Investment appraisal and

capital structure and funding

 Using CAPM to value shares

Rj = Rf +  (Rm – Rf)

Where:
• Rj = rate of return on security j as predicted by the model
• Rf = risk free rate of return
• Rm = market rate of return
• = Beta co-efficient of security j

2
 What is Beta? Measurement of the volatility of a
company’s share price to that of the market

A beta of 1.1 means the

share price is 10% more
volatile than the market.

1 Volatility of share price = market 1

A beta of 0.9 means that the
share price is 10% less
volatile than the market
3
 GEARED AND UNGEARED BETAS
• The Beta of a firm reflects two aspects :
• the business risk (ie the risk of the underlying operations)
• the financial risk (the proportion of debt in the capital structure).

• Published betas are sometimes known as geared betas since the

effects of gearing are incorporated into their calculation.

4
Geared and Ungeared BETAS
Published BETA
Equity/Geared Beta of a firm
(Systematic Risk)

Business Risk
Financial Risk
(Asset/Ungeared Beta)

Risk from nature of Risk from how a company finances itself

business (amount of debt)

5
USES OF UNGEARED BETAS –
CALCULATING PROJECT RISK
Example:
• X plc is considering a capital investment in a new industry &
needs to establish an appropriate discount rate to be used for
NPV.

• The published (i.e. geared) beta of a specimen company, Y plc in

the new industry could be used to establish Ke via CAPM.

• However, Y's geared beta will reflect Y's capital structure which
may differ from that of X plc.

• To rectify this Y's beta should be “ungeared”, and then it should

be “regeared” to reflect the capital structure of X. 6
USES OF UNGEARED BETAS –
CALCULATING A VALUATION IN A TAKE-
OVER
Example:
• Ungear the Target company's beta.

• Then regear the Target's ungeared beta to reflect the post

acquisition capital structure of the acquiror.

• Calculate Ke using the "new" beta & then calculate WACC

using he post acquisition capital structure of the acquiror.

• Use the resultant WACC to establish an NPV of the future

cash flows from the target company

7
FORMULA FOR UNGEARED BETA
u = ungeared beta of target firm
g = geared beta of target firm
D = debt (market value)
E = equity (market value)
t = rate of corporation tax for the company

u= g
------------------
1 + [(1-t) D/E
8
 Takeover Valuation Example
Information Company X Company Y

Capital Structure
Debt (Market Value) 30% 40%
Equity (Market Value) 70% 60%
Cost of debt (after tax) 8%
Published Beta 1.2

Rm = 16% (net of tax)

Rf = 6% gross

Company X is looking to take over Company Y and wants to

calculate the maximum amount it should pay for Y Plc 9
Step 1: Ungear Company Y’s Beta to obtain
asset beta (business risk)

u= g
------------------
1 + [(1-t) D/E

u of Company Y = 1.2/
1+ (1-0.3) x 40/60

= 1.2/ 1.467
= 0.8179 ( 0.82 to 2 dpl) 10
Step 2: Regear the asset beta of Company Y
using the capital mix of Company X

• Rearrange the ungeared Beta formula to obtain

the geared Beta:
g = u x 1 + [(1-t) D/E
• Insert the capital structure from Company X and
the ungeared Beta of company Y:
g for Company X = 0.82 x
1+ ( (1-0.3) x 30/70)
= 0.82 x (1 + 0.3)
= 1.066 (1.07 to 2 dpl)
11
Step 3: Use the “new” geared you have calculated
to calculate the cost of equity of combined entity:

Cost of equity of x = Rf +  (Rm – Rf)

= 6% + 1.07 (16% - 6%)

= 6% + 10.7%
= 16.7%

12
Step 4 Calculate the WACC to use as the discount
rate to assess the cashflow from Company Y
Finance Market Value Cost Weighted cost

Equity 70 16.7 11.69

Debt 30 8.0 2.4

Total 100 14.09%

70/100 x 16.7 = 11.69

30/100 x 8 = 2.4 13
PERPETUITIES & MATHS
PRINCIPLES
Cost/Valuation of the perpetuity (Po) Example :
present value of given forecast of future An undated gilt with a
cash flows which continue to infinity nominal value of £100 has
and is calculated using: a coupon of 5%.
Po =cash flow in next period What is its current market
Required rate of return value if investors require a
return of 6%?

