F3, F2 and P3Financial Strategy, Advanced Financial Reporting and Risk Management

STUDY NOTES

STUDY NOTES

STUDY NOTES

STUDY NOTES

STUDY NOTES

STUDY NOTES

STUDY NOTES

STUDY NOTES

The previous articles in this series, published in December 2014 and January 2015, covered methods of determining an entitys weighted-average cost of capital (WACC) and related calculations. Now lets try applying these to a numerical scenarioBy John B Riordan FCMA, CGMA

John B Riordan is a freelance lecturer and specialist in corporate finance with First Intuition Ireland

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Calculating high and low NPVs from the redeemable bond cash flows

T0 T1 T2 T3 T4 T5

Investment (92m)

Interest flows after tax 3.5m 3.5m 3.5m 3.5m 3.5m

Redemption value 100m

Net cash flow (92m) 3.5m 3.5m 3.5m 3.5m 103.5m

Discount factor @ 10% 1.000 0.909 0.826 0.751 0.683 0.621

Discounted cash flow @ 10% (92m) 3.18m 2.89m 2.63m 2.39m 64.27m

NPV @ 10% (16.64m)

Discount factor @ 3% 1 0.971 0.943 0.915 0.888 0.863

Discounted cash flow @ 3% (92m) 3.40m 3.30m 3.20m 3.11m 89.28m

NPV @ 3% 10.29m

of financial position) and the market values, which can be derived from the observations in the following table.

the volatility of the businesss cash flow and earnings. There does seem to be a degree of debt capacity ie, its likely that the company could, if it needed to, raise additional debt funding and/or refinance existing debt relatively easily.

Equally, we can see that the return on capital employed is at a reasonable level of about 10 per cent. These considerations will be useful when were working through the detail below to calculate the WACC, especially the costs of its various components.

Calculating the cost of debtThe first instrument is bank borrowings. Libor is set at 4.5 per cent in this case and the borrowing carries a margin of 1 per cent, so the total pre-tax cost of debt is 5.5 per cent. On a post-tax basis, where the corporate tax rate is assumed to be 30 per cent, the borrowing simply carries a cost of 5.5% x (1 0.3) = 3.85%.

The second instrument is redeemable bonds. The calculation of the cost (yield to maturity of a redeemable bond is the applicable internal rate of return (IRR) after tax based on the market value of the bond, assuming that the bondholder is purchasing today, and its redemption value (assume this is 100 if its not given), net of tax cash flows in between (interest coupon after tax).

The IRR can be calculated by using simple net present value (NPV) techniques, with cash flows shown from the perspective of the bondholder (assume the same tax rate as the entity). In this case we have a redeemable bond trading at 92 per 100 bond, redeemable in five years time at 100 (par) and paying a 5 per cent coupon before tax ie, 3.5 per cent after tax. The figures required are derived using the table on the next page.

The IRR is calculated using the following formula: IRR = L + [(NPVL {NPVL NPVH})(H L)], where L is the low discount rate and H is the high discount rate.

In the expectation that the answer will fall logically between 3 per cent and 10 per cent, the IRR is as follows: 3% + [(10.29 {10.29 16.64})(10% 3%)] = 5.67%, noting that the two minuses convert into a plus.

A similar approach would apply to convertible bonds. The difference is that the relevant redemption value of the convertible is its potential equity value at the time the conversion option is exercised.

The third instrument is long-dated bonds, for which the maturity date is far enough away for us to treat them as irredeemable and still obtain a reasonable approximation of the cost of debt. The key here is to use the market value of the bond (95 per 100 bond) as the basis for calculating the cost/yield of the debt instrument. Here we can apply the typical exam formula kd = (l[1 t]) P0. In this case, therefore: kd = (3.5[1 0.3]) 95 = 2.58%.

Interim conclusion about the entitys cost of debtWhat we have established here is that the three debt instruments in the capital structure under consideration are demonstrating a post-tax cost of debt (yield to

maturity, where applicable) in the range of 2.58 per cent to 5.67 per cent. This seems reasonable and its important that candidates perform such sense-checks occasionally. One way of doing so might be to apply the CAPM to calculating kd, given that we are provided with the requisite ingredients namely: kd = Rf + d (Rm Rf). This would typically be a last resort for calculating the cost of debt, because it relies on the availability and value of the beta of debt coefficient (assuming that debt is a marketable instrument) as well as of Rm and Rf both of which are historical estimates. Note also that the beta of debt instruments is anticipated to be relatively low. This is because debt carries a lower risk profile than equity, as it ranks higher in the cash flow waterfall. In this case the beta is 0.2, with Rm and Rf given as 9% and 3% respectively.Applying the CAPM formula to the numbers provided, we have kd = 3% + 0.2 (9% 3%) = 4.2%, which is within the range of values we have calculated above.

