The Theory and Practice of Investment Management - Assignment Example

Part A a) Why must this be true? Please provide your explanation with appropriate examples. Beta of the assets of a company is a weighted average of the betas for the debt, preferred equity, and common equity of a company: βAssets = xDebtβDebt +xcsβcs+ xpsβps (1) Taking into account that the value of the company is determined from the financing sources used to acquire the firm’s assets are expected to produce, the company’s risk originates from the individual risk of these financing sources. So, a firm can be interpreted as a portfolio of various types of assets with different level of market or beta risk. From here comes the analogy with a stockholder investing in a portfolio of different stocks, each having its own degree of risk and therefore beta (Fabozzi & Drake, 2009). The beta of the assets is the appropriate measure of a company’s overall risk. Common equity, preferred equity and debt each have a specific beta coming from differences in the required rates of return of investors, and most of all from the perceived risk of the company from the perspective of these investors (Howells & Bain, 2007). For example, a higher degree of leverage could have tax advantages due to deductibility of interest compared with taxed capital gains from the stock, but in the same time could relate to a higher likelihood of bankruptcy so investors will perceive this company more risky and require a higher rate of return. b) Discuss your understanding of WACC and explain how the individual cost of each capital component (equity, preference and debt capital) can be calculated. Weighted average cost of capital is the computation of a company’s cost of financing by considering the weight of each category of capital. So, all financing sources ranging from common stock, preferred stock, bonds and any other long-term debt - are taken into account into the formula of WACC. By considering other factors constant, the cost of capital of a company increases as the beta and rate of return on equity increases, as an increase the cost of capital determines a decrease in valuation and a higher level of risk. WACC is the weighted average cost of capital and is computed using the following formula: wacc= we*re + wd*(1-T)*rd (2) The cost of capital should play an important role in the committee’s work and in their decision making process. This committee must decide the best alternatives to finance the firm, at the minimum cost of capital in order to maximize the shareholders’ wealth (Reilly & Brown, 2002). This concept is also related to capital budgeting because the cost of capital is an opportunity cost, a hurdle rate used for comparison with rates of return and also a discount rate used for evaluating projects (Elliot & Elliot, 2011). Estimation of the cost of capital is a central issue for investment decision making. If a firm is investing in projects with rates of return higher than the cost of capital, the firm has created value, whereas if the firm is investing in projects with rates of return lower than the cost of capital has actually destroyed value (Haugen & Hains, 1975). An increase in the capital budget of the firm determines an increase in the WACC due to the following reasons. If the new investment is financed by issuing new equity, this involves additional flotation costs, which affect the required rate of return on equity, and eventually the cost of capital. Also, if the firm requires large amounts of capital relative to the firm’s size, the investors will require higher rates of return in order to compensate for the greater risk they undertake and the possibility of default of the firm (Fabozzi & Markowitz, 2002). Although, Modigliani and Miller’s proposition with taxes imply that if the amount of leverage increases to finance new projects, the overall cost of capital decreases following the tax advantage of debt (Grinbalt & Titman, 2002), but due to the bankruptcy costs and the possibility of default, it may be observed an increase in the cost of capital. It would be inappropriate to use the firm’s cost of capital on investments that have different levels of risk (i.e. higher or lower) than the overall firm. In this situation, if the new investment has below or higher risk than the firm’s average, it should be evaluated by using a hurdle rate less or greater than the firm’s WACC (Ross et al., 2002). Moreover, it cannot be used the existing WACC for the evaluation of new investments, because there are changes in the capital structure of the firm over the life of the new investments. So, in order to use the WACC, it should be made the assumption that the firm will remain at its target capital structure over the investment’s period. Using the WACC as computed for evaluating new investment opportunities would be appropriate when the investment or the project has the same risk as the overall firm. So, in order to use the existing cost of capital, the project or investment must have the same beta and participate with the same percentage as the firm to the overall debt capacity. In practice, due to the cost and time involved in determining for every new investment the appropriate cost of capital for its specific level of risk, it is preferred as benchmark the cost of capital computed