You are on page 1of 26

SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL

1001
OVERVIEW
Objective
To develop a model for the valuation of shares and bonds.
To use this model to estimate the cost of equity and the cost of debt.
To consider further practical influences on the valuation of securities.



EQUITY
ANALYSIS
SECURITY
VALUATION AND THE
COST OF CAPITAL
DEBT
ANALYSIS
Dividend Valuation Model
Cost of equity
Irredeemable debentures
Redeemable debentures
Semi-annual interest
Convertible debentures




SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1002
1 DIVIDEND VALUATION MODEL
1.1 The general model
The dividend valuation model states that:
the market value of a share or other security is equal to the present value of the
future expected cash flows from the security discounted at the investors required
rate of return.
A security is any traded investment e.g. shares and bonds.
1.2 Constant Dividend

The formula for share valuation can be developed as follows:
Ex-div market value at time 0 = Present value of the future dividends
discounted at the shareholders
required rate of return
Ex-div market value is the market value assuming that a dividend has just been
paid.
Let:
Po = Current ex-div market value
Dn = Dividend at time n
ke = Shareholders required rate of return/companys cost of equity
The model then becomes:
Po =
ke) (1
D
ke) (1
D
ke) (1
D
3
3
2
2 1
+
+
+
+
+
.....
ke) (1
Dn
n
+

If the dividend is assumed to be constant to infinity this becomes the present
value of a perpetuity which simplifies to:
Po =
ke
D

This version of the model can be used to determine the theoretical value of a share
which pays a constant dividend e.g. a preference share or an ordinary share in a zero
growth company.
SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1003
1.3 Constant growth in dividends
If dividends are forecast to grow at a constant rate in perpetuity, where g = growth rate
Po =
g ke
g) (1 D0

+
=
g ke
D1


where D
o
= most recent dividend
D
1
= dividend in one year
The formula is published in the exam in the following format:
P
O
=
( )
( ) g
g

+
re
1 D
O

Where re

= required return of equity investors = ke
1.4 Assumptions behind the dividend valuation model
rational investors
all investors have the same expectations and therefore the same required rate of return
perfect capital market assumptions, e.g.,
no transactions costs
large number of buyers and sellers of shares
no individual can affect the share price
all investors have all available information
dividends are paid just once a year and one year apart
dividends are either constant or are growing at a constant rate.
1.5 Uses of the dividend valuation model
The model can be used to estimate the theoretical fair value of shares in unlisted
companies where a quoted market price is not known. .
However if the company is listed, and the share price is therefore known, the model can
be used to estimate the required return of shareholders i.e. the companys cost of equity
finance.
SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1004

Illustration 1

Suppose that a share has a current ex-div market value of 80 cents and
investors expect a dividend of 10 cents per share to be paid each year as has
been the case for the past few years.
Using the dividend valuation model the required return of the investors for
this share can be determined:
Po =
ke
D

80c =
ke
10c

ke =
80c
10c

ke = 12.5%
Investors will all require this return from the share as the model assumes they
all have the same information about the risk of this share and they are all
rational.
If investors think that the dividend is due to increase to 15 cents each year then
at a price of 80 cents the share is giving a higher return than 12.5%. Investors
will therefore buy the share and the price will increase until, according to the
model, the value will be:
Po =
0.125
15c
= 120 cents
Alternatively suppose that the investors' perception is that the dividend will
remain at 10 cents per share but that the risk of the share has increased thereby
requiring a return of 15%. If the share only gives a return of 12.5% (on an 80
cents share price) then investors will sell and the price will fall. The fair value
of the share according to the model will be:
Po =
0.15
10c
= 66.7 cents


SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1005
1.6 Practical factors affecting share prices
The dividend valuation model gives a theoretical value, under the assumptions of the
model, for any security.
In practice there will be many factors other than the present value of cash flows from a
security that play a part in its valuation. These are likely to include:
interest rates
market sentiment
expectation of future events
inflation
press comment
speculation and rumour
currency movements
takeover and merger activity
political issues.
The dividend valuation model helps us to understand how a change in these
variables should affect the market value of the security.
Share prices change, often dramatically, on a daily basis. The dividend valuation model
will not predict this, but will give an estimate of the underlying fair value of the shares.
2 COST OF EQUITY
2.1 Shareholders required rate of return
The basic dividend valuation model is:
Po =
ke
D

