Cost of Captial

1 Introduction

- This is much more important, in order to appraise investments

the company needs to know the cost of capital to use. The
calculations in this chapter will start to help us to calculate
this cost of capital.

- We identify the main source of long-term finance within a

company as:

Equity (or ordinary shares)

Preference share
Debt

- The return demanded by equity holder/debt holder is

dependent on two specific factors:

Risk vs. Reward

Prevailing risk-free rate (Rf) of return: minimum rate
required by all investors for an investment whose return
are certain (return on treasury bills and return on
government gilts)

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2 Estimating the cost of equity

2.1 Dividend growth model

- The dividend growth model can be used to estimate a cost of

equity, on the assumption that the market value of share is
directly related to the expected future dividends from the
shares.

2.1.1 DVM (assuming constant dividends)

Formula:

Po = D
Re
Where,

P0= Share price now (Year 0)

D= Constant dividend from year 1 to infinity

Re= Shareholders required return

Cost of equity: (Arranging the formula)

Formula:

Re = D
Po

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Question 1

A company has paid a dividend of 30c for many years. The

company expects to continue paying dividends at this level in the
future. The company’s current share price is $1.50

Required:

Calculate the cost of equity

2.1.2 DVM (assuming dividend growth at a fixed rate)

- In reality growth is not constant but assuming a constant

growth rate in perpetuity.

Formula:

Po = Do (1+g)
Re –g
Cost of equity formula (arranging the formula):
Re = Do (1+g) + g
Po

Where,
D0 (1+g)= Dividend just paid, adjusted for one year's growth
D1= Dividend to be received in one year- i.e. at T1

g= constant rate of growth in dividends

Re= Shareholders required return

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Question 2

P Co has just paid a dividend of 10c. Shareholders expect dividends

to grow at 7% pa.P Co’s current share price is $2.05.

Required

Calculate the cost of equity of P Co.

Question 3

A company has recently paid a dividend of $0.23 per share. The

current share price is $3.45. If dividends are expected to grow at
an annual rate of 3%

Required:

Calculate the cost of equity

The ex-div share price

- Cum dividend or cum div means the purchaser of shares is

entitled to receive the next dividend payment.
- Ex-dividend or ex div means that the purchaser of shares is
not entitled to receive the next dividend payment.

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The relationship between the cum-div price and the ex-div price is:

Market price per share (ex div) = Market price per share (cum div)
– forthcoming dividend per share.

Note: Po represents the "ex div" share price. A question may give
you the cum div share price by stating that the dividend is to be
paid shortly.

Question 4

The current share price is 140c and a dividend of 8c is due to be

paid shortly.

Required:

Calculate the value of P0, the ex div share price.

Question 5

D Co is about to pay a dividend of 15c. Shareholders expect

dividends to grow at 6% pa. D Co’s current share price is $1.25.

Required:

Calculate the cost of equity of D Co.

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2.1.2.1 Estimating the growth rate

- There are two methods for estimating the growth rate that
you need to be familiar with.

I) Past dividends

Example: 1

Year Dividends Earnings

$ $
20X1 150,000 400,000
20X2 192,000 510,000
20X3 206,000 550,000
20X4 245,000 650,000
20X5 262,350 700,000

Dividends have risen from $150,000 in 20X1 to $262,350 in 20X5.

The increase represents four years' growth. (Check that you can
see that there are four years' growth, and not five years' growth,
in the table.)

The (geometric) average growth rate, g, may be calculated as

follows.

Dividend in 20X1 * (1 + g)4= Dividend in 20X5

(1 + g)4= Dividend in 20X5
Dividend in 20X1
(1 + g) =$262,350
4

$150,000
(1 + g) =(1.749)1/4
g =1.15-1
g =0.15 or 15%

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The growth rate over the last four years is assumed to be expected
by shareholders into the indefinite future. If the company is
financed entirely by equity and there are 1,000,000 shares in issue,
each with a market value of $3.35 ex div, the cost of equity, Ke,
is:
Ke = Do (1+g) + g
Po
Ke = 0.26235*(1+0.15) + 0.15
3.35

=3.35 + 0.15 = 0.24, ie 24%

II) Gordon's growth approximation

g = br
Where g is the annual growth rate in dividends
b is the proportion of profits that are retained
r is the rate of return on new investments

Question 6
A company is about to pay an ordinary dividend of 16c a share.
The share price is 200c. The accounting rate of return on equity is
12.5% and 20% of earnings are paid out as dividends.

