TECHNICAL | IFIN

Get capital-lettered
Kirsty Flint
Cost of capital is one of the key topics on the intermediate level Finance syllabus, so students need to know the underlying theories as well as how to do the calculations

n any area of business, the return thats generated from performing an activity needs to exceed the cost of employing the resources to do that activity. This is no different for financial management. The return generated from the activities the company invests in must exceed the cost of financing these projects. If that is achieved, value will be created for the investors. This is where the cost of capital comes in. The cost of capital represents the percentage annual rate of return required to reward investors for the level of risk they have accepted. It is the hurdle rate above which the companys projects need to generate a return in order to satisfy the providers of that capital. If the cost of capital is the hurdle rate, logic says that this should be the discount rate used when calculating the net present value (NPV) of potential future projects. If the projects cash flows generate a positive NPV at the weighted-average cost of capital, the company will have added to its investors wealth. The cost of capital is therefore important because it provides the link between the investment decision (ie, what should the company invest in?) and the finance decision (ie, how should the company finance its investment?). But how do we go about calculating it? Consider the example in panel 1, above. The first step is to calculate the individual costs of capital: the cost of equity (Ke), the cost of preference shares (Kp) and the cost of debt (Kd). From the formula sheet given in the intermediate level Finance exam, we can see that: Ke = Do(1 + g) + g Po Kp = d Po Kd = I(1 t) Po These formulas all start from the same premise: that the required rate of return is a function of the investors expectations of future cash flow returns expressed as a percentage of the current value of their investment. The cost of equity share capital 18 CIMA Insider September 2003

1 Calculating the cost of capital

A company has the following capital structure: l 2,000,000 50p ordinary shares 1,000,000 l 1,000,000 6% 100p preference shares 1,000,000 l 5% irredeemable debentures 500,000 The ordinary shares are quoted at 124p cum dividend, and the dividend about to be paid is 13p per share. Dividends are expected to grow by 2 per cent every year. The preference shares are quoted at 63p and the debentures 72. The preference dividend and interest has just been paid. Corporation tax is 30 per cent.

is calculated using the dividend valuation model. The usual assumption made is that future dividends are expected to grow at a reasonably constant rate, known as g. Preference share capital usually pays a constant dividend each year, so no growth function is required. For debt, the future cash flow stream is the interest payments. As with preference shares, these cash flows are constant, but, given that a company can deduct interest payments in determining taxable profits, it will experience a tax saving of (1 tax rate) for each 1 of interest paid. This so-called tax shield reduces the cost of debt finance from the perspective of the company. In all of these formulas, Po is the exdividend or ex-interest market price today. If an instrument is quoted cum-dividend or cum-interest, the price will need adjusting before it is used in the calculation. So, using our example: Ke = Do(1 + g) + g Po Do = current dividend = 13p g = expected future growth rate = 2% Po = ex-dividend share price = cum-dividend share price current dividend = 124p 13p = 111p Ke = 13(1.02) + 0.02 = 13.9% 111 Kp = d Po d = constant dividend per annum = 6% x 1 = 6p Po = ex-dividend share price = 63p

(We know this is ex-dividend because the dividend has just been paid.) Kp = 6 = 9.5% 63 Kd = I(1 t) Po I = annual interest = 5% x 100 (Debentures have a nominal value of 100.) = 5 t = tax rate = 30% Po = ex-interest price = 72 per debenture (We know 72 is the ex-interest price because the interest has just been paid.) Kd = 5(1 0.3) = 4.9% 72 We now need to calculate an average cost of capital for the company. This will tell us the return that the companys projects need to earn to cover the average cost of financing those activities, assuming that they are financed out of the pool of funds. The weighted-average cost of capital (WACC) takes into account the proportion of funds (and hence the cost) that comes from each individual source in the pool (see panel 2, opposite page). Going back to our example, we have already calculated that: Ke = 13.9% Kp = 9.5% Kd = 4.9% Now we need to calculate the values of equity, debt and preference shares. Ve = number of ordinary shares x ex-dividend price per share = 2,000,000 x 111p = 2,220,000

