C O S T O F C A P I T A L

Group 3

Sera Bose (S92476450)

Aisake Mausio (S11088915)

Anup Prakash (S01001914)

Raymond Kumar (S11037932)

Lanieta Cheer (S94003879)

Luke Naisila (S02000356)

Nirupa Devi (S01007128)

Ateca Vakaloloma (S11100600)

What is the Cost of Capital?

The Cost of Equity

Dividend Growth Model Approach

The SML Approach

The Cost of Debt

Weighted Average Cost of Capital

Divisional & Project Cost of Capital

Case Study

Discussion Outline

Cost of Capital associated with an investment depends on the risk of that investment

Cost of Capital depends on the use of the funds, not the source.

Cost of a companys funds (both debt & equity) or from an investment point of view the required rate of return

Minimum return that investors expect for providing capital to the company

What is Cost of Capital?

Cost of Capital provides an indication of how the market views the risk of our assets

Knowing Cost of Capital helps determine the required return for capital budgeting projects.

Relevance of Cost of Capital

Definition:

The return that equity investors require on their investment in the firm.

Introducing Cost of Equity

There is no direct way of observing the return that the firms equity investors require on their

investment.

Dividend Growth Model Security Market Line (SML)

0 =0 1 +

=

1

Thus, may be rearranged to determine Return on Equity.

=1

0 +

A model that determines the current price of a share as its dividend next period divided by the discounted rate less the dividend growth rate

Dividend Growth Model

Return on Equity Next Dividend Projection

Growth rate Price per share

3 Critical pieces of information required to use the Dividend Growth Model:

Price per share (P0)

Dividend payout (D0) Growth rate (g)

Dividend Growth Model

Estimating (g) Use either

ADVANTAGE

Simple to use

Easy to understand

DISADVANTAGE

Only applicable to companies that pay dividends

Key assumption that dividend grows at a constant rate only steady growth applicable

Estimated cost of equity is sensitive to the estimated growth rate

Does not account for risk

Dividend Growth Model

Security Market Line Method

The required or expected return on a risky investment depends on 3 things:

The risk-free rate (Rf)

The market risk premium E(Rm) - Rf

The Beta coefficient ()

Determining Cost of Equity Capital:

= +

Return on Equity

Risk-free rate

Coefficient Market risk premium

ADVANTAGE

Explicitly adjusts for risk

Applicable to companies other than those with steady dividend growth

Also applied to individual projects and not limited to companies

DISADVANTAGE

Requires the market risk premium and the beta coefficient values to be estimated

If estimates are poor results will be inaccurate.

Uses the past info to predict the future (economic conditions can change fairly quickly)

Security Market Line Method

The required return on a companys debt

The cost of debt is simply the interest rate the firm must pay on new borrowing.

Focusing on long-term debts or bonds

The Cost of Debt

Method 1

Compute the yield to maturity on existing debt

Method 2

Use estimates of current rates based on the bond rating expected on new debt.

The minimum return a company needs to earn to satisfy all of its investors, including shareholders, debt holders and preference shareholders.

The weighted average of the cost of equity and the after-tax cost of debt

The required return on any investments by the firm that have essentially the same risks as existing operations.

What is WACC?

Capital Structure Weights = +

Taxes & WACC

=

+

(1 )

When using preference shares (Classical Tax System):

=

+

+

(1 )

More about WACC

Value Equity

Debt

Cost of preference share Cost of Equity Cost of Debt

Corporate Tax Rate

Imputation Tax System

= 1 + (1 )

More about WACC

Equity Weights

Return on Equity

Corporate Tax

Weighted Debt

Return on Debt

CASE STUDY

You have recently been employed by Hubbart Computer Ltd (HCL)

Founded 8-years ago by Bob Hubbart Operates 14 stores on the South Island of New

Zealand Ran sales of $9.7 million the previous year Orders are made to fill with customers paying for

the order immediately. Average 15 days for delivery and a 30 day guaranteed delivery.

HCL finances its growth via profits where new stores are opened when there is sufficient capital.

Case Study Highlights

Part A Find the most recent yearly/half-yearly report for Harvey Norman. Find the book value of debt and book value of equity.

Part B: i. (i) What is the most recent stock price listed for Harvey

Norman? ii. What is the market capitalization? iii. How many shares does Harvey Norman have outstanding? iv. What is the most recent annual dividend? v. Can the dividend discount model be used for Harvey

Norman? vi. What is ? vii. What is the yield on government debt? viii. What is the cost of Equity using the CAPM?

Case Study Outline

Case Study Outline

Part C Calculate cost of debt for Harvey Norman. What is the WACC value of debt for Harvey Norman using the book-value weights and the market-value weights? Does it make a difference in this case if you use book-value weights or market-value weights?

Part D Calculate the WACC using book value weights and market value weights.

Find one or more companies

Compute Beta for each company

Take an average

Use beta along with CAPM to find return

Before we begin

PURE PLAY APPROACH

SUBJECTIVE APPROACH

Consider overall risk relative to overall firm

If project is less risky than firm, use discount rate less than WACC

Decision can go either way (If data indicate reject, you may accept or vice-versa)

Part A (i) Book Value (Debt)

Case Study Answers

Part A (ii) Book Value (Equity)

Part B (i)

Market Capitalization: Shares x Stock Price

$4,806 million (1,063,291,352 x $4.520)

Case Study Answers Part B (ii)

Part B (iii) Outstanding Shares

Case Study Answers

Part B (iv) Annual Dividend

Part B (v) Can we use the Dividend Growth Model?

We cannot as the growth is not constant as indicated above

Case Study Answers

Part B (vi) What is ?

Case Study Answers

Part B (viii) Cost of Equity

RE = RF + BE x (RM RF)

= 3.01 + 1.04 x 4.29

= 3.01 + (4.4616)

= 7.47%

Part B (vii) Government Yield

Case Study Answers

Case Study Answers

Interest Rates with corresponding borrowings

Case Study Answers

Part C Calculating weighted average cost of debt

Cost of Debt = RD x (1 TC)

(book value) = 3.14 x (1 0.30)

= 3.14 x 0.70

= 2.20%

Cost of Debt = RD x (1 TC)

(market value) = 5.43 x (1 0.30)

= 5.43 x 0.70

= 3.80%

=

+

(1 )

Using Book Value

= 0.781 x 0.0747 + 0.22 x 0.022 x 0.70 = 0.062 or 6.2%

Using Market Value

= 0.781 x 0.0747 + 0.22 x 0.038 x 0.70 = 0.064 or 6.4%

Case Study Answers

Part D Calculate WACC for Harvey Norman

Harvey Normans return on Invested Capital as at June 14 is 5.22% (http://www.gurufocus.com/) while the Weighted Average Cost of Capital sat @ 6.4%.

Therefore, the returns on investments are lower than the costs required to raise capital needed for the investment.

CONCLUSION CASE STUDY

QUESTIONS