2. Use principles
of:
- Capital
budgets
- Portfolio
management
- Valuations
and
take-overs
- Cost of
capital
INVESTORS Want to
Maximise profit
CONSIDER
PRINCIPLES
OF:
-Analysis and
interpretation
-Risk and
return
-Hedging
-Time value of
money
INVESTMENT DECISION
Thus seek investment opportunities
And consider different aspects
FINANCING DECISION
If decided upon an investment,
must consider how to finance it
DIVIDEND DECISION
Hopefully the investment yielded
a profit, and then one must
Decide how the profit will be
applied
Invest in:
- EAT
- Operational
-
assets
- Businesses
-Shares
Use principles
of:
- Sources of
financing
- Capital
structure
- Types of
financing
(leases/inter
-
national)
Finance
with:
- Equity
- Debt
OBTAIN INFORMATION:
- Internal:
Accounting
records and
management
- External:
Economic and
Business
environment
3. Learning outcomes
Upon completion of the Study unit you
should be able to:
• Know and apply the valuation techniques of
the following items:
DEBT EQUITY
Debentures/Bonds Ordinary shares
Long term loans
Preference shares
6. 1. Redeemable debentures
Company A holds R1 million's debentures in
company B. The annual interest rate is 15%.
The debentures are redeemable over 5 years
at par. The current market return for similar
debentures with a life of 5 years is 20%.
Current tax rate is 28%.
Required:
Calculate the market value of the debentures.
8. 2. Non-redeemable debentures
Company A holds R1 million's non-redeemable
debentures in Company B. The annual interest
rate is 15%. The current market return for similar
debentures is 20%. The current tax rate is 28%.
Required:
Calculate the market value of the debentures
Formula:
(Interest / Market related interest rate)
10. 3. Convertible debentures
Debentures in issue: 1 000 000 Value: R1 000 000
These debentures expires in 2 years and the debenture holders have
the option to:
Convert their debentures into ordinary shares at an exchange rate of 1
debenture for 1 ordinary share.
OR
The debentures can be redeemed for cash at a 28% premium.
All issued debentures currently earn interest at 28% per year. Debentures are
currently trading at a market return of 30%.
Ordinary shareholders currently receive a dividend of 0.25c. Annual growth
was 4%, and shareholders expect a return of 26.22% on equity.
11. 3. Convertible debentures
Approach to convertible debentures/bonds:
1. Calculate the market value of both options
@time of conversion (over 2 years in this
example) – draw a timeline if needed
2. Choose highest value
3. Calculate the value as of TODAY for the
chosen option (discount back)
12. 3. Convertible debentures
Option 1: Convert to equity
Vo = D1/ (Ke-g)
(0.25*1.04(3)) / (26.22-4)
1.27 * 1 000 000
= 1 270 000 (value over 2 years)
Note that D1 is the dividend in the
year after the conversion date i.e.
Year 3.
Option 2: Cash
1 000 000 *1.28
= 1280 000 (value over 2
years)
Choose option 2!!!
15. Preference shares
• 3 Types of preference shares:
1. Redeemable – the same as debentures
(no tax)
2. Non-redeemable – the same as
debentures (no tax)
3. Convertible
16. 1. Redeemable preference shares
The example has a par value of R100 and bears
dividends at 15% per year. A market-related
dividend rate for similar investments is 16%. This is
redeemable over 5 years.
Required:
Calculate the market value of the preference shares
18. 2. Non-redeemable preference
shares
A person wants to sell 100 preference shares. The
preference shares have a face value (the value
printed on the shares certificate) of R1 and bears
interest at 10%. A market-related interest rate for
similar preference shares is 8%.
20. 3. Convertible preference shares
Preference shares 5 000 000
Issued Value 5 000 000
Currently shareholders are earning R200 000 of dividends on
preferred shares and similar preference shares are currently trading
on the market at 11%
In 5 years time preference shareholders will have a choice to convert
their preference shares into 10 000 ordinary shares OR
to keep it in perpetuity and earn dividends of 10%.
Ordinary shareholders are currently earning a dividend of R15 per
share and shareholders require a return rate of 21%. The company
has a growth rate of 6%
22. 3. Convertible preference shares
Calculate present value of option 2:
N = 5
I = 11% (market rate)
FV = 4 545 455
Pmt = 200 000 (earning currently)
Comp PV = 3 436 685
23.
