WACC
Equity
Debt
Traditional capital structure theory
Assumptions
Common mistakes
Hurdle rate
Types
Target WACC
Book value (last resort)
Market value
Project is marginal
Project = risk as entities existing activities
Firm will retain existing proportion of debt:equity
Using D:E ratio instead of %
Using short term instead of long term target ratios
Using book values instead of market values
Advantages
Disadvantages
Financial gearing
Ratios
Make sure value is added
Don't just break even on WACC
Debt capital has lower after tax cost
As debt increase - WACC decrease
Company cannot max SH wealth unless optimal WACC achieved
Optimal WACC exist and depend on gearing
Dividend valuation model
Market value = dividend / cost of equity
Dividend is generally one of the major determinants of equity value
CAPM
Limits
Lever/ unlever
Used in
Assumption that government bonds are risk free
Assumption of perfect capital market
Use Beta as measure of systematic risk
May be difficulties in finding suitable proxy Beta
Single period model
Use similar company Beta and take out debt then add entities debt back to get entities Beta
Will give formula to lever / unlever
Investment appraisal
WACC
CAPM = Rf + Beta(Rm - Rf)
WACC + %
Market value of ordinary share represents future expected dividend flow discounted to PV
Market value if constant growth = Dividend / (cost of equity - constant growth)
Business risk
Finance risk increase
Portion of debt compared to equity
High financial gearing
Gearing ratio = long term debt / (long term debt - equity)
Debt (solvency) ratio = total debt / total assets
Debt : equity ratio = non-current liabilities / equity
Debt is cheaper than equity because
Debt (except pref shares) = tax deductable
Higher risk = higher return
Equity carries higher risk
High reliance on debt
Increase risk