE COST OF CAPITAL

Example 3

A company has 300,000 ordinary shares in issue with an ex-div market value of $2.70 per share. A dividend of $40,000 has just been paid out of post-tax profits of $100,000.

Net assets at the year end were $1.06m.

Estimate the cost of equity.

Solution

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SESSION 02 – SECURITY VALUATION AND THE COST OF CAPITAL

3.5Cost of equity and project appraisal

Illustration 3

A plc is all equity financed and has 1m shares quoted at $2 each ex div. It pays constant annual dividends of 30c per share.

It is considering a project which will cost $500,000 and which is of the same risk as its existing activities. The cost will be met by a rights issue. The project will produce inflows of $90,000 per annum in perpetuity. All inflows will be distributed as dividends.

What is the new value of the equity in A plc and what is the gain to the shareholders? Ignore tax.

¾ ke = 0.302.00 = 15%

¾New dividend

= Existing value + Present value of additional dividends

¾Therefore the NPV of a project increases the value of the company’s shares i.e. the NPV of a project shows the increase in shareholders’ wealth.

¾This proves that NPV is the correct method of project appraisal – it is the only method consistent with the assumed objective of maximising shareholders’ wealth.

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SESSION 02 – SECURITY VALUATION AND THE COST OF CAPITAL

3.6Cost of preference shares

¾By definition preference shares have a constant dividend

¾Ke = PoD

¾where D = constant annual dividend

¾Preference dividends are normally quoted as a percentage, e.g. 10% preference shares. This means that the annual dividend will be 10% of the nominal value.

Example 4

A company has 100,000 12% preference shares in issue (nominal value $1).

The current ex-div market value is $1.15 per share.

What is the cost of the preference shares?

Solution

4COST OF DEBT

4.1Terminology of debentures

A debenture is a written acknowledgement of a company’s debt. A debenture usually pays a fixed rate of interest and it may be secured or unsecured. It may be traded on the bond market and will reach a market price. The terms debenture, bond and loan stock all basically refer to the same thing i.e. traded corporate debt (unlike bank loans which are not traded).

¾The coupon rate is the interest rate printed on the debenture certificate. Annual interest = coupon rate × nominal value

Nominal value is also known as par or face value. In the exam the nominal value of one debenture is usually $100.

¾Market value (MV) is normally quoted as the MV of a block of $100 nominal value.

e.g. 10% debentures quoted at $95 means that a $100 block is selling for $95 and annual interest is $10 per $100 block.

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SESSION 02 – SECURITY VALUATION AND THE COST OF CAPITAL

4.2Irredeemable debentures

Irredeemable debentures are a type of debt finance where the company will never repay the principal but will pay interest each year until infinity. They are also referred to as undated debentures.

¾Using the same logic as for dividends and looking at the cash flows from the investor’s point of view:

¾MV (ex interest) = present value of future interest payments discounted at the debenture-holder’s required rate of return

¾For irredeemable debentures the interest stream is a perpetuity.

¾MV (ex int) = rI

¾The company gets tax relief on the debenture interest it pays, which reduces the cost of debentures to the company – debt provides a “tax shield”.

Illustration 4

Consider two companies with the same earnings before interest and tax (EBIT). The first company uses some debt finance, the second uses no debt.

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SESSION 02 – SECURITY VALUATION AND THE COST OF CAPITAL

4.3Redeemable debentures/dated debentures

¾The cash flows are not a perpetuity because the principal will be repaid. However from the dividend valuation model we can derive the following rule:

The cost of any source of funds is the IRR of the cash flows associated with that source.

¾If we are looking at the return from an investor’s point of view, interest payments are included gross.

¾If we are looking at the cost to the company, we take the interest payments net of corporate tax. Assume instant tax relief.

¾Assume that the final redemption payment does not have any tax effects.

¾To estimate the cost of debt for a company find the IRR of the following cash flows:

The IRR is found as usual using linear interpolation.