This can be rearranged to find ke:
ke =
Po
D

If ke is the return required by the shareholders in order for the share value to remain
constant then ke is also the return that the company must pay to its shareholders.
Therefore ke also equates to the cost of equity of the company.
Therefore the cost of equity for a company with a constant annual dividend can be
estimated as the dividend divided into the ex-div share price i.e. the dividend yield.
The ex-div market value is the market value of the share assuming that the current
dividend has just been paid. A cum-div market value is one which includes the value of
the dividend just about to be paid. If a cum-div market value is given then this must be
adjusted to an ex div market value by taking out the current dividend.
SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1006

Example 1

A companys shares have a market value of $2.20 each. The company is just
about to pay a dividend of 20c per share as it has every year for the last ten
years.
What is the companys cost of equity?


Solution


2.2 Dividend with constant growth
The model can also deal with a dividend that is growing at a constant annual rate of g.
The formula for valuing the share is as seen earlier:
Po =
g ke
g) (1 D
0

+
=
g ke
D
1


where D
o
= most recent dividend
D
1
= dividend in one year
Rearranged this becomes
k
e
= g
Po
g) (1 D0
+
+

where g = growth rate (assumed constant in perpetuity).
where P
o
= ex div market value
Therefore the cost of equity = dividend yield + estimated growth rate
SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1007

Illustration 2

D
o
= 12c, Po (ex div) = $1.75, g = 5%.
What is the value of k
e
?
k
e
=
75 . 1
) 05 . 1 ( 12 . 0
+ 0.05
= 12.2%

The growth rate of dividends can be estimated using either of two methods.
Two methods
Extrapolation of
past dividends
Gordons growth model


2.3 Growth from past dividends
Look at historical growth and use this to predict future growth. If you have specific
information about future growth, use that.
If dividends have grown at 5% in each of the last 20 years, predicted future growth
= 5%.
Uneven but steady growth take an average overall growth rate.
Discontinuity in growth rate take the most recent evidence.
New company with very high growth rates take care! It is unlikely to produce
such high growth in perpetuity.
No pattern do not use this method (i.e. dividends up one year, down the next).
SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1008

Example 2

A company has paid the following dividends over the last five years.
Cents per share
19X0 100
19X1 110
19X2 125
19X3 136
19X4 145

Estimate the growth rate and the cost of equity if the current (19X4) ex div
market value is $10.50 per share.


Solution


2.4 Gordons growth model
Gordons growth model states that growth is achieved by retention and reinvestment of
profits.
g = br
e

b = proportion of profits retained
r
e
= return on equity

Take an average of r and b over the preceding years to estimate future growth.
r
e
=
funds rs' Shareholde
tax after Profit
=
assets Net
tax after Profit

b =
tax after Profit
profit Retained

These figures can be obtained from the statement of financial position and income
statement.
SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1009

Example 3

A company has 300,000 ordinary shares in issue with an ex-div market value of
$2.70 per share. A dividend of $40,000 has just been paid out of post-tax profits
of $100,000.
Net assets at the year end were valued at $1.06m.
Estimate the cost of equity.


Solution


SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1010
2.5 Cost of equity and project appraisal
Illustration 3

A plc is all equity financed and has 1m shares quoted at $2 each ex div. It pays
constant annual dividends of 30c per share.
It is considering adopting a project which will cost $500,000 and which is of the
same risk as its existing activities. The cost will be met by a rights issue. The
project will produce inflows of $90,000 pa in perpetuity. All inflows will be
distributed as dividends.
What is the new value of the equity in A plc and what is the gain to the
shareholders? Ignore tax.
k
e
=
00 . 2
30 . 0
= 15%
New dividend
$
Existing total dividend 300,000
Dividends from the project 90,000
New total dividend 390,000
Value of equity =
15 . 0
000 , 390

= $2,600,000
Shareholders gain = $(2,600,000 2,000,000) $500,000
= $100,000
Project NPV = ($500,000) +
15 . 0
000 , 90
= $100,000
Therefore, new value of equity = Existing value + Equity outlay + NPV
= Existing value + Present value of
additional dividends

Therefore the NPV of a project serves to increase the value of the companys shares i.e.
the NPV of a project shows the increase in shareholders wealth.
This proves that NPV is the correct method of project appraisal it is the only method
consistent with the assumed objective of maximising shareholders wealth.
SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1011
2.6 Cost of preference shares
By definition preference shares have a constant dividend
Ke =
Po
D

where D = constant annual dividend
Preference dividends are normally quoted as a percentage, e.g. 10% preference shares.
This means that the annual dividend will be 10% of the nominal value, not the market
value.
Example 4

A company has 100,000 12% preference shares in issue (nominal value $1).
The current ex-div market value is $1.15 per share.
What is the cost of the preference shares?


