14-1 copyright 2009 mcgraw-hill australia pty ltd ppts t/a business finance 10e by peirson slides...

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides prepared by Farida Akhtar and Barry Oliver, Australian National University

Chapter 14

The Cost of Capital and Taxation Issues in Project Evaluation

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Learning Objectives• Understand the concept of the cost of capital.

• Understand the effect of risk on the cost of capital.

• Understand how the cost of capital can be measured under the imputation tax system.

• Understand why the cost of capital for a company is expressed as a weighted average of the costs of all of the company’s sources of capital.

• Estimate the cost of each source of capital and combine these costs into a weighted average cost of capital for a company.

• Explain how to treat issue costs in project evaluation.

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Learning Objectives (cont.)• Understand the distinction between the cost of

capital for a project and a company’s weighted average cost of capital.

• Estimate the cost of capital for a division of a diversified company.

• Understand the advantages and disadvantages of using the weighted average cost of capital in project evaluation.

• Understand the effects of taxes on project cash flows.

• Understand the application of the certainty equivalent method of incorporating risk into project evaluation.

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Net Present Value Analysis• Calculation requires:

– Net cash flows.– Required rate of return/cost of capital.– Consistency in the definition of cash flows and the

discount rate applied to the cash flows.

• Required rate of return = opportunity cost. • Cost of Capital — Minimum rate of return

needed to compensate suppliers of capital for committing resources to an investment.

• The cost of capital is very important — accept or reject decision of project can change with small changes in cost of capital.

• The key is consistency between cash flows and cost of capital in NPV calculation.

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Risk, Return and the Cost of Capital

• The returns received by investors in securities must be provided by the issuers of those securities and, from the issuer’s point of view, the return demanded by investors is effectively a cost (cost of capital).

• We can thus interchange the term ‘cost of capital’ with the term ‘required return’.

• The cost of capital for a project is critically determined by the risk of the project.

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Risk Independence

• Implicit in the use of a discount rate related to the risk of a project is that the cost of capital for a project does not depend on the characteristics of the company considering the project.

• The value of a project depends on what the project is, not who the investor is.

• Capital markets lead to risk independence because investors can diversify through markets rather than requiring firms to do so.

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Taxes and the Cost of Capital

• Taxes should be treated consistently in the net cash flows and in the cost of capital.

• Projects are normally evaluated on an after-tax basis.

• Definition of ‘after company tax’ in an imputation environment.

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Taxes and the Cost of Capital (cont.)• Approach to be adopted (Officer, 1994):

– After-tax cash flows = before-tax cash flows multiplied by (1 – te), where te is the effective company income tax rate.

– Traditional rate of return measures do not include tax credits; therefore, adjustment is necessary to obtain true after-company-tax rates of return.

– Where = franking premium (part of the return on shares or a share market index that is due to tax credits associated with franked dividends).

e f e M fk R E R R

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Alternative Approaches to Estimation of Cost of Capital

project f M f projectR R R R • Direct use of CAPM to estimate the project’s beta.

– Can Rf , RM and the project’s beta be accurately observed?

– Would be OK if the company’s projects were all of the same systematic risk and if the company was financed solely by equity because:

equity assets project= =

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Alternative Approaches to Estimation of Cost of Capital (cont.)• Estimate the project’s beta by a weighted average

of the debt and equity beta:

– Calculation of debt beta? Little opportunity in Australia to estimate debt betas.

• Direct use of CAPM is limited due to lack of debt betas and correct treatment of tax and leverage effects.

project debt equity

D E

V V

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Alternative Approaches to Estimation of Cost of Capital (cont.)• Estimate the required rate of return as a weighted

average of the required return on debt and equity (weighted average cost of capital — WACC).

• The CAPM can be used to estimate the costs of the equity source of financing, ke.

• A cost of debt, kd, is then estimated, and these costs are then weighted to calculate the company's required rate of return for use in capital budgeting decisions.

1d e e

D EWACC k k t k

V V

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Calculating the Cost of Capital

• Steps involved:

– Determine the permanent sources of capital utilised by the company.

– Determine the cost of each component of capital based on current conditions. The historical cost of raising funds is irrelevant.

– Weight each component to determine the weighted average cost of capital — to do this, we need the value of each source of funds and total value of project.

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Costing of Debt

• The costs of some non-marketable short-term debts are taken into account in other ways, so they are excluded from the calculation.

• Calculate the effective annual interest rate for sources of debt. If current cost cannot be measured, estimate the rate that the company would now have to pay to raise those funds.