24. Equity
Valuation of ordinary shares:
1. Gordon's growth model
OR
2. Share price x number of shares
Market price (V0) = D1
Ke - g
25. Equity – Constant growth
Company A's dividend for the next year is
estimated at 50c. It is evident from the last 5
years' results that the company has an annual
growth rate of 15%. The investor expects a
return of 20% on his investment.
Required:
Calculate the market value
27. Equity: Non-Constant growth
• In the case of non-constant growth, the share must
be valued on the date on which the growth changes.
• This value then has to be discounted back to the
current date, together with the other dividends (Cfi
function).
• 2 dimensions:
– Calculate the value of the dividends
– Calculate the value of the share
• Example in Correia C6.10 pp 6-15
28. Equity: Non-Constant growth
X just paid a dividend of 60c per share.
Shareholders demands a return of 12% p.a.
Growth for the next 3 years are expected to be
30% and after that growth will stabilize at 6% p.a
*Draw a timeline
29. Equity: Non-Constant growth
• 0 = 60 c
• 1 = 0.78c (0.60*1.30)
• 2 = R 1.01 (0.78*1.30)
• 3 = R 1.32 (1.01*1.30)
• 4 = R 1.39 (1.32*1.06)
1.39/(12%-6%)
= R23.17 is the value over 3 years
now calculate the present value (y0)
30. Equity: Non-Constant growth
• 0 = 0 Ent
• 1 = 0.78c Ent
• 2 = R 1.01 Ent
• 3 = R 1.32 + R23.17 = R 24.487
• 2nd F Cfi
• 12% Ent
• Down button NPV Comp = R18.93
31. Self study
• Please look at the example in Correia pp 6-17.
Here dividends weren't pay for a number of
years. (Delayed dividend)
33. Learning outcomes SU 2.3
• Calculate the cost of debt;
• Calculate the cost of preference shares;
• Calculate the cost of equity;
• Calculate the weighted average cost of capital at
market value; and
• Determine the cost of capital of specific projects
and advice on it.
34. WACC - introduction
• Weighted average cost of capital
(WACC) is the weighted average of the
required rates of return of equity, debt and
preference shares employed by the entity.
• Capital refers to all permanent sources of
economic resources used by the business to
conduct its business activities.
35. WACC - introduction
If investment has a higher return than cost of
capital, what happens to the value of the company?
36. WACC - introduction
• Investments create value for a business
when the return of the investment exceeds
the cost of the funds that were used to
finance it.
• The cost of capital is the best estimate of the
cost of finance and therefore only projects
with returns in excess of the cost of capital
are typically taken on by management.
38. WACC – introduction
• Why is WACC important?
– A company makes investments decisions by
comparing return generated from a project to
WACC (cost of financing the project)
– WACC reflects both risk and capital structure
– If WACC is calculated inaccurately this could
lead to the company accepting projects that
will destroy wealth
40. WACC - introduction
• Each company has a target equity / debt
relation, e.g. 60% / 40% (SEE SU7).
• Each project is not financed with the same
capital in the same relation as capital structure.
• Equity and debt will reflect the capital structure
in the long term.
• Which cost of capital to use:
• Marginal cost of capital
• Pooling of funds
41. Marginal cost of capital
• Cost of new increments of capital that is issued
• Use marginal cost of capital for decisions
regarding new projects that can possible change
the company's WACC profile (Large projects)!!!
• Historical capital is not suitable to base one’s
decision on for new projects
42. Pooling of funds
• An entity’s target capital structure may not
necessarily be the same as the capital
structure that the entity achieves on a day-
to-day basis.
• Each project is not financed with capital in
the same ratio as the capital structure
• Equity and debt will in the long term
represent the capital structure
43. Pooling of funds
A company can invest in a project that will
yield a 15% return. This project will be
financed by a 13% loan. WACC is 17%
Which rate should be used to evaluate the
project against?
45. Current WACC assumptions
• The project is marginal
• The entity’s capital structure will remain
unchanged after accepting the project. This does
not refer to minor deviations in the short term, but
rather major divergences from the target capital
structure as a result of the new investment.
• The project’s systematic risk is the same as the
systematic risk of the entity’s existing operations.
46. Cost of capital
• Cost of different sources of financing that entity uses:
• Cost of equity
• Cost of preference shares
• Cost of debt
• Principles
• Use market values
• Remember the effect of tax
• Use nominal rates
47. Cost of components of capital
Weight Cost Weigthed cost
Equity 50% 20% 10.0%
Long-term debt 30% 9% 2.7%
Preference shares 20% 12% 2.4%
15.1%
48.
