Fin management materials / 1 P4AFM-Session02_j08

SESSION 02 – SECURITY VALUATION AND THE COST OF CAPITAL

This can also be referred to as “preferred habitat theory” i.e. different investors have a preference for being in different segments of the yield curve.

Pension fund managers often have a preference for investing in long-dated bonds – to match against the long term liabilities of the fund. This can drive up the price of longdated bonds which brings down their yield, possibly resulting on an “inversed” (falling) yield curve.

¾Risk

On high quality government/sovereign debt e.g. UK Gilt-Edged Securities (“Gilts”) the risk of default is not significant even for long-dated bonds.

However default risk may be more significant on corporate debt, therefore the corporate yield curve may rise more steeply than the government yield curve.

Key points

The Efficient Markets Hypothesis deals with the pricing efficiency of the capital markets i.e. what information is included in the price of securities.

If capital markets are perfect the sale/purchase of any security must be a zero NPV transaction i.e. market price = present value of future cash flows discounted at investors’ required return.

This general rule can be specifically applied to shares to develop the Dividend Valuation Model (DVM) and also applied to bond valuation.

If the market price of a security is already known then the model can be rearranged to find the required return of investors’ i.e. the company’s cost of equity and debt finance.

Care must be taken with the cost of debt as interest, unlike dividends, is a tax allowable expense form the side of the company.

The term structure of interest rates deals with the relationship between short and long term interest rates. Everything else being equal long term rates should be higher due to compensate investors for locking their money away and deferring consumption. However other factors such as expectations or preferred habitat can produce an inversed yield curve.

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SESSION 02 – SECURITY VALUATION AND THE COST OF CAPITAL

EXAMPLE SOLUTIONS

Solution 1

Solution 2

19X0–19X4 − four changes in dividend

g= 9.7%

D1 ke = P0 + g

= 145(1.097) + 0.097 1,050

= 24.8%

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SESSION 02 – SECURITY VALUATION AND THE COST OF CAPITAL

Solution 3

Note – return on average equity could be used rather than return on opening equity.

Solution 4

12% preference shares: dividend is 12% × nominal value

D

Ke = Po

=11512 × 100%

=10.4%

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SESSION 02 – SECURITY VALUATION AND THE COST OF CAPITAL

Solution 5

=15%

Return required by debenture-holders is 15%.

Cost to the company

Solution 6

Kd = 6.5%

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SESSION 02 – SECURITY VALUATION AND THE COST OF CAPITAL

Solution 7

To find the cost to the company, we need to know the market value of the debentures. We do this by discounting the future flows at the debenture-holder’s required return.

To find the cost to the company we do an IRR calculation, bringing in the effects of tax relief.

= 7.5% Therefore Kd = 7.5%

Solution 8

Time 0 is 1 January 19X7

Interest payments due

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SESSION 02 – SECURITY VALUATION AND THE COST OF CAPITAL

Each interest payment will be j half of the coupon rate, $3 each 6 months.

This is the semi-annual cost of debt.

Solution 9

First we need to decide whether the loan stock will be converted or not in five years. To do this we compare the expected value of 40 shares in five years’ time with the cash alternative.

We assume that the MV of shares will grow at the same rate as the dividends.

Therefore all loan stock-holders will choose the share conversion.

To find the cost to the company, find the IRR of the post-tax flows.

=11.2%

Therefore cost to the company = 11.2%

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