• Interest rates applicable to individual sources of debt are before-tax and need to be converted to after-tax:

• Where te is the effective company tax rate.

after-tax before-tax 1-d d ek k t

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Costing of Equity• Preference shares:

– The value of preference shares is given by:

• Ordinary shares CAPM:

• DCF approach (Dividend Valuation Models)where D0* includes the tax credit

where:

current market price of preference shares

effective yield per half-year

half-yearly preference dividend per sharep

P

i

D

pDPi

e f e M fk R E R R

*0

0

1e

D gk g

P

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The Weighting System

• The appropriate weights are the proportion that each source of funds represents of the total sources used to finance proposed projects.

• Current capital structure can be used unless the capital structure is expected to change, whereby the company’s target capital structure should be used.

• The weights should be calculated using current market values rather than book values.

– This is consistent with the manner in which the costs of each source of funds have been calculated.

– These values reflect the amounts investors can realise from selling their investment.

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Weighted Average Cost of Capital (WACC) — Simple ExampleInterest rate kd 0.10

Statutory company tax rate tc 0.30

Proportion of tc claimed by shareholders λ 0.60

Market value of debt D $10 000 000

Cost of equity capital ke 0.20

Market value of equity E $10 000 000

Annual interest cost of debt: = kd (1 – te) D= kd (1 – tc (1 – λ) ) D= 0.10 (1 – 0.30 (1 – 0.60) ) $10 = $880 000

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Weighted Average Cost of Capital (WACC) — Simple Example (cont.)Net cash flow required by shareholders:

= ke E

= 0.20 х $10 000 000

= $2 000 000

Total required cash flow:

= ke E + kd (1 – tc (1 - λ) ) D

= $880 000 + $2 000 000

= $2 880 000

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Weighted Average Cost of Capital (WACC) — Simple Example (cont.)

• k = annual net operating cash flow/market value of capital

= [ ke E + kd (1 – te) D ]/[ E + D ]

= ke (E/(E + D)) + kd (1 – te)(D/(E + D))

= ke (E/V ) + kd (1 – te) (D/V )

= 0.20 (10/20) + 0.10 (1 – 0.12) (10/20)

= 0.10 + 0.044

= 0.144 or 14.4% p.a.

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Example: Cost of Capital • Consider the example of Tasman Industries

Limited (TIL).

• Debt capital of TIL comprises commercial bills, bonds and a bank overdraft with the following characteristics:

Type of debt Market Val.($m)

Proportion Cost(%)

Weighted Cost

Comm. Bills 19.796 0.5291 6.24 3.302

Overdraft 7.368 0.1970 9.73 1.916

Bonds 10.247 0.2739 9.24 2.531

37.411 7.749

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Example: Cost of Capital (cont.)• Equity capital of TIL comprises preference and

ordinary shares with the following characteristics:

• From this information, together with the fact that the effective tax rate of te= 0.12, we can determine TIL’s overall cost of capital.

Type of equity Market Val.($m)

Proportion Cost(%)

Weighted Cost

Pref. Shares 1.500 0.0278 10.95 0.304

Ord. Shares 52.500 0.9722 18.00 11.278

54.000 11.582

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Example: Cost of Capital (cont.)

• Using the equation for the WACC, we have:

1

37.410 54.000.0775 1 0.12 0.1158

91.411 91.411

0.096319 9.63%

d e e

D Ek k t k

V V

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Issue Costs and the Cost of Capital• Issue costs include underwriters’ fees and

legal and administrative costs.

• For project evaluation, issue costs should not be included in the cost of capital.

• However, issue costs need to be accounted for and are included in the cash flows associated with the project.

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Project and Company Cost of Capital• The cost of capital (COC) should only be used as

an estimate of the cost of capital for a new project if:

– The risk of the new project is equivalent to the risk of existing projects.

– The new project will not cause the company’s optimal or target capital structure to change.

• Calculating COC for diversified companies:

– If a company’s operations are in more than one industry, and the industries differ in risk, the company’s overall cost of capital will not be appropriate for project evaluation.

– Why? Because the discount rate will not reflect the risk of a particular project, leading to incorrect investment decisions.

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Cost of Capital for Diversified Companies• To estimate a cost of capital for a division within a

company:– Identify a pure play company with operations similar to

the proposed project. Estimate the beta of the pure play’s equity.

– Adjust the equity beta for financial leverage to reflect the equity beta based on business risk (the asset beta).

