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