Required:
Calculate the cost of equity for the company.

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2.1.3 Assumption of DVM
- Future income stream is the dividends paid out by the
company

- Dividends will be paid in perpetuity

- Dividends will be constant or growing at a fixed rate

2.1.4 Weaknesses of the dividend growth model

- Dividends do not grow smoothly in reality, so g is only an
approximation

- It assumes there are no issue costs for new shares

- It does not produce meaningful results where no dividend is

paid (if d is zero, Ke is 0)

- The model does not explicitly incorporate risk

2.2 Capital asset pricing model (CAPM)

- The capital asset pricing model can be used to calculate a cost
of equity and incorporates risk.

- The CAPM is based on a comparison of the systematic risk of

individual investments with the risks of all shares in the
market.

- It states that when investor face extra risk they requires risk
premium for taking that risk

- Required return= risk-free return + risk premium

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2.2.1 Portfolio theory
- Portfolio theory suggests that investors can reduce the total
risk on their investments by diversifying their portfolio of
investments.

2.2.2 Systematic risk and unsystematic risk

- Systematic risk
It is the risk which affects all companies in the same way
but at varying degrees
Example: recession but not at same degree to all
Even when a portfolio has been well‐diversified over a
number of different investments, there is a limit to the
risk‐reduction effect, so that there is a level of risk
which cannot be diversified away. This undiversifiable
risk is the risk of the financial system as a whole, and so
is referred to as systematic risk or market risk.

- Unsystematic risk
Diversifiable risk (unsystematic risk), which is the
element of total risk which can be reduced or minimised
by portfolio diversification, is referred to as unsystematic
risk or specific risk, since it relates to individual or
specific companies rather than to the financial system as
a whole.
For example, the weather: if we have a wet summer then
raincoat manufacturers will benefit but sunglasses
manufacturers will suffer. However, for the majority of
businesses, it won't make any difference. Overall, the
stock market is unlikely to be affected much by the
weather.

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Question 7

The following factors have impacted the volatility of the earnings

of Chocbic Co, a manufacturer of chocolate biscuits and cereals:

- increase in interest rates

- increase in the price of cocoa beans
- legislation changing the rules on tax relief for investments in
noncurrent assets
- growth in the economy of the country where Chocbic Co is
based
- government advice on the importance of eating breakfast
- industrial unrest in Chocbic Co’s main factory.

Are they sources of systematic or unsystematic risk?

CAPM Formula:

E(r)= Rf + beta (β)*(Rm-Rf)

Where,
E(r)=Expected return on investment
Rf = Risk-free rate of return
Rm = expected average return on the market
Beta(β )= systematic risk of investment

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2.2.3 Systematic risk and the CAPM

- The CAPM is mainly concerned with how systematic risk is

measured, and how systematic risk affects required returns
and share prices. Systematic risk is measured using beta
factors.

Understanding beta:
- If an investment is riskier than average (i.e. the returns more
volatile than the average market returns) then the β > 1
- If an investment is less risky than average (i.e. the returns
less volatile than the average market returns) then the β < 1
- If an investment is risk free then β = 0.

Question 8

The current average market return being paid on risky investments

is 12%, compared with 5% on Treasury bills. G Co has a beta of
1.2.

What is the required return of an equity investor in G Co?

Question 9

B Co is currently paying a return of 9% on equity investment. If

the return on gilts is currently 5.5% and the average return on the
market is 10.5%

What is the beta of B Co and what does this tell us about the
volatility of B’s returns compared to those of the market on
average?

