** Worked Example: Lease or buy decision, with taxation**

**Question 6: Impact of returns on share price**

Mansfield has just paid an annual dividend of 14c to its shareholders. The expected future growth rate in dividends is 5 per cent per annum, and the cost of equity capital is 10 per cent. The company has just announced that the expected future growth rate in dividends will be 3 per cent, instead of the 5 per cent previously forecast.

By how much would the share price be expected to fall, given no change in the cost of equity?

A 6c B 59c C 80c D 88c

**(The answer is at the end of the chapter) **

**Key chapter points **

• The cost of capital is the rate of return that a business must pay to satisfy the providers of funds, and it reflects the riskiness of the funding transaction.

• The fundamental theory of share values states that the market price of shares reflects investors’

expectations of what the future returns from the shares will be.

• The dividend valuation model can be used to estimate a cost of equity, on the assumption that the share price represents the present value of all future dividends, discounted at the investors’ yield requirements (the cost of equity).

• Expected growth in dividends can be allowed for in calculating a cost of equity, using Gordon's growth model. Growth can be estimated from past dividend growth or using the retained earnings model, g = bR.

• The cost of preference share capital is the return an enterprise must pay to the investors. For preference shares, this is the annual dividend as a percentage of the ex- div market value of the shares.

• The cost of debt is based on the return an enterprise must pay to its lenders. However, the company benefits from additional tax relief on interest payments, so the cost to the company is after-tax.

– For irredeemable debt, this is the (post-tax) interest as a percentage of the ex div market value of the loan stock (or preference shares).

– For redeemable debt, the cost is given by the internal rate of return of the cash flows involved.

• The weighted average cost of capital is calculated by weighting the costs of the individual sources of finance according to their relative importance as sources of finance.

• The weighted average cost of capital can be used to evaluate a company's investment projects if:

– the project is small relative to the company.

– the existing capital structure will be maintained (same financial risk).

– the project has the same business risk as the company.

– new investments are financed by new sources of funds, and a marginal cost of capital approach is used.

• Leasing is another form of debt finance. Like all forms of debt the cost of the lease can be calculated by finding the IRR of the leasing cash flows.

• The decision whether to lease or buy an asset is a financing decision which interacts with the investment decision to buy the asset. The decision about how to finance the asset (whether to borrow money in order to buy it, or whether to lease it) is made once the decision to invest in the asset has been made.

• We compare the cost of purchasing with the cash flows of leasing by discounting the financing cash flows at an after-tax cost of borrowing.

• In theory, if a company undertakes a new capital investment and the net present value is positive when the cash flows are discounted at the company’s cost of capital, the wealth of shareholders will be increased by the amount of the NPV.

** Quick ** **revision ** **questions **

1 *Fill in the blanks. *

Cost of capital = (1) ... + (2) a premium for ... risk + (3) a premium for ...risk.

2 Hurstbourne Electronics has issued nominal share capital of $10 million, made up of $0.25 ordinary shares, and a market capitalisation of $20 million. The company expects post-tax profits for the forthcoming year to be $8 million and wishes to maintain a constant dividend payout ratio of 25 per cent. Dividends are expected to increase by 3 per cent per year for the foreseeable future.

What is the expected rate of return from the ordinary shares?

A 7%

B 13%

C 17%

D 23%

3 Appleton has issued loan stock of $100 nominal value with annual interest of 10 per cent per year, based on the nominal value. The loan stock has two years remaining before it is redeemed at par.

Interest is paid annually and the most recent interest payment has just been paid. Investors currently require a yield of 8 per cent per year on the loan stock.

What is the market value of the loan stock per $100 nominal value, to the nearest dollar?

A $95 B $100 C $104 D $125

4 Stockton has 20 million $0.50 ordinary shares and irredeemable loan capital with a nominal value of

$40 million in issue. The ordinary shares have a current market value of $2.40 per share and the loan capital is quoted at $80 per $100 nominal value. The cost of ordinary shares is estimated at 11 per cent and the cost of loan capital is calculated to be 8%. The rate of corporation tax is 25 per cent.