The fourth and final part of this complex series will cover how to calculate our entitys cost of equity and, lastly, the WACC itself.

Visualising the bigger picture before jumping inWACC calculations typically refer to the market value of the relevant instruments in the entitys capital structure. At this point, therefore, you should seek to distinguish between the book values presented (in the statement

Other data, including the entitys most recent ex-dividend share price.

The information is presented in tabular form. In each table I have noted down my initial observations, proposing possible applications for various figures where appropriate.

approach summary financial data when they are specifically addressing the WACC, especially where the most appropriate way of determining the cost of each element of the entitys capital structure isnt clear. Make big-picture calculations addressing return on capital employed (ROCE) and gearing for both book and market valuations of debt and equity. Neither figure is needed specifically to calculate the WACC, but both will enable us to check that were heading in the right direction. Calculate the cost of debt for the entitys various debt instruments, taking into account market values where applicable, as well as any relevant redemption criteria concerning such debt. Calculate the cost of equity. This will initially entail evaluating the equity base in terms of valuation and returns eg, dividend and earnings yields, both of which can be simple surrogates for ke. We then expand this to take into account dividend growth and distribution policy, which can have an impact on the assessment of g for growth models. Then we evaluate the CAPM approach separately. Calculate the WACC itself, allowing for all that can be derived above. The calculation will be presented in a tabular format in this case, making it easier to ensure that all relevant items, by market value (to enable weightings) and relevant cost, are included. Extend the WACC method into the approach proposed by Merton Miller and Franco Modigliani, with a link on how to approach adjusted present value (APV) calculations.

The scenarioThe following information is provided in this case: Extracts from the entitys statement of profit or loss and other comprehensive income. An extract from its statement of financial position. Six years worth of historical financial data covering the entitys dividends and earnings history.

I have segmented my WACC analysis of the following scenario into logical steps based on the key information provided. Candidates should note that the same material could be presented in a number of formats in an exam.

My approach is broken down into six steps: Evaluate a simplified statement of financial position and statement of profit or loss and other comprehensive income for an entity, along with additional information thats typically provided eg, variables relevant to the capital asset pricing model (CAPM). This is the key starting point, at which candidates are given guidance notes on how to

Other data

Distinguishing book values from market values

Extracts from the statement of financial position

Historical financial data

Parameter

Most recent share price (ex-dividend)

Equity beta (eg) of comparable competitor

Competitors gearing

Estimated beta of(non-risk-free) debt instruments (d)

Estimated return on UK government gilts

Estimated return on the market portfolio

Instrument / initial calculation parameters

Long-term bank borrowings

Redeemable bonds

Long-dated bonds(irredeemable)

Preference share capital

Ordinary share capital (1 nominal value of shares)

Reserves

Total in effect, capital employed (Vd + Ve)

Return on capital employed: Ebit (Vd + Ve)

Gearing: Vd (Vd + Ve)

Debt/equity ratio: Vd Ve

Capital instrument

Long-term bank borrowings

Redeemablebonds

Long-dated bonds (treated as irredeemable)

Preference share capital

Ordinary share capital

Retained reserves

Total equity and liabilities

Earnings and dividend history T0 T1 T2 T3 T4 T5

Profit after tax (m) 78 74 72 67 60 55

Dividends (m) 31 30 28 26 24 21

Initial observations The T0 values are consistent with those in the statement of profit or loss and other comprehensive income, where profit after tax equates to earnings available for distribution to ordinary shareholders. With these figures, we can calculate historical dividend pay-out ratios as well as earnings and dividend growth trends. Note that, while six years worth of data is presented, we need to use the 5th root for compound annual growth rate calculations, on the understanding that dividend growth will be key in our calculation of ke.

Value

4

1.3

45%

0.2

3%

9%

Book value

300m

100m

100m

100m

600m

300m

1,500m

10.7%

500 1,500= 33%

33:67

Market value

300m

92m

95m

100m

1,200m

1,787m

8.9%

487 1,787= 27%

27:83

m

300

100

100

100

300

600

1,500

Initial observations and/or likely applications

Market capitalisation, dividend valuation model, dividend and earnings yields. (Always seek to use the ex-dividend value.)

Both of these parameters will be used to establish the ungeared beta for the competitor or proxy entity ie, to work out the business risk component of the beta coefficient (eu). We can assume that the gearing is given by market values and is net of tax.