– Relever the asset beta to reflect the financial leverage of the company considering the project.

– Use the CAPM to estimate the cost of equity for the project.

– Calculate the WACC using the target debt–equity ratio for the company considering the project.

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The Pure Play Approach

• Conceptual problems:

– Adjusting equity betas for financial leverage.

– Appropriate leverage adjustment depends on company’s capital structure policy.

• Practical problems:

– Pure play companies are rare.

– Ignores valuable information from diversified companies.

– Possible to estimate divisions cost of capital from diversified company WACCs — Harris, O’Brien and Wakeman (1989).

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Alternative Approach

• Infer divisional costs of capital from information on diversified companies.

• Assume that a diversified company’s WACC is itself a weighted average of the WACC of its divisions.

• Information required:

– The WACC of each company.

– The ratio of the value of each division to total company value for each company.

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The Weighted Average Cost of Capital• Advantages of WACC:

– Flexibility and simplicity — several definitions that are all correct if used in conjunction with appropriate cash flows.

• Disadvantages of WACC:

– Can only be estimated directly for a whole company.

– Should not be used to analyse financing decisions — intended to analyse investment decisions.

– Excludes strategic options associated with project.

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The Weighted Average Cost of Capital (cont.)• Adjusted Present Value (APV) is an alternative

valuation technique that separates the value created by the project and the value created by financing.

– Forecast cash flows assuming full equity finance.

– Value created by tax benefits of debt financing can be treated separately, added to valuation given by full equity finance.

– Government subsidies can also be added to the total value.

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Effects of Taxes on Net Cash Flows• Project evaluation normally based on after-company-tax cash

flows.

• Under imputation the tax collected from a company comprises:

– Pre-payment of personal taxes.

– Effective company tax.

• Effective company tax rate (te):

where tc = statutory company tax rate

= proportion of tax collected from a company that is paid out to shareholders and recovered through tax credits associated with franked dividends.

1e ct t

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Effects of Taxes on Net Cash Flows (cont.)• Converting pre-tax cash flows to after-tax cash flows:

• Consideration must then be given to non-cash expenses that are tax deductible (i.e. depreciation)

after-tax NCF before-tax NCF 1- et

tax savings on depreciation = depreciation ×

After-tax NCF = NCF before tax 1-

+ depreciation

e

e

e

t

t

t

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Tax Effects of Asset Disposal

• After-tax cash flows associated with ownership of a depreciable asset will depend on the relationship between the asset’s disposal value and its written-down value.

• Only when the disposal value is equal to the written-down value will the sale of the asset have no tax effect.

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Using Certainty Equivalents to Allow for Risk• In most cases, risky projects are evaluated by using

a cost of capital that reflects the risk of the project.

• The certainty-equivalent approach is an alternative method of incorporating risk into project evaluation.

• It incorporates risk into the analysis by adjusting the cash flows rather than the discount rate, i.e. each year’s expected net cash flow is converted to a certainty-equivalent.

• The certainty-equivalent net cash flow in year t, Ct*, is the smallest certain cash flow that the decision maker would be prepared to accept in exchange for the expected risky cash flow E (Ct ).

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Using Certainty Equivalents to Allow for Risk (cont.)• The expected net cash flow for any year can be

converted to its certainty-equivalent:

where t = the certainty-equivalent factor in year t

• The NPV is calculated by discounting the certainty-equivalent net cash flow for each period at the appropriate risk-free rate:

*t t tC E C

n

tt

f

t

R

CCNPV

1

*

0 1

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Using Certainty Equivalents to Allow for Risk (cont.)• If all variables are properly specified, the present

value of any future cash flow must be identical in either the risk-adjusted discount rate method or the certainty-equivalent method.

1 1

1

1

t t tt t

f

tf

t t

E C E C

k R

R

k

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Summary• Cost of capital is critical in valuing projects.

• CAPM can be used but requires betas specific to the project being evaluated.

• Weighted average cost of capital (WACC) for the company as a whole is used in practice.

• Use effective company tax rate in calculation of after-tax cash flows.

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Summary (cont.)

• Company WACC is only appropriate when project risk matches company risk.

• For diversified company, use of single WACC for all projects is likely to result in wrong investment decisions.

• While WACC has limitations that need to be understood, its simplicity and flexibility recommend it.

• Certainty equivalent approach incorporates risk into the cash flows rather than the discount rate.

14-1 copyright 2009 mcgraw-hill australia pty ltd ppts t/a business finance 10e by peirson slides...

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