What is the weighted average cost of capital for the company?

A 7.0%

B 9.0%

C 9.5%

D 9.8%

5 When calculating the weighted average cost of capital, which of the following is the preferred method of weighting?

A book values of debt and equity

B average levels of the market values of debt and equity (ignoring reserves) over five years C current market values of debt and equity (ignoring reserves)

D current market values of debt and equity (plus reserves)

**Answers to quick revision questions **

1 *Cost of capital = a risk-free rate of return, a premium for business risk and a premium for financial risk. *

2 B Ke = ^{1}

XD

d

E + g = 8m x 25%

20m + 3% = 13%

3 C Investors require 8% so use that as a discount rate to find MV:

Year 1 interest (10 × 0.926) $ 9.26

Year 2 interest (10 × 0.857) 8.57

Redemption value (100 × 0.857) 85.70

103.53 Rounded to $ 104 per $ 100 nominal value.

4 B

* MV $m * * Weighting * * % * * WACC *

Equity 20m × $2.40 48 0.60 11 6.6

Debt 40m × $0.80 32 0.40 6 (8% × 0.75) 2.4

80 9.0%

5 C Current market values of debt and equity (ignoring reserves).

**Answers to chapter questions **

4 **Equity. Given a 5 per cent annual increase in dividend in perpetuity, the cost of equity capital may **
be estimated as:

60 000(1+ 0.05)

+ 0.05 = 0.17 = 17%

585 000 - 60 000 *

*** Market value of equity ex div, not cum div. The current dividend must be subtracted from the cum **
div price.

**Preference shares. The cost of capital is ** 6c

×100% = 15%

40c

**Debentures. The cost of capital is the IRR of the following cash flows. **

*Year Cost *

** Debentures are redeemed at par so each individual debenture is redeemed at its nominal value of $100

*Try 10% * *Try 8% *

**Weighted average cost of capital **

*Item Market value Cost of capital * *Product *

WACC = 0.150 15.0%

600 755

681

113 = =

5 *Tax allowable depreciation *

*Year * $

The financing decision will be appraised by discounting the relevant cash flows at the after-tax cost of borrowing, which is 10% × 70% = 7%.

(a) Purchase option

*Cash * *Discount * *Present *

*Year * * Item * *flow * *factor 7% * *value *

$ $

0 Cost of machine (63 000) 1.000 (63 000)

Tax saved from tax allowable depreciation

It is assumed that the lease payments are tax-allowable in full.

*Cash * *Discount * *Present *

*Years * *Item * *flow * *factor 7% * *value *

$ $

1 – 4 Lease costs (20 000) 3.387 (67 740)

2 – 5 Tax savings on lease costs (× 30%) 6 000 3.165 18 990 (48 750) The purchase option is cheaper, using a cost of capital based on the after-tax cost of

borrowing. On the assumption that investors would regard borrowing and leasing as equally risky finance options, the purchase option is recommended.

6 D Share price P =

**Topic list **

1 Portfolios and portfolio theory 2 Investors' preferences

3 The Capital Asset Pricing Model (CAPM)

**Learning objectives ** **Reference **

**The Capital Asset Pricing Model ** **LO3 **

Demonstrate the relationship between systematic risk and expected return of individual securities and portfolios using the CAPM and the security market line relationship

LO3.1

**Cost of funds ** **LO4 **

Calculate and interpret the cost of capital associated with leases; and debt and equity

LO4.7

**Long term financing, investment appraisal and dividend policy ** **LO6 **
Calculate and interpret measures of expected return and risk using the

probability distribution approach LO6.1

**Portfolio management ** **LO7 **

Calculate and interpret rates of return on financial investments LO7.1 Calculate and interpret measures of expected return and risk for

two-security portfolios

LO7.2 Explain the impact of portfolio leveraging and short selling on the risk and

expected return of two-security portfolios

LO7.3

Analyse and assess portfolio risk LO7.4