This figure is relevant to the expanded ungearing formula in the CAPM. We can also use the CAPM to calculate the cost of debt (as a last resort if nothing else is available).

This is the Rf component of the CAPM. Its described in many ways, but in essence its risk-free.

This is the Rm component of the CAPM. Note that Rm Rf is known as the market risk premium (so dont mix them up). In this case that figure would be 6%.

Observations / basis for calculation

These values are the same (ignoring the existence of any secondary market for such debt).

Reflecting discount to 92 per 100 bond.

Reflecting discount to 95 per 100 bond.

Trading at par, so book value equals market value.

The share price is 4, so the market cap is 1.2bn, assuming that 300 million shares are in issue. Reserves are priced into the market cap, so we need to avoid double counting.

This sum of equity and debt values is sometimes known as enterprise value.

This assumes that the Ebit is 160m. The ROCE in market-value terms will usually be lower than the book-value ROCE purely because of the size of the denominator. The figure can be used for g = r x b calculations concerned with earnings retention.

This assumes that preference share capital is considered equity. The figure will be relevant when were approaching the CAPM and the regearing of beta, while noting that the debt values will be diluted by the (1 t) factor.

This enables us to see that the entity is relatively equity-rich, meaning that the WACC is more likely to be biased in the direction of ke.

Initial observations

This is a standard variable rate loan that is priced at a total interest cost of 5.5%. The associated cost of debt for this component of the capital structure will simply be this rate net of tax.

The cost of debt of a redeemable bond, also known as yield to maturity, is the internal rate of return of the relevant cash flows underpinning the bond, taking into account the market value, coupon (net of tax) and redemption value (assume redemption at a par value of 100).

This is included here for illustrative purposes but not used in practice. The associated cost of debt will be the coupon payment net of tax relative to the market price of the instrument.

The cost of preference share capital is calculated in a similar way to that of irredeemable bonds, except there is no tax adjustment, because the coupon is in effect a dividend.

Several approaches available to calculate the cost of ordinary share capital (ke) using (for example) the dividend growth model and the CAPM. This is our first indication of the number of shares in issue, which will be relevant to the calculation of the entitys market capitalisation (share price given below).

This figure is part of the book value of equity, but its not to be double counted when calculating the market value of equity (ie, the market capitalisation).

In effect, this total figure is the combined value of the capital structure, which enables us to initially gauge the relative proportions of debt/equity instruments while remembering that the WACC will (where possible) be based on market values.

Associated information provided

Floating rate, priced at Libor + 1%, secured on non-current assets. Assume 12-month Libor to be 4.5%.

5% coupon, due in 5 years, trading at 92 per 100 bond unsecured, but with a cross-default clause.

Coupon 3.5%, trading at 5 per 100 bond, secured by a floating charge on working capital.

7% coupon, trading at par.

Nominal value 1 per share.

Extracts from the statement of profit or loss and other comprehensive income

Parameter

Sales

Cost of sales

Earnings beforeinterest and tax (Ebit)

Finance costs

Tax

Profit after tax

Distributions to preference shareholders

Earnings available for distribution to ordinary shareholders

Dividends to ordinary shareholders

Retained earnings

m

550

(390)

160

(25)

(50)

85

(7)

78

(31)

47

Initial observations

These first three entries are standard items in a statement of profit or loss and other comprehensive income, with limited applicability to capital instruments in terms of immediate returns (accepting fully that Ebit values will ultimately be the original drivers of returns to capital providers).

This is the first case of where a return to providers of capital arises. It rationally arises here because debt attracts a higher priority in the cash flow waterfall, whereby interest is paid before any distributions to equity providers. We now need to watch out for the kinds of debt that may trigger the finance costs.

Interest payments will in themselves reduce taxable profit, which is reflected in tax shield discussions below.

This is the first instance in which distributable earnings arise, but there may be an order of priority applying to such distributions.

Preference share capital is invariably first in line for subsequent distributions. Watch out here for the coupon or dividend policy applying to preference share capital.

This is an important value on any statement of profit or loss and other comprehensive income. Its relevant to business valuations and earnings per share and price/earnings calculations.

From this line we can derive the pay-out ratio and dividend per share. If the right historical data is provided, we can also use it to estimate dividend growth.

In effect, this is the undistributed element of distributable earnings. Note that this is not necessarily cash, because its derived from accruals accounting principles and simply added to the book value of equity/retained reserves.

So far, we can infer that this appears to be an entity characterised by low to moderate gearing ie, about 30 per cent. The eventual validity of this conclusion would depend on the industry concerned and particularly on