September 2006 Q19

[maz1987]

Explain why it may be difficult for companies to determine their cost of equity in order to measure the WACC.


The solution discusses investors using the cost of equity to discount future cashflows, but because companies do not know the cashflows used in the investors' calculation they cannot determine the return on capital required by investors.

However in my answer I focussed on the CAPM model and discussed the limitations with it i.e. the company cannot know how diversified the investors' portfolios are, they do not know which value of beta investors are using, do not know the market equity premium, etc. Would I have lost marks here for not mentioning that companies do not know the future cashflows used by investors? I guess I went for a more theoretical approach using the CAPM where the cashflows themselves don't determine the cost of equity rather than investors analysing the cashflows and the risks associated with them, and determining a required return on equity accordingly.

Thanks

 

[Colin McKee]

cost of cap

Hi, there is a littl bit amount of flexibility in the marking structure to award other ideas, or other ways of saying the same ideas. However one or two of the things you have mentioned below dont seem to quite ring true.

However in my answer I focussed on the CAPM model and discussed the limitations with it i.e. the company cannot know how diversified the investors' portfolios are,


(This doesnt seem to be relevant. If an investor's portfolio is diversified or not, does not affect the allowance for systematic risk. Nor would it affect the investors discount rate. It may affect whether the investor ends up lucky with a high return, (or not!) but it wouldnt impact the investors rate)

they do not know which value of beta investors are using,

(again, you dont need to know this as a company manager. Everyone is free to do what they want. All the manager wants to know is, based on the movements of the share in the market, which is governed by ALL investors, how risky in the company perceived.)

do not know the market equity premium, etc.

(this is fine, and is discussed in the examiners report. Measuring the ERP is not at all easy)

Would I have lost marks here for not mentioning that companies do not know the future cashflows used by investors?

(This seems like the examiner is saying, investors find it hard to know what future return they will get from an investment in the company's shares. The concept of future cashflows is unusual. But if someone asked you what return you "expect" or "require" from a company's share, you would probably forecast the dividends and capital growth you expect and equate it to the current share price to give you an internal rate of return. So the examiners has got on to the subject of future dividends and cashflows.)


I guess I went for a more theoretical approach using the CAPM where the cashflows themselves don't determine the cost of equity rather than investors analysing the cashflows and the risks associated with them, and determining a required return on equity accordingly.

(It is a compex area. there are two ways of determining expected return. 1. analyse future cashflows and equate to the price to get an expected return. 2. Look at the riskiness or beta in the market, assume that other investors have got the cashflow calculations right and use the market beta, then combine that with an equity risk premium (which might require you to forecast future "market" cashflows or use historical returns). Sounds like you took the second approach. You would have got marks for this I suspect. The examiners second para covers some of these ideas.)

 

[maz1987]

Thanks for the reply

Hi, there is a littl bit amount of flexibility in the marking structure to award other ideas, or other ways of saying the same ideas. However one or two of the things you have mentioned below dont seem to quite ring true.

However in my answer I focussed on the CAPM model and discussed the limitations with it i.e. the company cannot know how diversified the investors' portfolios are,


(This doesnt seem to be relevant. If an investor's portfolio is diversified or not, does not affect the allowance for systematic risk. Nor would it affect the investors discount rate. It may affect whether the investor ends up lucky with a high return, (or not!) but it wouldnt impact the investors rate)

It doesn't affect the allowance for systematic risk, but I can't see why the level to which an investor's portfolio is diversified wouldn't affect the investors' discount rate. Surely investor A would discount future cashflows at a rate that reflects the riskiness of the investment to his portfolio. If his portfolio is not diverse, they will require a higher return, because the project has increased systematic risk, no? I know that he *should* have a diverse portfolio, but isn't that the whole point: that we don't know for sure? Then apply the same to investor B, C, D,... until you have the entire market. Does the assumption become that investor A may not have a diverse portfolio, but the market as a whole does have a diverse portfolio?

they do not know which value of beta investors are using,

(again, you dont need to know this as a company manager. Everyone is free to do what they want. All the manager wants to know is, based on the movements of the share in the market, which is governed by ALL investors, how risky in the company perceived.)

As before, when we look at investor A, he will discount the cashflows at his own rate. And that rate will be different to investor B, and investor C, and so on. And isn't that discount rate their required return on equity invested? In which case, if we did know that their portfolio was diverse, and we did know the value of beta each investor is using, then we can work out the required return on equity for each investor, and thus find a general market rate.

do not know the market equity premium, etc.

(this is fine, and is discussed in the examiners report. Measuring the ERP is not at all easy)

 

[maz1987]

Wanted to add something. Your reply of "The concept of future cashflows is unusual" got me thinking that maybe I'd misinterpreted the part of the course about shareholders analysis future dividend returns to mean that they discount future cashflows of a project in order to determine whether it will add or take away from the current share price.

But the solution to April 2012 Q20 (ii) says that "logically, the shareholders will evaluate projects using their own evaluation of risk and return and the share price will decline if the company accepts projects that have a negative NPV when evaluated in the shareholders' terms."

From what I understand, the course says that investors analyse the company, and projects the company will take on, and discount the cashflows at their own required rate of return to determine the NPV of the cashflows. In my solution, it was the uncertainty of determining this discount rate (i.e. required rate of return = the cost of equity) that the question was looking for us to delve into. Is this wrong?

Many thanks.

 

[Colin McKee]

diversification

It sounds like the core difference here is two different interpretations of the key factors. Both solutions answer the question, but the examiner majors on one, when you major on another. Its hard to avoid this in some questions.
However, my experience of most CT2 questions is that it is wrong to say that an investor will use a different discount rate to another investor because his portfolio is not as diversified. I suppose the idea is that if an indiversified investor tried to use a higher rate for an investment, then he will get a low value for the investment. Because there are lots of diversified investors out there who will get a higher value for the investment, and will be prepared to pay that for the investment, the undiversified investor will never get the investment anyway. It will be snapped up at a higher price. the same applies to a company considering projects, and trying to use a different rate because they are undiversified.
However, each investor will have a different feeling for the riskiness of a business. So someone wll feel Tescos business is risky and needs a high return. But they measure the beta which is low, and measure its historical return, which is low, and decide that the investment is not for him. So in this way every investor makes their own personal choices, but overall in the market, the equilibrium reflects the "average" investor.