49. Cost of debt
• Return expected by creditors
• Interest is tax-deductible – therefore use after
tax cost of debt:
• Sources:
– Long-term loans
– Debentures
– Permanent short term financing
Kd = I (1 – t)
50. Cost of Debt
• Cost of non-redeemable debt
• Taking tax into consideration
51. Cost of Debt
Cost of non-redeemable debt:
ABC has got 2.2 million non-redeemable 11%, R100
debentures. Similar debentures currently trade in
the market at R90 per debenture. Tax is 28%.
Kd = 11 / 90
= 12.22 *0.72
= 8.8%
52. Cost of debt
Cost of redeemable debt
• PV calculation
• Take tax into account
53. Cost of debt
Cost of redeemable debt:
ABC has got 2.2 million redeemable 11%, R100 debentures. Debentures are redeemable
at par value in 4 years. Similar debentures currently trade in the market at R90 per
debenture. Tax is 28%.
FV = 100 INTEREST is tax deductible, therefore
N = 4 AFTER TAX cost of debt!!!!!!
Pmt = (100 * 11%) = 11
PV = -90
Comp I = 14.46%
Can be redeemed at a discount
or a premium!!
AFTER tax = 14.46 * 0.72 = 10.41%
54.
55. Cost of preference shares
• Rate required by investors in preference shares
• Dividends paid at the coupon rate of par value
of preference shares
• Calculation similar to debentures except for
dividends not deductible for tax, therefore use
pre-tax rate.
56.
57. Cost of equity
• The required return expected by ordinary
shareholders
• Two methods to calculate:
Gordon’s growth model Capital asset pricing model (CAPM)
Dividend growth model
(Gordon’s dividend growth
model) (manipulate formula to
isolate cost)
Ke = Rf + (Market rate – Rf rate)
58. • Dividend growth model:
2 scenarios:
- Dividend stays constant
- Dividends grows at constant rate
Ke = D1 + growth rate
Vo
Cost of equity
59. Growth rate (g)
• Calculate growth rate by using historical
information.
• It can be given or it can be calculated.
Cost of equity
60. Growth rate (g)
• Example:
• A Company has the following after-tax earnings
for the previous 5 years:
Year After-tax earnings
2006 1 200 300
2007 1 323 931
2008 1 455 265
2009 1 601 373
2010 1 765 033
Cost of equity
61. Growth rate (g)
• If the annual growth is calculated, it will be as
follows:
Year Growth
2006 to 2007 10.30%
2007 to 2008 9.92%
2008 to 2009 10.03%
2009 to 2010 10.22%
Formula: (New – Old)/Old * 100
Cost of equity
62. Growth rate (g)
G can be determined in two ways:
Average:
(10.30 + 9.92 + 10.03 + 10.22) / 4 = 10.12%
OR
Compounded growth:
PV 1 200 300
FV 1 765 033
N 4
COMP i
Also 10.12%.
Not always the same.
Cost of equity
63. Capital asset pricing model:
• Remember market premium= (market rate –
risk-free rate)
Cost = Risk-free rate + (Market rate – Risk-free rate)
Or in short:
Ke = Rf + (Rm – Rf)
Cost of equity
65. Beta
• Beta = 1 – Risk similar to market
• Beta < 1 – Less risk than market
• Beta > 1 – Higher risk than market
http://www.investing.com/equities/woolworths-
limited
66. Effect of flotation costs
• Companies often make use of outside parties
when issuing new finance.
• These services are not free and the costs paid to
the outside party reduce the amount that the
company receives from issuing new debt.
• This increases the effective cost of financing.
67. Effect of flotation costs
A wants to issue 11% debentures at R100 each. Current
market value of R90. Flotation cost of 1%.
Normal MW = 90 but * 99% will be received
89.10
Kd = Pmt / market
= (11% * 100) / 89.10
= 12.35 * 0.72
= 8.89%
68. WACC calculation
• Steps to calculate WACC:
a) Calculate the cost of the various components
b) Determine the weight of each component:
1. Optimal capital structure
2. Market values
c) Calculate WACC a x b
70. Homework and Preparation
• Class test 2: 2017 (2.1) adjusted
• Class test 1: 2012
Tutorial question:
• Flinstone crushers (flotation cost)
• Company A
• Prepare for SU 3
• Efundi test (WACC): 11 Feb 22:00
• Efundi test (SU3): 11 Feb 22:00
