Mrjackd ?
There are dozens of minor differences in U.S. and U.K.
generally-accepted accounting practices or GAAP. The differences are
in such things as revenue recognition, treatment of assets, treatment
of derivatives but I don?t think any are really relevant to this
question, which is about financial theory.
As I?m sure you know it?s the Financial Accounting Standards Board
(FASB) which governs U.S. GAAP and the International Accounting
Standards Board (IASB) which governs U.K. accounting principles:
FASB
?FASB Works With IASB Towrd Global Convergence,? (Nov. 27, 2002)
www.fasb.org/articles&reports/ fasb&iasb_work_toward_convergence_tfr_nov2002.pdf
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Now that I?m done with that disclaimer, I have to put on another
disclaimer ? but this regarding finance standards. For decades there
was strong debate on ?cost of equity.? It was important in a variety
of ways, including regulated industries, which by law have certain
returns allowed. (A friend used to argue these types of cases with
state agencies for a telephone company until the mid-1970s.)
Finally, by the mid-1970s, the Capital Asset Pricing Model (CAPM),
developed by William F. Sharpe in the 1960s, became widely accepted
for pricing capital. It
predicts that a risk will carry a premium in the prices of bonds or
stocks ? and that the stock?s required return is determined by it?s
?beta? or covariance with the expected stock market returns.
Sharpe was awarded the Nobel Prize for the work in 1990:
NobelPrize.org
?THIS YEAR'S LAUREATES ARE PIONEERS IN THE THEORY OF FINANCIAL
ECONOMICS AND CORPORATE FINANCE,? (Oct. 16, 1990)
http://nobelprize.org/economics/laureates/1990/press.html
The full valuation model, widely used throughout finance is spelled
out in this excellent Price Waterhouse page:
PricewaterhouseCoopers
?PricewaterhouseCoopers WACC Formula?
http://www.pwc.com/Extweb/pwcpublications.nsf/docid/2FC3C1F236E6ED328525694200135FB5
So here?s the disclaimer: we have neither tax rate, nor beta (nor
risk-free rate) ? so we have to find another, less generally accepted
financial model for valuing the Re or return on equity. That would
be a dividend valuation model.
Oh, and note that the WACC that we get in the end will be a pre-tax
model. That?s not bad for operational measures like comparing various
projects internally but would not be accurate for an outside investor
looking at the company.
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DIVIDEND VALUATION MODEL
The general model for stock pricing looks like this:
Pi = Di / (Re-g)
Pi = price in period i
Di = dividends in period i
Re = required rate of return (in decimals)
g = dividend growth rate (in decimals)
i = period, usually expressed in years
From the financial information on 7? Plc we know that:
P = 198p
D = 7.35
All we have to do is to figure the dividend growth rate to find Re.
There are several ways to do it:
2002 growth: 2.41%
2003 growth: 10.31%
2004 growth: 10.66%
2005 growth: 8.99%
AVERAGE = 8.09%
You can also take the 2001-2005 growth of 36.11%, then calculate a
compounded growth rate over 4 years. That?s 8.01%
CAGR (compounded average growth rate) = 8.01%
At this point, it?s important to remember that your capital cost
estimates are just that ? estimates. You?re trying to arrive at a
value that represents the MINIMUM return acceptable for internal
projects. The company may choose a higher hurdle rate for riskiness
or in particular operating areas. The rate may also be changing ? as
in the U.S. these days where the chairman of the Federal Reserve is
trying hard to push up interest rates.
But net, there?s not much difference between 8.01% and 8.09%. I?ll
choose the lower number, so:
198p = 7.35p / (Re ? 0.0801) =? Re = 7.35/198 + 0.0801 = .0371 + 0.0801 = 11.72%
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WACC
The weighted-average cost of capital is figured by calculating debt
and equity costs at the current market value. From the
PricewaterhouseCoopers page:
WACC = Rd(1-Tc) * D/V + Re * E/V
where:
Rd: pre-tax cost of debt, based on the current yield on traded
company debt instruments
Tc: the marginal corporate tax rate
D, E & V: D and E are the market values of the business' debt and
equity respectively and V is the sum of D and E. Therefore, D/V and
E/V represent the relative weightings of debt and equity
Re cost of equity
Since we?re doing this as pre-tax, Tc = 0 and things simplify to:
WACC = Rd * D/V + Re * E/V
D = ?0.85M + ?1M = ?1.85M (8.55%)
E = ?19.8M (91.45%)
V = ?21.65M
The debentures (now valued at only $850,000) are yielding 11.76% and
the bank link of credit 6%. So the mixed debt payments are:
Rd = 0.4595 * (11.76%) + 0.5405 * (6%) = 5.40% + 3.24% = 8.64%
WACC = 8.64% (0.0855) + 11.72% (0.9145) = 0.7387 + 10.72 = 11.46%
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ASSUMPTIONS IN WACC
There are dozens of assumptions behind a WACC calculation but I?ll
list the more important ones:
? the project investment is not inherently more (or less) risky than
the business in general
? the new product will produce a minimum return of 11.46% in pre-tax
net present value (NPV)
? costs of raising capital are not important in taking on the project
? the financing method itself for the project will not have a
significant impact on the cost of capital here
? no taxes are being paid. As noted previously at contemporary tax
rates, they dramatically reduce the cost of borrowing
? future dividend growth is expected to match that of the past 4 years
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PRACTICAL PROBLEMS FOR LARGE PUBLIC COMPANY
? The company is diversified and each division has a different
business risk ? thus a different cost-of-equity and WACC.
? Each division is also likely to have a different optimal debt-equity
ratio, yet all divisions share the overhead of the bonded
indebtedness.
? Leasing of equipment or property can change the debt-equity
structure and not show on the balance sheet. (This is one area where
there has been quite a bit of effort to standardize U.S. and U.K.
rules by creating a classification of capitalized leases.)
? If the new product investment is to occur outside the U.K. there is
additional foreign exchange risk involved in reporting assets,
liabilities and earnings. It may require a hedging strategy to reduce
currency translation risks.
You may wish to explore other risk factors. The following Google
search strategies work pretty well at bringing up a mix of academic
and practical articles:
Investments ?issues with? WACC
?Investment risk? ?cost of capital?
Google search strategy:
?differences between? IASB FASB
WACC + ?cost of equity?
Investments ?issues with? WACC
Best regards,
Omnivorous-GA |