Po = 5 = £83.33
0.06

NB: An undated gilt can be replaced by a company i.e. an

entity expected to generate returns from now until infinity
14
VALUATION OF A PERPETUITY
WHICH WILL GROW
• Valuation of a given forecast of future cash flows which continue to
infinity (perpetuity) and GROW at a set rate per annum is:

Po = cash flow in next period

Required rate of return less growth
• Example one:
An undated index linked gilt with a nominal value of £100 has a
coupon of 3% which is expected to grow by 2% per annum in
perpetuity. What is its current market value if investors require a
return of 6% on an investment such as this?
Po = (3 x 1.02) = 3.06 = £76.50
(0.06-0.02) 0.04
15
DIVIDEND STREAM APPROACH – CONSTANT
GROWTH
This method calculates the share price of a company using the
present value of future dividend streams discounted at the
company’s cost of equity capital
If the dividends are expected to grow then the following
calculation could be used:

Price of share (P0) = Next dividend = D1

(Cost of equity – growth) (Re – g)

Example - Constant Growth Rate
Z Plc’s next dividend is expected to be 25p & future
dividends are expected to grow at 4%. If the company’s cost
of capital is 16.5% what is its likely current share price?
Solution:
25 = 25 = 200p
(0.165-0.04) 0.125 16
GENERAL
• Dividend valuation methods are appropriate
for a potential minority shareholder

• For quoted companies, brokers can give

estimates of future dividends, but is much
harder to find meaningful estimates for
unquoted companies.

• Hard to obtain Ke

17
DIVIDEND STREAM APPROACH
WITH VARIED GROWTH
• Many firms go through a cycle where their growth is much faster
than that of the economy as a whole, before it falls back in line
with the economy.
• This can be due to having a temporary competitive advantage
which will eventually be acquired by other firms.

Example:
X plc expects its dividends to grow by 20% per annum for 10
years. After year 10, dividends are expected to grow at 4% per
annum. Its cost of equity capital is 9%. The latest dividend
was 2p per share.

What might the present market price of the shares be?

18
Step 1: Calculate PV of first 10 years dividends
Year Monetary 9% Disc Present Value (p)
Dividend
2 x (1.2)
1 2.40 0.917 2.20
2 2.88 0.842 2.42
3 3.46 0.772 2.67
4 4.15 0.708 2.94
5 4.98 0.650 3.24
6 5.97 0.596 3.56
7 7.17 0.547 3.92
8 8.60 0.502 4.32
9 10.32 0.460 4.75
10 12.38 0.422 5.22
35.24
19
Step 2 Calculate PV of share from
year 11 onwards

1.Year 10 dividend adjusted for forecast growth

12.38 x 1.04 = 12.88
2.Calculate price of share at year 10

P10 = d II = 12.38 1.04 = 12.88 = 257.5p

Re-g 0.09-0.04 0.05
3. Calculate the present value of P10 today.
Po = 257.5 x 0.422 = 108.67p

NB: 0.422 is discount factor in year 10 at 9%.

20
 Step 3: Summarise PV’s to get total
share price today
• Sum up the present value of the next 10 years’
dividends and the present value of the share price
in 10 years’ time.

35.24 p/v of divs in years 1-10

108.67 p/v of divs after year 10
143.91p or £1.44

£1.44 is the theoretical share price of the company

X today

21
VALUATION METHOD - BID
PREMIUM
Quoted company “ Bid Premium” = How much above the current share price
must be bid to acquire control.

For "hostile For "agreed

bids" in the UK, bids" in the UK,
the premium is the premium is
around 30% about 18%.

E.M.H. says the current share price of the target must reflect
all known information so the only way that the target could be
worth more than its current share price to the bidder is if there
are synergies, or some other justifications.

22
JUSTIFICATION OF BID PREMIUM
A bid premium could be justified if a successful take-over would:

• Result in synergy
• Allow the bidder to “change shape” quickly and easily
• Give the bidder a competitive advantage
• Prevent a rival from acquiring a competitive advantage
by acquiring the target.
• Secure supplies or outlets if the target is a supplier or
buyer (vertical integration)
• Gain control of a competitor (horizontal integration).
23
SYNERGY/BID PREMIUM
Value of the = Current Share + Present value/
target to bidder Price share of synergy

Lowest bid price =

Current share price

Highest bid price = current share price

& PV per share of synergy
BUT it is difficult to quantity synergy without full
access to the target’s books.
24
 TASKS FOR THE WEEK
• Complete the Pre session reading for this topic

• Look through / prepare for the seminar questions

• Review lecture materials to ensure understanding

25
 7. CAPITAL STRUCTURE AND
FUNDING
Learning outcomes:

•Discuss the various components of funding which a

multinational company could utilise.
•Critically evaluate the use of short and long term funding
techniques and how the funding maturity could impact the risk
profile of the company
•Suggest appropriate capital structures for companies with
different risk profiles and the impact on their credit rating
•Calculate and evaluate the significance of WACC on the
valuation of a company.
26
THE FINANCING DECISION
• Cost and flexibility are key considerations in respect of deciding how
to raise funds
• As debt is ranked higher in the credit hierarchy, if the company were
to go bankrupt debt holders would be paid before equity holders
• Therefore debt is often cheaper than equity as it is perceived as being
less risky especially with the added tax advantages

