ñòð. 19 |

32

pronounced â€˜cee â€“ oh â€“ ceeâ€™. There are two similar terms. CoE refers to the cost of equity and perhaps

confusingly is usually pronounced â€˜cee â€“ oh â€“ eeâ€™. Finally, the term CoD refers to the cost of debt. I

have heard this referred to either as â€˜codâ€™ or â€˜cee â€“ oh â€“ deâ€™.

49 Building block 2: Financial markets

At this stage it might look as though the cost of debt and the cost of equity

would be decided upon through two separate and independent calculations.

This is not, however, how things work. The key principle for this section con-

cerns how debt and equity interact. We will learn how risk is concentrated

on the equity portion of finance and how a vital implication of this is that the

cost of equity will change every time the amount of borrowing changes.

The capital asset pricing model

The capital asset pricing model (CAPM33 for short) suggests that there should

be a simple linear relationship between risk and required return. The model

was proposed in the 1960s by three economists led by William Sharpe. A

particular feature of the model concerns how they chose to define risk. We

will come back to this point in the final building block which deals specifi-

cally with the question of risk. For the time being, however, we can make

some good progress if we simply accept the concept of a linear relationship

between risk and required return.

The model is summarised in the following chart. The basic idea is that the

line which specifies required returns is the straight line between the risk-

free rate and the return required by investors who invest in a portfolio of all

the shares on the stock market.

The particular jargon of the model is as follows:

Required

Return

rM

rF

Risk of a

Risk

typical share

Fig. 2.1 The capital asset pricing model

Pronounced â€˜cap emâ€™.

33

50 The five financial building blocks

â€¢ the risk-free rate is referred to as rF;34

â€¢ the return required by investors who invest in a portfolio of all the shares

on the stock market is referred to as rM;

â€¢ the line linking these two points is referred to as the security market line;

â€¢ risk is characterised by a term given the Greek letter Î² (beta). This is

explained later in this book.

There is some clever economic thinking behind why the line has to be straight

but we do not need to concern ourselves with this. All we need to know for

now is that there is an accepted way of linking required return to risk and

that this comes through CAPM.

Armed with CAPM we can calculate the cost of equity for any particular

situation. We can then combine this with the cost of debt in order to calculate

the CoC. The expression WACC,35 short for weighted average cost of capital,

is used for this because the calculation weights the two costs in proportion to

the amount of money provided. We will see what the WACC numbers should

look like soon, but first we have to consider one more piece of theory. This

concerns how the risk inherent in equity changes with the level of debt.

Risk is carried on equity

Debt represents a fixed obligation for a borrower. In any year, the amount of

money left over for the equity shareholders will equal the total cash genera-

tion less this fixed obligation. Anything which increases the fixed commit-

ments must mean that the remaining variable commitments will be more

exposed and that, in the limit, there is a greater chance that the company

will run out of money. Now think about the fact that we can never be certain

what a companyâ€™s future cash generation will be. This is what we mean when

we say that cash flows are risky. The combination of uncertain cash inflows

and fixed flows due to borrowing serves to reduce the amount of equity that

is needed but it increases the volatility of the residual equity returns. This is

best illustrated through a simple example:

Practical example â€“ how debt makes companies more risky

This example develops the scenario first introduced as the Grand Design (exam-

ple 2) in the first building block. It concerns a plan to purchase land and then

develop a house for subsequent sale. Suppose that instead of funding all of the

For the US market the risk-free rate is generally considered to be the interest rate on 90 day US T

34

bills.

Pronounced â€˜whackâ€™.

35

51 Building block 2: Financial markets

project from a single source, it was financed by a blend of debt and equity. Say

that the development company borrows a specified percentage of the original

cost of the plot and repays this loan along with all accumulated interest when the

house is finally sold. 36

The revised assumptions follow. The new assumptions concern the borrowing as

a percentage of the plot price and also the cost of debt.

Grand Design â€“ with finance

ASSUMPTIONS

Plot price â€“ $ 1,450,000

D & A expense â€“ $ per year 50,000

D & A period â€“ year 2.0

Demolish & build cost â€“ $ 850,000

Build time â€“ years 1.0

Selling price â€“ $ 3,000,000

Cost of capital â€“ % 8.0%

Borrow as % plot price 80.0%

CoD 5.0%

The initial cash outflow for the investor on the land purchase is reduced by 80%

but in return there is a need to repay the loan plus interest out of the sales proceeds.

Now readers should recall from the previous building block (page 9) that the need

to exclude finance effects from cash flows was stressed. This example will help to

explain why this needs to be done by illustrating what happens if the instruction is

ignored.

The revised financial model makes the following adjustments in order to incorpor-

ate the effect of finance on the project:

â€¢ A debt repayment factor is calculated. This calculates the amount of money nec-

essary to repay the loan and the principal. It is equal to one plus the interest rate

raised to the power of the number of years between land purchase and the final

house sale.

â€¢ The cash flows are referred to as equity cash flows in order to distinguish them

from cash flows before any financing effects.

â€¢ The plot purchase is now net of the borrowing and is calculated by multiplying

the purchase price by one minus the borrowing percentage.

â€¢ The sales proceeds are shown net of the loan repayment.

This would be quite a normal thing for a property company to do and a bank would consider a loan

36

ñòð. 19 |