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2.2.3 Assumptions
- Well diversified investors
- Perfect capital market
- Unrestricted borrowing or lending at the risk free rate of
interest
- All forecasts are made in the context of a single period
transaction horizon
- Linear relationship between the return obtained from an
individual security and the average return from all securities
in the market.

2.2.4 The advantages and disadvantages of CAPM

- Advantages:
Works well in practice
Focuses on systematic risk
Is useful for appraising specific projects.

- Disadvantage
Less useful if investors are undiversified
Ignores tax situation of investors
Actual data inputs are estimates and may be hard to
obtains

2.3 Cost of preference shares

Formula:
Kp= D
Po

Where,
D= constant annual preference dividend
Po= Ex div MV of the share
Kp= Cost of the preference share
Note: Do not assume nominal value is always $1

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 Question 10

A company has 50,000 8% preference shares in issue, nominal

value $1. The current ex div MV is $1.20/share.

What is the cost of the preference shares?

3 Estimating the cost of debt

3.1 Cost of debt and the impact of tax relief

- 'Kd': The required return of the debt holder (pre-tax)

- 'Kd (1 – T)': The cost of the debt to the company (post tax)

3.2 Types of debt

Irredeemable

Traded Redeemable

Types of debt Convertible

Non-traded Bank Loan

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3.2.1 Irredeemable debt
- The company does not intend to repay the principal but to pay
interest forever.

The formula for valuing a loan note is therefore:

MV= I
Kd

Where,
I = Annual interest starting in one year's time
MV= Market price of the loan note now (year 0)
Kd = Debt holders’ required return (pretax cost of debt), expressed
as a decimal.

The required return (pre-tax cost of debt) can be found by

rearranging the formula:

Kd = I
MV

The required return (post-tax cost of debt) can be found by

rearranging the formula:

Kd(1-T) = I (1-T)
MV

Where,
T = Rate of corporation tax

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Question 11

A company has in issue 10% irredeemable debt quoted at $80 ex

interest. The corporation tax rate is 30%

a) What is the return required by the debt providers (the pre-tax

cost of debt)?
b) What is the post-tax cost of debt to the company?

3.2.2 Redeemable debt

- The company will pay interest for a number of years and then
repay the principal (sometimes at a premium or a discount to
the original loan amount).

Expected income stream will be:

- Interest paid upto redemption
- The repayment of the principal

Hence, the market value of redeemable loan notes is the sum of

the PVs of the interest and the redemption payment

Question 12

A company has in issue 12% redeemable loan notes with 5 years

to redemption. Redemption will be at par. The investors require a
return of 10%.

What is the MV of the loan notes?

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Question 13

A company has in issue 12% redeemable debt with 5 years to

redemption. Redemption is at par. The current market value of the
debt is $107.59. The corporation tax rate is 30%.

What is the return required by the debt providers (pre-tax cost of

debt) and (post-tax cost of debt)?

Question 14

A company has in issue 10% loan notes with a current MV of $98.

The loan notes are due to be redeemed at par in five years’ time.
If corporation tax is 30%.

What is the company’s post tax cost of debt?

3.2.2.1 Debt redeemable at current market price

- In this situation, where the debt is redeemable at its current

market price, the position of the investor is the same as a
holder of irredeemable debt.

Question 15
- An irredeemable loan note trading at $100 with a coupon rate
of 5%
- A redeemable loan note trading at $100 with a coupon rate of
5%, due to be redeemed at $100 in 3 years.

Find the return required by an investor (pre-tax cost of debt)

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3.2.3 Convertible debt

1. Calculate the value of the conversion option using available

data
2. Compare the conversion option with the cash option. Assume
all investors will choose the option with the higher value.
3. Calculate the IRR of the flows as for redeemable debt

Note: There is no tax effect whichever option is chosen at the

conversion date.

Question 16

A company has issued convertible loan notes which are due to be

redeemed at a 5% premium in five years’ time. The coupon rate is
8% and the current MV is $85. Alternatively, the investor can
choose to convert each loan note into 20 shares in five years’ time.
The company pays tax at 30% per annum. The company’s shares
are currently worth $4 and their value is expected to grow at a rate
of 7% pa.