Solution

3 COST OF DEBT
3.1 Terminology of debentures
A debenture is a written acknowledgement of a companys debt. A debenture usually pays a
fixed rate of interest and it may be secured or unsecured. It may be traded on the bond
market and will reach a market price. The terms debenture, bond and loan stock all basically
refer to the same thing i.e. traded corporate debt (unlike bank loans which are not traded).
The coupon rate is the interest rate printed on the debenture certificate.
Annual interest = coupon rate nominal value
Nominal value is also known as par or face value. In the exam the nominal value of one
debenture is usually $100.
Market value (MV) is normally quoted as the MV of a block of $100 nominal value.
e.g. 10% debentures quoted at $95 means that a $100 block is selling for $95 and annual
interest is $10 per $100 block.
Market value (ex-int) is where interest has just been paid.
Market value (cum-int) includes the value of accrued interest which is just about to be
paid.
SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1012
3.2 Irredeemable debentures
Irredeemable debentures are a type of debt finance where the company will never repay
the principal but will pay interest each year until infinity. They are also referred to as
undated debentures.
The market value of undated debt can be calculated using the same logic as the
Dividend Valuation Model:
MV (ex interest) = present value of future interest payments discounted at the debenture-
holders required rate of return
For irredeemable debentures the interest is a perpetuity.
MV (ex int) =
r
I

where I = annual interest
r = return required by debenture holder
r =
int) (ex MV
I
= Interest yield
The company gets tax relief on the debenture interest it pays, which reduces the cost of
debentures to the company known as the tax shield on debt.
Illustration 4
Consider two companies with the same earnings before interest and tax (EBIT).
The first company uses some debt finance, the second uses no debt.

$ $
EBIT 100 100
Debt interest (10)
___ ___
Profits before tax 90 100

Tax @ 33% 29.70 33

$3.30 difference
Therefore
Effective cost of debt
$
Debt interest 10.00
Less Tax shield (3.30)

_____
Effective cost of debt 6.70

_____


SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1013
Because of tax relief, the cost to the company is not equal to the required return of the
debenture holders.
Unless told otherwise, we assume that tax relief is instant (in practice, there will be a
minimum time lag of nine months under the UK tax system).
Note that if debt is irredeemable then:
Cost of debt to the company (also
known as the post tax cost of debt)
=


=
Return required by the debenture
holders (1Tc)

Interest yield (1Tc)

Where Tc = corporate tax rate as a decimal
Kd can be used to denote the cost of debt but care is needed as to whether it is stated
pre-tax or post-tax.
Example 5

12% undated debentures with a nominal value of $100 are quoted at $92 cum
interest. The rate of corporation tax is 33%.
Find
(a) the return required by the debenture-holders
(b) the cost to the company.


Solution
SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1014
3.3 Redeemable debentures/dated debentures
The cash flows are not a perpetuity because the principal will be repaid. However from
the dividend valuation model we can derive the following rule:
The cost of any source of funds is the IRR of the cash flows associated with that source.
If we are looking at the return from an investors point of view, interest payments are
included gross.
If we are looking at the cost to the company, we take the interest payments net of
corporation tax. Assume instant tax relief.
Assume that the final redemption payment does not have any tax effects.
To find the cost of debt for a company find the IRR of the following cash flows:
Time $
0 Market value (ex-interest) x
1 n Post-tax interest (x)
n Redemption value (x)

The IRR is found as usual using linear interpolation.
Example 6

A company has in issue $200,000 7% debentures redeemable at a premium of
5% on 31 December 19X6. Interest is paid annually on the debentures on 31
December. It is currently 1 January 19X3 and the debentures are trading at $98
ex interest. Corporation tax is 33%.
What is the cost of debt for this company?


