MODULE 4

COST OF CAPITAL
Cost of capital is the rate of return that a firm must earn on its project investments to maintain
its market value and attract funds. Cost of capital is the required rate of return on its investments
which belongs to equity, debt and retained earnings.
If a firm fails to earn return at the expected rate, the market value of the shares will fall, and it
will result in the reduction of overall wealth of the shareholders.
Definitions
The following important definitions are commonly used to understand the meaning and concept
of the cost of capital.
According to the definition of John J. Hampton “Cost of capital is the rate of return the firm
required from investment in order to increase the value of the firm in the marketplace”.
According to the definition of Solomon Ezra, “Cost of capital is the minimum required rate of
earnings or the cut-off rate of capital expenditure”.
Selection of appropriate sources of finance

The need for finance Firms needs funds to:

• provide working capital.

• invest in non-current assets.

The main source of funds available is retained earnings, but these are unlikely to be sufficient to
finance all business needs.

Criteria for choosing between sources of finance

A firm must consider the following factors:

Short-term sources of finance

Working capital is usually funded using short-term sources of finance. Sources of short-term finance
include:

• bank overdrafts

• bank loans

• better management of working capital

• squeezing trade credit

• leasing

• sale and leaseback.

Long-term finance – equity

Types of share capital

Equity shareholders are the owners of the business and exercise ultimate control, through their voting
rights. The term equity relates to ordinary shares only. Equity finance is the investment in a company
by the ordinary shareholders, represented by the issued ordinary share capital plus reserves.

There are other types of share capital relating to various types of preference share. While strictly
preference shares are an equity source of finance, their characteristics bear more resemblance to debt
finance and so for the purposes of such calculations as gearing, they are part of debt rather than
equity.
Types of share capital

Raising equity

There are three main sources of equity finance:

1. Internally-generated funds – retained earnings

Internally-generated funds are earnings retained in the business (i.e. undistributed profits attributable
to ordinary shareholders). They are generated as a result of increased working capital management
efficiency and from successful short- and long-term projects. For an established company, internally-
generated funds can represent the single most important source of finance, for both short and long-
term purposes.

2. Rights issues

A rights issue is an offer to existing shareholders to subscribe for new shares, at a discount to the
current market value, in proportion to their existing holdings.

This right of pre-emption:

• enables them to retain their existing share of voting rights

• can be waived with the agreement of shareholders.

Shareholders not wishing to take up their rights can sell them on the stock market.

Advantages:

• it is cheaper than a public share issue

• it is made at the discretion of the directors, without consent of the shareholders or the Stock
Exchange

• it rarely fails.

TERP: The new share price after the issue is known as the theoretical ex-rights price and is calculated
by finding the weighted average of the old price and the rights price, weighted by the number of
shares.

Sum 1: Babbel Co, which has an issued capital of 2 million shares, having a current market value of
$2.70 each, makes a rights issue of one new share for every two existing shares at a price of $2.10.
Required: Calculate the TERP.

Sum 2: ABC Co announces a 2 for 5 rights issue at $2 per share. There are currently 10 million shares
in issue, and the current market price of the shares is $2.70. Required: Calculate the TERP.

Shareholders’ options

The shareholder’s options with a rights issue are to:

(1) take up their rights by buying the specified proportion at the price offered

(2) renounce their rights and sell them in the market

(3) renounce part of their rights and take up the remainder

(4) do nothing.
3. New external share issues – placings, offers for sale, etc.

Equity finance can also be raised through the sale of ordinary shares to investors via a new issue.

Placing

A placing may be used for smaller issues of shares (up to $15 million in value). The bank advising the
company selects institutional investors to whom the shares are ‘placed’ or sold. If the general public
wish to acquire shares, they must buy them from the institutions.

Unquoted companies may find it difficult to raise finance because:

• shares are not easily realisable.

• it is cheaper to invest in large parcels of shares rather than in many companies.

• small firms are regarded as riskier. However, unquoted companies can arrange for a placing of shares
with an institution.

