k R E R R = + + â
Franking credits So you as an individual who receives these dividends because you hold shares in the company are receiving an income that tax has already been paid on. Now you as an individual are separate from the company; you have to pay tax on your income at your marginal rate. The dividends you received are taxable income too and you will have to pay tax on the amount you receive, this results in double taxation. With the introduction of the dividend imputation system, investors who receive dividends will now only be taxed the difference between 30% and their own marginal tax rate since the company has already paid the 30% tax. Your tax liability = (dividends + franking credits (the tax that the company has paid) )* your marginal tax rate – franking credits
ke = R f + βe ⎡⎣ E ( RM + τ ) − R f ⎤⎦
Observed rates of return on shares do not include tax credits, therefore, adjustment is necessary to obtain true after-‐company-‐tax rates of return. Where t = franking premium (Part of the return on shares or a share market index that is due to tax credits associated with franked dividends). 3 steps to calculate WACC 1) Determine the permanent sources of capital the company utilizes. 2) Cost each component of capital based on current conditions. The historical cost of raising funds is irrelevant. Use market value of equity and debt. 3) Weight each component to determine the weighted average cost of capital — to do this, we need the value of each source of funds and total value of project. Calculate the cost of debt -‐ use market interest rate; suppose the company has a fixed rate debt paying at 5% per annum and the current market rate of the equivalent debt is at 7%, the company should use 7%. -‐ Calculate the effective annual interest rate for sources of debt. If current cost cannot be measured, estimate the rate that the company would now have to pay to raise those funds.
after-tax kd = before-tax kd (1-te )
this calculation assumes that the company is operating profitably and that there is no time lag in the payment of company income tax. Cost of short-‐term debt -‐ use effective annual rates -‐ exclude non-‐marketable short term debt such as taxes payable, wages payable and accounts payable, which do not have an explicit interest cost. The reason is not that these forms of debt are free, rather their costs are accounted for in other ways. For example the cost of accounts payable has already been deducted in calculating cash flows. Cost of long-‐term debt -‐ for those long term debt that doesn't have an explicit interest rate, one should estimate the current cost Calculate the cost of equity 1) CAPM approach
ke = R f + βe ⎡⎣ E ( RM + τ ) − R f ⎤⎦
2) DCF approach P0 =
D0 (1 + g ) D* (1 + g ) ke = 0 +g (ke − g ) P0
where D0* = current period dividend per share that includes the tax credit. Disadvantage of DCF approach: The result based on the DCF approach is very sensitive to the inputs of the DCR approach Calculate the cost of capital § Appropriate weights are the proportion that each source of funds represents of the total sources used to finance proposed projects. § Current capital structure can be used. – If capital structure expected to change, use company’s target capital structure. § Weights should be calculated using current market values rather than book values. – Consistent with the manner in which the costs of each source of funds have been calculated. – These values reflect the amounts investors can realise from selling their investment. Issue with firm wide WACC
E(R)
24% 17% 12%
Risk
If the firm applies the single discount rate K to all projects, then the project on the left will be rejected as its expected rate of return < K, even though its expected return > the required rate of return consistent with its systematic risk, β. Conversely, for the other project, the firm will accept it even though its expected rate of return < the required rate of return consistent with its systematic risk. The likely consequence for a diversified company that uses a single discount rate is that it will make incorrect investment decisions. It will accept projects with negative expected NPV and reject project with positive expected NPV. Where high systematic risk divisions will find their proposed projects to be more easily accepted and low systematic divisions will find their proposed projects to be more easily rejected. The systematic risk of the company will drift upward over time. WACC should be only used if the new project is not expected to change the company’s optimal or target capital structure. If the debt capacity of a new project differs from that of the existing projects, then this difference could affect the project’s cost of capital.
ke = R f + βe ⎡⎣ E ( RM + τ ) − R f ⎤⎦
Observed rates of return on shares do not include tax credits, therefore, adjustment is necessary to obtain true after-‐company-‐tax rates of return. Where t = franking premium (Part of the return on shares or a share market index that is due to tax credits associated with franked dividends). 3 steps to calculate WACC 1) Determine the permanent sources of capital the company utilizes. 2) Cost each component of capital based on current conditions. The historical cost of raising funds is irrelevant. Use market value of equity and debt. 3) Weight each component to determine the weighted average cost of capital — to do this, we need the value of each source of funds and total value of project. Calculate the cost of debt -‐ use market interest rate; suppose the company has a fixed rate debt paying at 5% per annum and the current market rate of the equivalent debt is at 7%, the company should use 7%. -‐ Calculate the effective annual interest rate for sources of debt. If current cost cannot be measured, estimate the rate that the company would now have to pay to raise those funds.
after-tax kd = before-tax kd (1-te )
this calculation assumes that the company is operating profitably and that there is no time lag in the payment of company income tax. Cost of short-‐term debt -‐ use effective annual rates -‐ exclude non-‐marketable short term debt such as taxes payable, wages payable and accounts payable, which do not have an explicit interest cost. The reason is not that these forms of debt are free, rather their costs are accounted for in other ways. For example the cost of accounts payable has already been deducted in calculating cash flows. Cost of long-‐term debt -‐ for those long term debt that doesn't have an explicit interest rate, one should estimate the current cost Calculate the cost of equity 1) CAPM approach
ke = R f + βe ⎡⎣ E ( RM + τ ) − R f ⎤⎦
2) DCF approach P0 =
D0 (1 + g ) D* (1 + g ) ke = 0 +g (ke − g ) P0
where D0* = current period dividend per share that includes the tax credit. Disadvantage of DCF approach: The result based on the DCF approach is very sensitive to the inputs of the DCR approach Calculate the cost of capital § Appropriate weights are the proportion that each source of funds represents of the total sources used to finance proposed projects. § Current capital structure can be used. – If capital structure expected to change, use company’s target capital structure. § Weights should be calculated using current market values rather than book values. – Consistent with the manner in which the costs of each source of funds have been calculated. – These values reflect the amounts investors can realise from selling their investment. Issue with firm wide WACC
E(R)
24% 17% 12%
Risk
If the firm applies the single discount rate K to all projects, then the project on the left will be rejected as its expected rate of return < K, even though its expected return > the required rate of return consistent with its systematic risk, β. Conversely, for the other project, the firm will accept it even though its expected rate of return < the required rate of return consistent with its systematic risk. The likely consequence for a diversified company that uses a single discount rate is that it will make incorrect investment decisions. It will accept projects with negative expected NPV and reject project with positive expected NPV. Where high systematic risk divisions will find their proposed projects to be more easily accepted and low systematic divisions will find their proposed projects to be more easily rejected. The systematic risk of the company will drift upward over time. WACC should be only used if the new project is not expected to change the company’s optimal or target capital structure. If the debt capacity of a new project differs from that of the existing projects, then this difference could affect the project’s cost of capital.