Solution




SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1015
Care should be taken not to confuse the required return of the debenture holders with
the cost of debt of the company.
Required return of the
redeemable debenture
holder
= IRR of pre-tax cash
flows from the
debenture
= Gross redemption
yield

Gross Redemption Yield is also referred to as the Yield To Maturity (YTM)
The cost of debt of the company is then determined by finding the IRR of the market
value, net of tax interest payments and redemption value.
MV (ex interest) = present value of future interest payments and redemption value
discounted at the debenture-holders required rate of return

Example 7

A company has 8% debentures redeemable at a 5% premium in ten years.
Debenture-holders require a return of 10%.
What is the cost to the company? Corporation tax is 33%.


Solution




SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1016
3.4 Semi-annual interest payments
In practice debenture interest is usually paid every six months rather than annually.
This practical aspect can be built into our calculations for the cost of debt.
If interest payments are being made every 6 months then when the IRR of the debenture
cash flows is calculated it should be done on the basis of each time period being 6
months.
The IRR, or cost of debt, will then be a 6 monthly cost of debt and must be adjusted to
determine the annual cost of debt.
Effective annual cost = (1+semi annual cost)
2
-1
Example 8

A company has in issue 6% debentures the interest on which is paid on 30 June
and 31 December each year. The debentures are redeemable at par on 31
December 19X9. It is now 1 January 19X7 and the debentures are quoted at
96% ex interest.
What is the effective annual cost of debt for the company? Ignore corporation
tax.


Solution
SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1017
3.5 Convertible debentures
Convertible debentures allow the investor to choose between redeeming the debentures
at some future date or converting them into a pre-determined number of ordinary
shares in the company.
To estimate the market value it is first necessary to predict whether the investor will
choose redemption or conversion. The redemption value will be known with certainty
but the future share price can only be estimated.
MV (ex interest) = present value of future interest payments and the higher of (i)
redemption value (ii) forecast conversion value, discounted at the debenture-holders
required rate of return
You may also be required to calculate other data for convertibles:
Floor value = the value assuming redemption
Conversion premium = market value current conversion value

Example 9
A company has in issue 9% bonds which are redeemable at their par value of $100 in five
years time. Alternatively, each bond may be converted on that date into 20 ordinary shares.
The current ordinary share price is $4.45 and this is expected to grow at a rate of 6.5% per
year for the foreseeable future. Bondholders required return is 7% per year.
Required:
Calculate the following values for each $100 convertible bond:
(i) market value;
(ii) floor value;
(iii) conversion premium

Solution

SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1018
To find the post-tax cost of convertible debt for a company find the IRR of the following
cash flows:
Time $
0 Market value (ex-interest) x
1 n Post-tax interest (x)
n Higher of redemption value/forecast conversion value (x)

Example 10

A company has in issue some 8% convertible loan stock currently quoted at $85
ex interest. The loan stock is redeemable at a 5% premium in five years time, or
can be converted into 40 ordinary shares at that date. The current ex-div
market value of the shares is $2 per share and dividend growth is expected at
7% per annum. Corporation tax is 33%.
What is the cost to the company of the convertible loan stock?


Solution
SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1019

Key points

If capital markets are perfect the sale/purchase of any security must be a
zero NPV transaction i.e. market price = present value of future cash flows
discounted at investors required return.
This general rule can be specifically applied to shares to develop the
dividend valuation model (DVM) and also to bond valuation.
If the market price of a security is already known then the model can be re-
arranged to find the required return of investors i.e. the companys cost of
equity/debt finance.
Care must be taken with the cost of debt as interest, unlike dividends, is a
tax allowable expense form the side of the company.



FOCUS
You should now be able to:

understand and use the dividend valuation model;
estimate the cost of equity and cost of debt for a company;
understand the practical factors that affect share prices.
SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1020
EXAMPLE SOLUTIONS
Solution 1
Po (cum div) = $2.20
Po (ex div) = $2.00
K
e
=
Po
D

=
200
20
100%
= 10%
Solution 2
19X019X4 four changes in dividend
100 (1 + g)
4
= 145
(1 + g)
4
=
100
145

1 + g =
4
100
145

= 1.097
g = 9.7%
k
e
=
0
1
P
D
+ g
=
050 , 1
) 097 . 1 ( 145
+ 0.097
= 24.8%
SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1021
Solution 3
Growth rate g = br
e

b = % profit retained
=
000 , 100
000 , 60

= 60%
r
e
= Return on equity
=
assets net Opening
tax after Profit

=
60,000 1,060,000
100,000

100%
= 10%
Note return on average equity could be used rather than return on opening equity.
g = 0.6 0.1
= 0.06
= 6%
k
e
=
0
1
P
D
+ g
=
70 . 2 000 , 300
) 06 . 1 ( 000 , 40

