Financial Management : WACC calculation formula & dividend policy

Three key decisions made by a Financial Manager :-
A. Dividend decision
B. Investment decision
C. Financial decision


A. DIVIDEND DECISION
2 key considerations are :-
i) Can we afford to pay dividend? This could be influenced by (which must be considered by company) legal position, levels of performance and free cash flow, expectations of shareholder, optimal gearing position, inflation, control, tax, liquidity and other sources of finance.

ii) How much can we afford to pay? Key determinant are dividend capacity and free cash flow to equity. Dividend can be paid either by cash (for cash rich company) or by shares (right issue or bonus issue)


In practice, there are a number of commonly adopted dividend policy:-
a ) Stable dividend policy - dividend paid are constant, but take into account the inflation rate, to satisfy investor.
b) Constant payout % - constant % of dividend on Profit After Tax, every year.
c) Residual approach - Should there be a positive NPV project available, the cash to fund the project are the first priority before dividend payout.
d) Zero payout - No dividend, usually for start-up company that need sufficient fund to grow.


B. FINANCING DECISION
Finance could be sourced either by debt or equity. However, the main concern of the company is that of the Cost of Finance, which is WACC (Weighted Average Cost of Capital). Company usually opt for lowest WACC.
Use of WACC --> Discount factor for appraising capital project (lower WACC, give a higher NPV, in order to maximise shareholders' wealth)
Used for business valuation.(The lower WACC, the higher the company's value).

Sources of Finance :-
i) Equity (Ke)
ii) Preference shares (Kp)
iii) Debt (Kd)

All of the formula below are very important in P4 ACCA examination, because most of the formulas are not provided in book, and in exam sheet. For calculation of one items, there are multiple formulas that could be used to calculate it. To use which formula, it depends on what information that provided in the scenario in the exam, which will be explained briefly below :-

A. CALCULATION OF WACC (Ko)
There are 2 types of formulas used to calculate WACC. (WACC = Ko)
i. Traditional (formula will be given in exam sheet) - use this formula only when all elements needed to calculate WACC are provided in exam question scenario.

Ko = (Ke x e/Mc) + (Kd x d/Mc)x(1-T)

e = Market value of equity
d = Market value of debt
Mc = Market Capitalisation (e + d)
T = Tax rate

ii) Modigliani and Miller (This formula will NOT be given in the exam sheet, so have to memorise, this formula will be used when there is a missing element in the information given in the exam scenario question)

Ko =  Keu (1-DT/(D + E))

Keu = Cost of equity in an equivalent ungeared firm
D = Market value of debt
E = Market value of equity
T = Rate of tax

a) Calculation of Cost of Equity (Ke)
Please take note that The Cost Of Equity to the business is the same as the required Return to The Equity Investors.

There are 3 ways to calculate Ke - namely :-
i) DVM (if given level of dividend & rate of growth)
ii) CAPM (If given the rate of risk & return)
iii) Modigliani and Miller(there are missing element & Level of Gearing are given)

i) DVM method 
Ke = (D(1+g)/Po) + g 

D(1+g) = future dividend
Po = Current share price (ex-div)
D = use current dividend
g = rate of growth

Growth - exist when there is money retained to be reinvested, indicating growth. There are 2 ways to calculate growth (g)
 
a. Averaging (Historic)
g = (n √Di / Dn) - 1
Di = current dividend
Dn = dividend in the past
n = No. of years changing

b. Gordon's (Earning Retention Model) - given in exam

g = rb
r = Rate of return on reinvested funds (ARR or ROCE)
b = proportion of funds retained (minus % of funds distributed as dividends After Tax), which is PAT-div

ii) CAPM

Ke = rf + (rm - rf)ß
rf = risk free rate (return on government security)
rm = expected return on market
(rm - rf) = Equity risk premium (maybe given as a whole in exam)
ß = beta factor (level of systematic risk faced by an investor)

iii) Modigliani and Miller
Keg = Keu + (Keu - Kd) (D(1-T)/E)
Kd = Pre-tax cost of debt (Cost of debt x (1-T))

b) Calculation of Cost of Preference Shares (Kp)
-The cost of preference shares is the same as the return to the preference shares to investors.

Kp = D / Po

D = Dividend
Po = ex-div market price of company's preference shares

c) Calculation of cost of debt (Kd)
The cost of debt to the company is not the same as the return to the debt investors. This is because the company receives a tax reluef on the interest payment, where at the investors of debt receives their interest growth (pre-tax).

Debt can be categorised into TRADEABLE and NON-TRADEABLE

I) For TRADEABLE debt such as debentures, it could be categorised into REDEEMABLE & NON-REDEEMABLE

i) Irredeemable - unlimited life
Kd  = $I (1-T)/Po
$I = Interest paid, in monetary value (coupon rate x nominal value of debenture)
T = rate of tax
Po = ex-interest of the market value of debt

ii) Redeemable - Limited life, will be redeemable or paid back at certain fixed date in the future
Kd = IRR (1-T)
IRR = Internal Rate of Return
T = Rate of tax

II) Non-tradeable debt, such as bank-loan

Kd = %I (1-T)

%I = Interest paid in percentage
T = Rate of tax

2 comments:

  1. Hey did your facebook have problems?

  1. Alex_yerevan said...:

    hi,
    nice post, thanks!

    This formula for the cost of irredeemable debt Kd = $I (1-T)/Po

    Where does it come from?

    There is case in BPP text book p4 where they calculate the cost of debt as Kd = I/Po(1-T), so I wonder if there is a misprint

    Thanks

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