TECHNICAL | IFIN

Vp = number of preference shares x ex-dividend price per share = 1,000,000 x 63p = 630,000 Vd = nominal value of debt x ex-interest value 100 = 500,000 x 72 100 = 360,000 Therefore the WACC = [(13.9% x 2,220,000) + (9.5% x 630,000) + (4.9% x 360,000)] (2,220,000 + 630,000 + 360,000) = 12% An alternative method of setting this out in the examination is to use a table (see panel 3, right). As discussed, the WACC represents the average cost of financing, assuming that the activities of the company are financed out of the pool of funds. The other two assumptions made when the WACC is used as the discount rate in project appraisal are that: l the business risk of the company will not change if the project is accepted; l the financial risk ie, the gearing of the company will not change.

3 Tabular calculation of WACC

Source Equity Preference shares Debt

K 13.9% 9.5% 4.9%

V 2,220,000 630,000 360,000 3,210,000 (Ve + Vp + Vd)

VxK 308,580 59,850 17,640 386,070 (VeKe + VpKp + VdKd)

WACC = VeKe + VpKp + VdKd Ve + Vp + Vd = 386,070 3,210,000 = 12%

Redeemable debt
In the original example, the 5 per cent debentures were irredeemable. Suppose instead that they were redeemable in three years at par ie, nominal value. If the debt is redeemable, the formula Kd = I(1 t) Po cannot be used, because this would measure only the cost of the debt in terms of the interest paid. It would ignore any gain or loss on redemption. The correct way 2 The pool of funds

to calculate the cost of redeemable debt is by using an internal rate of return (IRR) approach ie, the discount rate that sets NPV at zero. The cost of debt will be the IRR of the after-tax cash flows associated with the debt instrument. For our modified example, these cash flows will be as follows: Time Cash flow Today Ex-interest price as an outflow (t0) = 72 Years 1-3 Net interest as an inflow (t1 t3) = I(1 t) = 5(1 0.30) = 3.50 Year 3 Redemption value as an inflow (t3) = 100 To calculate the IRR, discount the cash flows at two different discount rates and linearly interpolate between the two points using the following formula: IRR = R1 + NPV1(R2 R1) NPV1 NPV2 See panel 4 on the next page to view the final calculation of IRR for this example.

Calculating g
The example gives an expected future growth rate of 2 per cent. This could be the case in an examination question, but you may instead be asked to estimate g. This can be done in two ways: l using the formula g = rb, where r is the return on investment for the firm and b is the proportion of funds retained; l using historic growth to estimate future expected growth.

Capital asset pricing model (CAPM)

The formulas used so far to estimate Ke, Kp and Kd have all been based on the dividend valuation model. A key problem in using the this model to calculate the cost of equity is that theres no obvious way to modify this cost to reflect different business risk profiles. Costs of capital calculated using this model reflects the company as it is. This discount rate will be inappropriate for appraising projects with different business risk profiles from those of the existing activities. The CAPM provides a solution. It allows the calculation of risk-adjusted discount rates for use in project appraisal. It works on the simple idea that investors will require at least the risk-free rate of return when investing in a project. They will also require a premium to compensate them for the particular risk of the investment. Since the investors required rate of return is exactly the same as the cost of equity to the company, CAPM can be used to calculate the cost of equity. Where CAPM is special is in the nature of the risk considered. There are two types of risk to take into account. The first is unsystematic and is a function of factors specific to the company or the industry in which it operates. By definition, shareholders will be able to diversify away much of this risk by spreading their funds among a wide range of securities from different industries. The September 2003 CIMA Insider 19

