BUSF_A01.qxd

Summary

figure is stated), it might appear that valuable investment opportunities may be being

rejected as a result of businesses having too high an expectation of acceptable returns.

Incidentally, it seems that an increasing number of businesses reveal their WACCs

in their annual report. This practice used to be quite rare, but recently it appears that

about a third of all businesses are publishing their WACCs.

Some further points on WACC

There are some other points that need to be made about using WACC as the discount

rate, but since these require some understanding of the contents of Chapter 11, we

shall leave them until the end of that chapter.

Cost of capital estimations

l Cost of capital (k) is the IRR for a set of cash flows, such that current market

price of the investment equals the sum of the discounted values of all future

cash flows relating to the investment, from the business’s point of view.

l Market price used because opportunity krequired.

l With a perpetuity, k=annual interest (or dividend) payment/current market

price.

Loan notes

l Interest payments are tax deductible; effective interest payment is 70 per cent

of the coupon rate.

l May be redeemable; redemption payment not tax deductible.

Preference shares

l Treated like loan notes, except:

ldividends are not tax deductible;

ldividends need not always be paid.

Ordinary shares

l Need to make an assumption about future dividends, usually either:

lconstant (perpetual) – treat like a preference share; or

lassume a constant rate of dividend growth, g[g=proportion of profits

retained (b) times the rate of return on those retained profits (r)].

l Assuming constant growth,

Cost of equity, kE=+g

where d 0 is the current dividend per share (top part of fraction is next year’s

dividend, that is, this year’s dividend plus the growth over the next year) and

d 0 (1 +g)

p 0

Summary

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