+ 0.06
= 11.2%
Solution 4
12% preference shares: dividend is 12% nominal value
K
e
=
Po
D

=
115
12
100%
= 10.4%
SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1022
Solution 5
r =
int ex MV
Int

=
12 92
12

100%
= 15%
Return required by debenture-holders is 15%.
Cost to the company
K
d
=
int ex MV
) T (1 Int
c


=
12 92
) 33 . 0 1 ( 12


= 10.05%
Solution 6
Time Cash PV @ 10% PV @ 5%
flow
0 98 98 98
(7) 0.67
1 4 = (4.69) (14.87) (16.63)
4 (105) (71.72) (86.42)
_______ _______
11.41 (5.05)
_______ _______
IRR = 5 +
41 . 11 05 . 5
05 . 5
+
(10 5)
K
d
= 6.5%
SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1023
Solution 7
To find the cost to the company, we need to know the market value of the debentures.
We do this by discounting the future flows at the debenture-holders required return.
MV = (8 6.145) + (105 0.386)
= $89.69
To find the cost to the company we do an IRR calculation, bringing in the effects of tax relief.
DF @ 10% PV DF @ 5% PV
$ $
t
0
89.69 1 89.69 1 89.69
t
110 (
8) 0.67 6.145 (32.94) 7.722 (41.39)
t
10 (105)
0.386 (40.53) 0.614 (64.47)

______

______

16.22 (16.17)

______

______

IRR = 5 +
22 . 16 17 . 16
17 . 16
+
(10 5)
= 7.5%
Therefore K
d
= 7.5%
Solution 8
Time 0 is 1 January 19X7
Interest payments due
30 June X7 Time 1
31 Dec X7 Time 2
30 June X8 Time 3
31 Dec X8 Time 4
30 June X9 Time 5
31 Dec X9 Time 6
SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1024
Each interest payment will be just half of the coupon rate, $3 each 6 months.
Time Cash flow PV @ 3% PV @ 5%
0 96 96 96
1 6 (3) (16.25) (15.23)
6 (100) (83.70) (74.60)
______ ______
(3.95) 6.17
______ ______
IRR = 3 + ) 3 5 (
17 . 6 95 . 3
95 . 3

+

= 3.78%
This is the 6 monthly cost of debt.
The effective annual cost of debt is (1.0378
2
) -1 = 7.7%
Solution 9
(i) Market Value
Expected share price in five years time = 4.45 x 1.0655 = $6.10
Forecast conversion value = 6.10 x 20 = $122
Compared with redemption at par value of $100, conversion will be preferred
Todays market value is the present value of future interest payments, plus the present value
of the forecast conversion value.
= (9 x 4.100) + (122 x 0.713) = $123.89
(ii) Floor value
Floor value is the present value of future interest payments, plus the present value of the
redemption value.
= (9 x 4.100) + (100 x 0.713) = $108.20
(iii) Conversion premium
Current conversion value = 4.45 x 20 = $89.00
Conversion premium = $123.89 89.00 = $34.89
This is often expressed on a per share basis, i.e. 34.89/20 = $1.75 per share
SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1025
Solution 10
First we need to decide whether the loan stock will be converted or not in five years. To do
this we compare the expected value of 40 shares in five years time with the cash alternative.
We assume that the MV of shares will grow at the same rate as the dividends.
MV/share in five years = 2(1.07)
5
= $2.81
MV of 40 shares $2.81 = $112.40
Cash alternative = $105
Therefore all loan stock-holders will choose the share conversion.
To find the cost to the company, find the IRR of the post-tax flows.
DF @ 5% PV DF @ 10% PV
$ $
t
0

(85) 1 85.00 1 85.00
t
15
(8) 0.67 4.329 (23.20) 3.791 (20.32)
t
5
(112.4) 0.784 (88.12) 0.621 (69.80)

______

______

(26.32) (5.12)

______

______

IRR = 5 +
12 . 5 32 . 26
32 . 26

(10 5)
= 11.2%
Therefore cost to the company = 11.2%.
SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL
1026

You might also like