Value = Ve + Vp + Vd Cost = WACC = VeKe + VpKp + VdKd Ve + Vp + Vd

Equity Value = Ve Cost = Ke

Debt Value = Vd Cost = Kd

Preference shares Value = Vp Cost = Kp

TECHNICAL | IFIN/IMPM

second element of risk, systematic, is caused by general economic factors. These affect all companies in the same way to a greater or lesser extent and therefore cannot be removed by diversification. In an efficient market, shareholders are assumed to be well diversified and will therefore only require a return for systematic risk. Different companies can be more or less subject to these general economic factors and therefore be more or less systematically risky. The measure of a companys systematic risk is the beta factor (). These factors are published quarterly for all quoted companies by London Business Schools risk measurement service. The beta factor, together with an estimate of the risk-free rate of return and the market portfolio return, allow an estimate of the cost of equity to be made as follows: ke = rf + (rm rf ) where rf = the risk-free rate of return = the beta factor for the company rm = the market portfolio return Suppose a company has a beta factor of 1.2, and the risk-free rate of return and the market portfolio return are estimated at 3 per cent and 9 per cent respectively.

4 Calculation of the IRR Time t0 t1 t3 t3 Cash flow (72) 3.5 100 Df @ 5% 1 2.723 100 PV @ 5% (72) 9.53 86.40 23.93 Df @ 20% 1 2.106 0.579 PV @ 20% (72) 7.37 57.90 (6.73)

IRR = R1 + NPV1(R2 R1) NPV1 NPV2 = 5% + 23.93(20% 5%) 23.93 6.73 = 16.7%

Using the CAPM, the cost of equity of the company is calculated as: 3% + 1.2(9% 3%) = 10.2% The fact that is greater 1 implies that the company is more systematically risky than the market on average. The cost of equity of 10.2 per cent is therefore higher than the return on the market portfolio of 9 per cent. Cost of capital is one of the key technical areas in the IFIN syllabus and is also carried through to final level in the Financial Strategy paper. Students need to know the

underlying theories as well as how to perform the calculations in their exams. In reality, firms rarely conduct the depth of analysis covered in IFIN and FLFS, since there are simply too many assumptions and unknowns in the real world. But it is critically important that they understand these assumptions and theories so that they can appreciate the real sensitivities that are inherent in project appraisals. n Kirsty Flint is a tutor at ATC

Means testing
Bob Scarlett
The difference between efficiency and effectiveness in a not-for-profit organisation is fine, but crucial as its possible to be both efficient and ineffective at the same time

he not-for-profit (NFP) sector incorporates a wide range of operations, including central government, local authorities, charitable trusts and executive agencies. The obvious central feature of such operations is that they are not primarily motivated by the desire to make a profit. The ultimate objective of a commercial enterprise is to generate a profit for its owners. Such a business may take a shortor long-term view of how it wishes to do this. There are often alternative methods of achieving this objective, and managers have to choose between them. But there is a clear primary objective from which subsidiary objectives may be derived. The objectives of NFP organisations may be partly legislated for, partly constitutional CIMA Insider September 2003

and partly political. For example, the Driver and Vehicle Licensing Agency is legally required to keep records of vehicle registration and to issue motorists with driving licences and road tax discs. Mencap, one of the UKs leading learning disability charities, has an obligation to provide assistance for mentally handicapped people written into its constitution. Sunderland City Council has a duty to run local schools, but has a wide measure of discretion over how it does this. It can spend money on salaries for teachers or it can switch some of that cash into acquiring IT systems and making greater use of computer-assisted learning. It can provide teaching in classical Greek or it can reinforce its sports provision. The relevant choices the local authority makes

are determined by a political process. Parties contesting local elections will include their spending proposals in manifestos and the party with the most popular proposals will be elected. Practical problems with management in the NFP sector include the following: l objectives may be unclear; l objectives may change regularly over time; l radically different means may be available to achieve given objectives. A further consideration is that the relationship between objectives and means is often poorly understood. For example, one public objective would be to contain street crime within limits considered to be acceptable. One means of achieving that objective is through the use of traditional police foot

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