However, there must usually be at least a prospect of eventually obtaining a quotation on the stock
exchange for the placing to be successful.
Choosing between sources of equity

When choosing between sources of equity finance, account must be taken of factors such as:

(1) the accessibility of the finance

(2) the amount of finance

(3) costs of the issue procedure

(4) pricing of the issue

(5) control

(6) dividend policy – using retained earnings could impact the share price

Long-term finance – debt

Long-term debt (bonds), usually in the form of debentures or loan notes, is frequently used as a source
of long-term finance as an alternative to equity. A bond is a written acknowledgement of a debt by a
company, normally containing provisions as to payment of interest and the terms of repayment of
principal.

Bonds are also known as debentures, loan notes or loan stock. They:

• are traded on stock markets in much the same way as shares

• are usually denominated in blocks of $100 nominal value

• may be secured or unsecured

• secured debt will carry a charge over:

– one or more specific assets, usually land and buildings, which are mortgaged in a fixed
charge.

– all assets – a floating charge.

On default, the loan note holders can appoint a receiver to administer the assets until the interest is
paid. Alternatively, the assets may be sold to repay the principal.

• may be redeemable or irredeemable.

Irredeemable debt is not repayable at any specified time in the future. Instead, interest is payable in
perpetuity. As well as some bonds, preference shares are often irredeemable. It should be noted that,
as a form of finance, irredeemable debt is very rare in reality.

If the debt is redeemable, the principal will be repayable at a future date.

Estimating the cost of equity – the Dividend Valuation Model (DVM)

The cost of equity finance to the company is the return the investors expect to achieve on their
shares.
Assumptions: DVM states that:
• 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.

Therefore: • Share price = Dividends paid in perpetuity discounted at the shareholder’s rate of
return.
DVM (assuming constant dividends)
The formula for valuing a share is therefore:
P0 = D
re
D = constant dividend from year 1 to infinity
P0 = share price now (year 0) re = shareholders’ required return, expressed as a decimal.
For a listed company, since the share price and dividend payment are known, the shareholders’
required return can be found by rearranging the formula:
re = D/ P0
Sum 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. Calculate the cost of equity.
DVM (assuming dividend growth at a fixed rate)
Although a firm’s dividends will vary year on year, a practical assumption is to assume a
constant growth rate in perpetuity. The share valuation formula then becomes:

Sum 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. Calculate the cost of equity of P Co.
Sum 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%, calculate the cost of equity.
The ex-div share price

Dividends are paid periodically on shares. During the period prior to the payment of dividends,
the price rises in anticipation of the payment. At this stage, the price is cum div. Sometime after
the dividend is declared, the share becomes ex div and the price drops. This may be expressed
diagrammatically:

Sum 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.
Sum 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. Calculate the cost of equity of D Co.
The earnings retention model (Gordon’s growth model)
Assumption • The higher the level of retentions in a business, the higher the potential growth
rate.
The formula is therefore:
g = bre
re = accounting rate of return on equity
b = earnings retention rate.
Sum 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. Calculate the cost of equity for the company.
Estimating the cost of preference shares
Preference shares usually have a constant dividend. So, the same approach can be used as we
saw with estimating the cost of equity with no growth in dividends. The formulae are therefore:
Sum 7: 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?
Redeemable Preference Share:
Kpr = D+1/n(MV-NP) x 100
½(MV+NP)
Sum 8: Coca Cola Ltd issued 9% preference shares of $100 each at a premium of 10%
redeemable after 5 years at par. Compute COC of preference share.

Sum 9: Azhar Ltd issued 50,000 10% preference shares of $100 each redeemable after 10
years at a premium of 5%. The cost of issue is $2 per share. Calculate COC.

Estimating the cost of debt

• The terms loan notes, bonds, loan stock and marketable debt, are used interchangeably. Gilts
are debts issued by the government.
• Irredeemable debt – no repayment of principal – interest in perpetuity.

• Redeemable debt – interest paid until redemption of principal.

• Convertible debt – may be later converted to equity.
Key points to note:
• Debt is always quoted in $100 nominal value blocks.

• Interest paid on debt is stated as a percentage of nominal value – called the coupon rate.
• The terms ex-interest and cum-interest are used in much the same way as ex-div and cum-
div was for the cost of equity calculations.
The coupon rate:
The coupon rate is fixed at the time of issue, in line with the prevailing market interest rate. An
8% coupon rate means that $8 of interest will be paid on $100 nominal value block of debt.
Cost of debt and the impact of tax relief
A distinction must be made between the required return of debt holders / lenders (Kd) and the
company’s cost of debt (Kd(1-T)). Although in the context of equity the company’s cost is
equal to the investor’s required return, the same is not true of debt. This is because of the impact
of tax relief.