for the firm’s existing capital structure, although this may lead to inappropriate investment decisions. If the new investment has a different level of risk than the overall firm, using the firm’s WACC is inappropriate. In this situation, a possibility would be to estimate the new investment’s cost of capital, which considers the investment’s specific level of risk (which is not the same with the firm’s). In order to estimate the investment’s cost of capital, it can be used a pure play approach, which considers comparative firms in the same business as the new investment (to assure the same level of risk) and computes the new cost of debt and equity starting from those estimations. So, it should find another firm with the same risk profile as the investment considered and using this firm’ WACC to discount the expected cash flows of the new investment (Ross et al., 2002). Can be considered debt a simple bank debt or commercial paper and corporate bonds. It can be defined as a contract between a company and an investor, whereby the company has a predetermined claim that is not a function of its operating performance, but which is treated in accounting standards as an expense for tax purposes and is therefore tax-deductible. The debt has a fixed life and has a priority claim on cash flows in both operating periods and bankruptcy. This is because interest is paid before the claims to equity holders, and, if the company defaults on interest payments, it will be declared bankrupt, its assets will be sold, and the amount owed to debt holders will be paid before any payments are made to equity holders. If companies use very high levels of debt, the expected return on risky debt, rises as the leverage ratio increases. Because debt holders share some part of the risk, the cost of equity increases more slowly as D/E rises than it does in the case of default-free debt. Equity is comprised of shareholders’ equity, venture capital (equity capital provided to a private firm in exchange for a share ownership of the firm), common equity, and warrants (the right to buy a share of stock in a company at a fixed price during the life of the warrant). In comparison to debt, equity is permanent in the company, its claim is residual and does not create a tax advantage from its payments as dividends are paid after interest and tax, it does not have priority in bankruptcy, and it provides management control for the owner (Bodie et al., 2009). The cost of equity is the expected return required by shareholders to convince them to hold the equity. Because the company’s equity beta increases linearly as the amount of default-free debt financing increases, the company’s cost of equity capital also increases linearly as a function of the leverage ratio i.e. D/E. Preferred equities are securities that share some characteristics with both debt and equity. Usually, the required return in the preferred stock is lower than the required on the bond, which is not consistent with the risk levels of the two instruments. There is a practical reason for this: if a company owns stock in other company, the tax code allows the first company to exclude a proportion of the dividends received from the other company i.e. this company does not pay taxes on this amount. However, a big proportion of the outstanding preferred stock is owned by other companies, who are receiving the decreased return due to its effectively tax exemption. The approach of considering the cost of new debt as the hurdle rate is inappropriate because assuming that the new investment is financed entirely with new debt, this will change the debt capacity of the firm, change its capital structure, and increase the default or bankruptcy risk. Starting from the idea that the firm will use more debt, the creditors will require higher rates in order to compensate for the additional risk they bear (Grinbalt & Titman, 2002). Also, because in the case of bankruptcy, debt holders are first claimers to the firm’s assets, shareholders need to be certain that the projects the firm undertakes are profitable. Another problem which may appear by considering the cost of new debt as the hurdle rate is the difficulty of quantifying this cost because debt is often not traded, and also yield to maturity is not available because there is no market price for the debt. Moreover, in the case of bank loans, the interest rates may be subject to reconsiderations over the life of the new investment due to changes in firm’s financial statements or general deterioration of its financial condition. So, it would not be in the interest of shareholders to not take into account all this issues when considering capital budgeting decisions. Furthermore, considering this approach of taking into account only the cost of new debt used to fund the investment, it would be a disproportionate allocation to the new investment, which would result in overestimating the shareholders wealth. Debt is considered to be cheaper than equity because interest rates on debt are usually much lower than the required rates of return on equity. Equity holders demand a higher rate of return as a consequence of their riskier claims compared to those of debt holders. Beside the cost advantage of debt, it also increases the shareholders value through return-on-equity. Although