The Cost of Capital

Cost of Equity: Ke Cost of Debt: Kd

Ke : the DGM

Ke : the CAPM
Ke=Rf+ (Rm-Rf) e
market premium for risk

Irredeemable Debt

Redeemable Debt
IRR of the cashflows

Convertible Debt

Cost of pref. shares

Cost of a Loan
(rate given in the exam)

Kpref = Pref dividend

Market value (ex div)

d Po

dividends are paid & the company has a share price

dividend growth can be estimated & is constant

E(ri) = Rf + B ( E(Rm) - (Rf)

No Tax

Tax

Time 0

Market value

(outflow)

Time 0 1-n n

Market value (Interest x [1-tax]) Value of the shares

they are paid out of post-tax profit and therefore do not received any tax relief

Multiply this for (1-t) to get the post-tax cost

*if there is a dividend about to be paid & the share is cum div, then the share price needs to be adjusted by stripping the dividend out of the share price

Estimating future dividend growth

Kd = i Kd = i (1-t) 1-n E(ri): expected return (e.g Ke) Po Po n Rf: the risk-free rate of interest B: the beta of the investment i: interest paid Po: market value of the debt ex-interest E(Rm): expected market return Po: market value of the debt (not given in exam) (E(Rm) - Rf): market premium or risk premium Steps:

(Interest x [1-tax]) inflow (Redemption value) inflow

Kd=i/Po

1) Calculate the NPV of the debt at your 1st rate (coupon rate) 2) Calculate de project at your 2nd rate 3) calculate the internal rate or return using the formula

Use historic growth

Use current reinvestment levels g=b r

r= a measure of return ROCE, ARR, IRR, RONA
if redeemed afer 1 year then (Total Debt + Interest) / MV of Debt

Ke

Kd

WA