Irredeemable debt
The company does not intend to repay the principal but to pay interest forever. Assumptions:
Market price (MV) = Future expected income stream from the debt discounted at the investor’s
required return. • expected income stream will be the interest paid in perpetuity. The formula
for valuing a loan note is therefore:

Sum 10: 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?
Sum 11: A company has irredeemable loan notes currently trading at $50 ex interest. The
coupon rate is 8% and the rate of corporation tax 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?
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).
Sum 12: A company has in issue 12% redeemable loan notes with 5 years to redemption.
Redemption will be at nominal value. The investors require a return of 10%. What is the MV
of the loan notes?
Sum 13: A company has in issue 12% redeemable debt with 5 years to redemption. Redemption
is at nominal value. 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)?

Sum 14: Using the same information as given in the previous question: A company has in issue
12% redeemable debt with 5 years to redemption. Redemption is at nominal value. The current
market value of the debt is $107.59. The corporation tax rate is 30%. What is the cost of debt
to the company (post-tax cost of debt)?
Sum 15: A company has in issue 10% loan notes with a current MV of $98. The loan notes are
due to be redeemed at nominal value in five years’ time. If corporation tax is 30%, what is the
company’s post-tax cost of debt?
Convertible debt
A form of loan note that allows the investor to choose between taking the redemption proceeds
or converting the loan note into a pre-set number of shares.
To calculate the cost of convertible debt you should:
(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.

Sum 16: A company has issued convertible loan notes that 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.
Non-tradeable debt
Bank and other non-tradeable fixed interest loans simply need to be adjusted for tax relief:
Cost to company = Interest rate × (1 – T).
Sum 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?
Weighted Average Cost of Capital (WACC)
A firm’s average cost of capital (ACC) is the average cost of the funds, normally represented
by the WACC. The computed WACC represents the cost of the capital currently employed.
Choice of weights
To find an average cost, the various sources of finance must be weighted according to the
amount of each held by the company. The weights for the sources of finance could be:
• book / nominal values (BVs/NVs) – represents historic cost of finance
• market values (MVs) – represent current opportunity cost of finance.
Wherever possible MVs should be used.
Calculating the WACC
The calculation involves a series of steps.
Step 1 Calculate weights for each source of capital.
Step 2 Estimate cost of each source of capital.
Step 3 Multiply proportion of total of each source of capital by cost of that source of capital.
Step 4 Sum the results of Step 3 to give the WACC.

Sum 18: Butch Co has $1 million loan notes in issue, quoted at $50 per $100 of nominal value
(book value also $50 per $100); 625,000 preference shares quoted at 40c (book value 30c per
share) and 5 million ordinary shares quoted at 25c (book value 20c per share). The cost of
capital of these securities is 9%, 12% and 18% respectively. This capital structure is to be
maintained.
(a) Calculate the weighted average cost of capital using market values
(b) Calculate the weighted average cost of capital using book values.
Sum 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 nominal value in five years’ time. If the rate of corporation tax is 33%,
what is the company’s WACC?
Sum 20: Ingham plc’s capital structure is as follows:
$m
50c ordinary shares 12
8% $1 preference shares 6
12.5% loan notes 20X6 8
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26
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The loan notes are redeemable at nominal value in 20X6. The current market prices of the
company’s securities are as follows.
50c ordinary shares 250c
8% $1 preference shares 92c
12.5% loan notes 20X6 $100

The company is paying corporation tax at the rate of 30%. The cost of the company’s ordinary
equity capital has been estimated at 18% pa. What is the company’s weighted average cost of
capital for capital investment appraisal purposes?

Systematic and unsystematic risk

The risk a shareholder faces is in large part due to the volatility of the company’s earnings.
This volatility can occur because of:
• systematic risk – market wide factors such as the state of the economy
• unsystematic risk – company/industry specific factors.
Systematic risk will affect all companies in the same way (although to varying degrees). For
example, the vast majority of companies suffer in a recession but not necessarily to the same
extent – e.g. house-builders typically suffer more than bakers.
Unsystematic risk factors don't affect everyone; indeed, their impact may be unique to an
individual company or restricted to a small number of companies, with some being winners
and some being losers. 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.