a high leverage ratio is considered attractive for companies, given the advantages just described, an excessive level of leverage can also cause disadvantages. For instance, it can lead to financial distress, because a high levered company will become risky for various stakeholders (e.g. it will encounter problems in selling the products, get inputs from suppliers and attract employees). Another disadvantage is related to the risk- shifting problem and also to debt overhang (i.e. in the presence of a large risky debt, firms might be unable to finance projects that would increase their total value). An important issue in corporate finance regards the relationship between – on the one hand – a company’s leverage ratio, and – on the other hand – various returns and costs of capital, in situations both with and without corporate taxes and bankruptcy costs. Part B Β = 1.06 E = 45 million D = 15 million rD = 4.85% a) If the risk free rate is 3.95 percent and the market risk premium is 6.01 percent, what is the beta of the assets of the comparable company? rf= 3.95% rm - rf = 6.01% D/E= 15/45 = 0.33 The beta for common equity was computed using the following formula: (3) βUA= 1.06/[ 1+ 0.33] = 0.7970 You can estimate the unlevered beta from a levered beta. The unlevered beta is the beta of the assets of the firm; as such, it is a measure of the business risk. Note that the unlevered beta will always be lower than the levered beta (assuming the betas are positive). The difference is due to the leverage of the company. Thus, the second risk factor measured by a levered beta is the financial risk of the company. b) If the total market value of Coral Gables’ financing consists of 35 percent debt and 65 percent equity (this is what the CFO estimates the market values to be) and the pretax cost of its debt is 5.45 percent, what is the beta for Coral Gables’ common stock? wE= 0.65 wD= 0.35 D/E = 0.54 rD = 5.45% βE = [1+0.54] * 0.7970 = 1.2273 The equity of this company is riskier because beta must pay off its debt holders before its equity holders receive any of the firm’s earnings. If the firm does not do particularly well, all of the firm’s earnings may be needed to repay its debt holders, and equity holders will receive nothing. The equity risk to the shareholder is composed of both business and financial risk. Even if the assets of the firm are not very risky, the risk to the shareholder can still be large if the financial leverage is high. These higher levels of risk will be reflected in the shareholder’s required rate of return RE, which will increase with higher debt/equity ratios (Elton & Martin, 1995). c) What is the weighted average cost of capital for Coral Gables using your estimated beta and the information provided above? Assume that the average and marginal tax rates for Coral Gables are both 25 percent. T = 25% We can use the Capital Asset Pricing Model to find the required return on each firm’s equity. The return on equity was computed using the following formula: ) (4) re = 3.95% + 1.2273* 6.01% = 11.43% This result (11.43%) is higher than the one that would have been obtained when there is no leverage, but still lower than in the case with no corporate taxes. An explanation for this would be that although leverage increases return-on-equity, the effect of corporate taxes diminishes the increase. This effect is caused by the negative relationship between corporate taxes and return on equity, because after paying corporate taxes, it will remain less value (income) to be distributed between shareholders. Since the CEO believes its current capital structure is optimal, these values can be used as the target weights in the firm’s weighted average cost of capital calculation. The yield to maturity of the company’s debt is its pretax cost of debt. The weighted average cost of capital was computed using the following formula: wacc= we*re + wd*(1-T)*rd (5) wacc = 0.65* 0.1143+ 0.35*(1-0.25)* 0.0545 = 8.86% This result is lower than the result obtained for the wacc that would have been obtained without the presence of corporate taxes. References Bodie, Z., Kane, A. and Marcus, A. (2009) Investments, 8th edn. New York: McGraw-Hill/Irwin. Elliot, B. and Elliot, J. (2011) Financial accounting and reporting, 14th edn. London: Prentice Hall. Elton, E.J. and Martin, J. (1995) Modern Portfolio Theory and Investment Analysis, 5th edn. New York: John Wiley & Sons. Fabozzi, F.J. and Drake, P. (2009) Capital Markets, Financial Management, and Investment Management, New Jersey: John Wiley & Sons. Fabozzi, F.J. and Markowitz, H. (2002) The Theory and Practice of Investment Management, New Jersey: John Wiley & Sons. Grinbalt, M. and Titman, S. (2002). Financial Markets and Corporate Strategy, 2nd edn. New York: McGraw-Hill/Irwin. Haugen, F. and Hains, R. (1975) Risk and The Rate of Return on Financial Assets: Some Old Wine in Financial Bottles, Journal of Financial and Quantitative Analysis, 10(5): 775–784. Howells, P. and Bain, K. (2007) Financial Markets and Institutions, Harllow: Pearson Education Limited. Reilly, F. and Brown, K. (2002) Investment Analysis and Portfolio Management, 7th edn. Boston: South-Western College Pub. Ross, S., Westerfield, R. and Jordan, B. (2002) Corporate Finance, 6th edn. New York: McGraw-Hill/Irwin. Read More