Example 6

A company has in issue $200,000 7% debentures redeemable at a premium of 5% on 31 December 19X6. Interest is paid annually on the debentures on 31 December. It is currently 1 January 19X3 and the debentures are trading at $98 ex interest. Corporation tax is 33%.

What is the cost of debt for this company?

Solution

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SESSION 02 – SECURITY VALUATION AND THE COST OF CAPITAL

¾Care should be taken not to confuse the required return of the debenture holders with the cost of debt of the company.

¾The required return of the debenture holders is used to determine the ex interest market value of the debentures using the dividend valuation model.

¾Gross Redemption Yield is also referred to as the Yield To Maturity (YTM)

¾The cost of debt of the company is then determined by finding the IRR of the market value, net of tax interest payments and redemption value.

Example 7

A company has 8% debentures redeemable at a 5% premium in ten years. Debenture-holders require a return of 10%.

What is the cost to the company? Corporation tax is 33%.

Solution

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SESSION 02 – SECURITY VALUATION AND THE COST OF CAPITAL

4.4Semi-annual interest payments

¾In practice debenture interest is usually paid every six months rather than annually. This practical aspect can be built into our calculations for the cost of debt.

¾If interest payments are being made every 6 months then when the IRR of the debenture cash flows is calculated it should be done on the basis of each time period being 6 months.

¾The IRR, or cost of debt, will then be a 6 monthly cost of debt and must be adjusted to determine the annual cost of debt.

¾Effective annual cost = (1+semi annual cost)2 -1

Example 8

A company has in issue 6% debentures the interest on which is paid on 30 June and 31 December each year. The debentures are redeemable at par on 31 December 19X9. It is now 1 January 19X7 and the debentures are quoted at 96% ex interest.

What is the annual cost of debt for the company? Ignore tax.

Solution

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SESSION 02 – SECURITY VALUATION AND THE COST OF CAPITAL

4.5Convertible debentures

¾Convertible debentures allow the investor to choose between redeeming the debentures at some future date or converting them into a pre-determined number of ordinary shares in the company.

¾In order to find the cost of convertibles it is necessary to be able to determine which option the investor will exercise and at what date.

¾This will normally involve the following stages:

Step 1 Estimate the value of the conversion option.

Step 2 Compare the conversion option with the redemption option. As investors are rational it can be assumed that they will all choose the option with the higher value.

Step 3 Calculate the IRR of the cash flows as for redeemable debentures using either the conversion value or redemption value as determined in Step 2.

Example 9

A company has in issue some 8% convertible loan stock currently quoted at $85 ex interest. The loan stock is redeemable at a 5% premium in five years time, or can be converted into 40 ordinary shares at that date. The current ex div market value of the shares is $2 per share and dividend growth is expected at 7% per annum. Corporate tax is 33%.

What is the cost to the company of the convertible loan stock?

Solution

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SESSION 02 – SECURITY VALUATION AND THE COST OF CAPITAL

5TERM STRUCTURE OF INTEREST RATES

The return provided by a security will alter according to the length of time before the security matures.

If, for example, a graph is drawn showing the yield to maturity/redemption yield of various government securities against the number of years to maturity, a “yield curve” such as the one below might result.

Yield

Years to maturity

It is important for financial managers to be aware of the shape of the yield curve, as it indicates to them the likely future movements in interest rates and hence assists in the choice of finance for the company.

The shape of the curve can be explained by the following:

¾Expectations theory:

If interest rates are expected to increase in the future, a curve such as that above may result. The curve may invert if interest rates are expected to decline.

¾Liquidity preference theory:

Yields will need to rise as the term to maturity increases, as by investing for a longer period the investor is deferring his consumption and needs higher compensation.

¾Segmentation theory:

Different investors are interested in different segments of the yield curve. Short-term yields, for example, are of interest to financial intermediaries such as banks. Hence the shape of the yield curve in that segment is a reflection of the attitudes of the investors active in that sector.

Where two sectors meet there is often a disturbance or apparent discontinuity in the yield curve as shown in the above diagram.

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