27
THE FINANCING DECISION
• However using equity based finance gives the company greater
flexibility in managing its cash flows
• Dividends have no contractual obligation to be paid unlike interest
payments.
• Therefore in times of economic uncertainty cash can be retained and
the company will not run the risk of default on debt repayments

28
 Availability

cost
Loans Hybrids
Shadow flexibility
Banking
Equity
Peer2Peer Corporate
Lending Bonds
Sources of Finance
29
Which is best – debt or equity?
Business Risk

Operating
Tax Exposure
leverage

Factors

Management
Cashflow
Style

30
Which is best – debt or equity?
Signalling
to
investors

Inflation
More Market
factors conditions

Control

31
 DEBT
BANK LOANS VS CAPITAL MARKETS

32
Banks vs. Financial Markets
Banks: Financial markets:
• Confidentiality,
• Speed? • Cheaper?– no middle
• No formal credit men/ different risk
rating e.g. attitudes
small/new co. • Longer maturities?
• Committed lines •Lighter regulation?
of finance – good e.g. Eurobond markets
for ST liquidity and alternative
currencies
• Removes reliance on
one source of funds. 33
 DEBT MATURITY PROFILE
• Financial markets = longer debt maturities than
would normally be offered by banks
• Walt Disney
• Kingdom of Denmark
• Bunching of bond/loan maturity dates:
• aim for a smooth debt transition period.
• eliminate timing issues or
• material impact if a large proportion of debt could not be
raised when required.

34
CALCULATING THE COST OF FINANCE

1. Calculate cost of each type of finance

2. Calculate WACC (always use market

values!)

3. Use WACC as discount factor – affects

NPV of project/ acquisition

4. Decide whether to accept project/make

acquisition

35
 FIXED RATE BANK LOANS
(NON MARKETABLE DEBT)
& Bonds quoted at par!

• After tax cost of the loan = Interest x (1-t)

• Example:

10% bank loan: 10 x (1 - 0.30) = 7%

Note:
• CT = corporation tax, for simplicity this module is always 30% but note there are
different tax rates in different countries!

36
 CAPITAL MARKET BONDS/LOANS
(MARKETABLE DEBT)

• The actual cash flows need to be considered in

respect of the position which would occur if an
equivalent debt instrument was to be issued today.

• When calculating the cost of that debt it is necessary

to ascertain the IRR of the future cash flows and the
present market value.

37
 MARKETABLE DEBT - Example
• A specific issue of
marketable loan stock Today is 31st Dec.
with a £100 par value
has a market value of Time Cash inflow/ Tax Net cash
£95. (outflow)/ £ relief/£ inflow/
(outflow) £
• This stock matures in 5
years’ time, and pays
0 (95) 0 (95)
11.43% (8% after tax) pa
1-4 11.43 3.43 8
interest on par value.
5 100 + 11.43 3.43 108

The marginal rate of taxation is 30% for this company

38
INTERPOLATION FORMULA

Where
• A = the rate of discount giving the positive NPV
• B = the rate of discount giving the negative NPV
• a = the value of the positive NPV
• b = the value of the negative NPV

39
Example: Cost of debt using Interpolation
A B
TIME CASHFLOW DF 6% PV @ 6% DF 12% PV @ 12%
0 (95) 1 (95) 1 (95)
1 8 0.943 7.5 0.893 7.1
2 8 0.890 7.1 0.797 6.4
3 8 0.840 6.7 0.712 5.7
4 8 0.792 6.3 0.636 5.1
5 108 0.747 80.7 0.567 61.3
Net Present Value a 13.3 b (9.4)

 a 
IRR = A +  x( B  A) 6+ 13.3 x (12-6) = 9.5%
a  b  (13.3- (-9.4))
40
 Equity: Gordon Growth Model (Ke/Re)
•

41
Example: Cost of ordinary shares
(Ke/Re)
Expected dividend in next period d1 = £0.25
Market price of each share P0 = £2.00
Expected constant growth rate of dividends g = 4

Re = 0.25 + 0.04 = 0.165

2
The return expected on this particular share is
(0.165 x 100/1)16.5% pa.

An alternative way to calculate Ke is using

CAPM - this will be covered in coming weeks.
42
 Weighted Average Cost of Capital
(WACC)
Market Value (you Cost of capital Weighted cost
must calculate (from previous
this based on the calculations)
info in the
question)

Equity a 16.5 = a/total MV x 16.5

Marketable debt b 9.5 = b/total MV x 9.5

Non-marketable c 7 = c/total MV x 7
debtor bonds
quoted at par

TOTAL Total MV = sum of WACC = SUM of

the above the above

43
TASKS FOR THE WEEK
• Complete the Pre session reading for this topic

• Look through / prepare for the seminar questions

• Review lecture materials to ensure understanding

44
ANY QUESTIONS

45