Find the post-tax cost of the convertible debt to the company.

3.2.4 Non tradable debt

- Bank and other non-tradable fixed interest loans simply need
to be adjusted for tax relief:
Cost to company = Interest rate × (1 – T)

Alternatively, the cost of any 'normal' traded company debt could

be used instead

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Question 17

A firm has a fixed rate bank loan of $1 million. It is charged 11%

pa. The corporation tax rate is 30%.

What is the post-tax cost of the loan?

4 Weighted average cost of capital (WACC)

- These funds are used, partly in existing operations and partly

to finance new projects.
- There is not normally any separation between funds from
different sources and their application to specific projects

Equity

Used to
Pool of finance
different
fund project

Debt

Note: Even if a question tells you that a project is to be financed

by the raising of a particular loan or through an issue of shares, in
practice the funds raised will still be added to the firm’s pool of
funds and it is from that pool that the project will be funded.

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4.1 Weighting

The weights for the sources of finance could be:

- Book values (BVs): Represents historic cost of finance
- Market values (MVs): Represent current opportunity cost of
finance.

Note: Market values should always be used if data is available.

4.2 Calculation WACC Pro-forma

Particular (V)MV ($) Cost of Capital (K) V*K

Equity XXX X% XXX
Debt XXX X% XXX
Preference share XXX X% XXX
Total XXX XXX

WACC= ∑V*K
∑V
Where,
MV of Equity = Market value of each share × no. of shares in issue
MV of Debt =Total Nominal Value of debt ∗ MV of Debt
100

Formula:

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Question 18

An entity has the following information in its statement of financial

position.
$'000
Ordinary shares of 50c 2,500
12% unsecured loan notes 1,000

The ordinary shares are currently quoted at 130c each and the loan
notes are trading at $72 per $100 nominal. The ordinary dividend
of 15c has just been paid with an expected growth rate of 10%.
Corporation tax is currently 30%.

Calculate the weighted average cost of capital for this entity.

(Ans: 21.59%)

Question 19

B Co has 10 million 25c ordinary shares in issue with a current

price of 155c cum div. An annual dividend of 9c has just been
proposed. The company earns an accounting rate of return to
equity (ROE) of 10% and pays out 40% of the return as dividends.
The company also has 13% redeemable loan notes with a nominal
value of $7 million, trading at $105. They are due to be redeemed
at par in five years’ time. If the rate of corporation tax is 33%,

What is the company’s WACC?

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4.3 Marginal cost Vs Average cost
Sam has the following capital structure.
After-tax cost Market value After-tax cost* Market value
Source % $m
Equity 12 10 1.2
Preference 10 2 0.2
Loan notes 7.5 8 0.6
20 2.0

Weighted average cost of capital = 2 *100%

20
= 10%

Sam directors have decided to embark on major capital

expenditure, which will be financed by a major issue of funds. The
estimated project cost is $3,000,000, one third of which will be
financed by equity, two thirds of which will be financed by loan
notes. As a result of undertaking the project, the cost of equity
(existing and new shares) will rise from 12% to 14%. The cost of
preference shares and the cost of existing loan notes will remain
the same, while the after-tax cost of the new loan notes will be 9%.

Required
Calculate the company's new weighted average cost of capital, and
its marginal cost of capital.

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 New weighted average cost of capital
After-tax cost Market value After-tax cost* Market value
Source % $m
Equity 14 11 1.54
Preference 10 2 0.20
Old loan notes 7.5 8 0.60
New loan notes 9 2 0.18
23 2.52

WACC = 2.52 *100%

23
= 11.0%

Marginal cost of capital = (2.52-2.0) *100%

23-20
= 17.3%

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4.4 Use of WACC as a discount rate for investment appraisal

- If Four criteria are met:

Investment relatively small (if large it would effect
WACC)
Project finance by pool fund
Capital structure unchanged (Debt: Equity) (Unaltered
Financial risk)
Same industry as the company (Unaltered Business
risk)

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