Chapter‐5: Cost of Capital

Dec 2014

(𝐾𝑒 𝑋 𝑀𝑉𝑒)+(𝐾𝑑 𝑋 𝑀𝑉𝑑)

i. Weighted Average Cost of Capital (WACC): = 𝑀𝑉𝑒+𝑀𝑉𝑑

Ke= {D0 (1+g)/P0} +g

g = Dividend in year 1 X (1 + g)n = last year dividend

= 200,000 (1 + g)4 = 300,000
g = 10.67%

Ke= {D0 (1+g)/P0} +g

Ke= {Tk.300,000 (1+.1067)/Tk3,760,000} + .1067
Ke = 19.50%

Cost of Debenture:
Market value of the debenture is Tk.75
1 1
Annuity formula = 𝑟 - 𝑟(1+𝑟)𝑛
Time Flow 10% df 10% PV 12% df 14% PV
t0 (75) 1 (75.00) 1 (75.00)
t1-8 8 5.335 42.68 4.638 37.10
t8 100 0.467 46.70 0.351 35.10
14.38 -2.796

14.38
IRR = 10% + 14.38+2.796 X (14%-10%) = 10.03%

(𝐾𝑒 𝑋 𝑀𝑉𝑒)+(𝐾𝑑 𝑋 𝑀𝑉𝑑)

Weighted Average Cost of Capital (WACC): = 𝑀𝑉𝑒+𝑀𝑉𝑑

(.1950 𝑋 (3.76∗1,000,000)+(.1003 𝑋 75∗7,000)

= = 18.34%
3.76∗1,000,000+75∗7,000

ii. Difficulties and uncertainties in my estimation

 There is considerable doubt about the future dividend growth rate. The past rate is
not steady, so it is very hazardous to make the assumption that was made. The
problem is that if we do not make this assumption, we shall have to make another
assumption, equally or more dubious.
 A major determinant of the appropriate discount rate for a particular project is the
business risk of that project. Since not all projects have the same risk, the discount
rate should not be the same.
 Changes in the level of gearing would affect the weightings: taking on positive NPV
projects will of itself alter the gearing.
 There could be other sources of funds that have not been considered, e.g. a bank
overdraft.
 The current market values of the shares and the debenture feature in the calculation,
both of the individual costs of capital and of WACC. Any change in market values
would probably alter the WACC.
 Changes in the tax rate could occur over the lifetime of the projects.
iii. NPV of Perpetuity = -Cost + Payment/Interest rate = (1,500,000) + 500,000/.1834

1 Amitav Deb Nath ACA

 = (1,500,000) + 2,726,281 = 1,226,281

As the NPV is positive so the project will be worthwhile.

iv. Appraisal of the dividend policy of the company:

 Traditional school of thought: Shareholders would prefer dividends today rather than
dividends or capital gains in the future. Cash now is more certain than in future. Future
payments would be discounted at a higher rate to take account of uncertainty. If current
dividends are reduced so that investment can occur then the market value will fall as the
discount rate increases. However does risk increase over time?
 Residual theory of dividends: Company should reinvest earnings rather than pay a
dividend as long as the rate of return achieved is higher than that of other investment
opportunities which have similar levels of risk and which are available to the shareholders.
Otherwise pay a dividend.
This can cause erratic dividend payments and these may not meet cash demands of
shareholders. Erratic dividends may give bad market signal. Sharp fluctuations in
dividends can lead to sharp fluctuations in share price.
 Modigliani and Miller: MM contend that share value is not determined by dividend policy,
but by future earnings and the level of risk. They argue that the amount of dividends paid
will not affect shareholder wealth providing the retained earnings are invested in
profitable investment opportunities. Any loss in dividend income will be offset by gains in
share price. Shareholders can create homemade dividends and don’t have to rely on the
company’s dividend policy. So if cash is needed, sell some shares instead.

June 2014

a) Relationship between risk and return: Capital Asset Pricing Model (CAPM), is a theory that
explains how asset prices are formed in the market place. The CAPM is an extension of
portfolio theory to examine what would be the relationship between risk and return in the
capital market if investors behaved in conformity with the prescription of portfolio theory.
The CAPM has implications for:
 Risk-return relationship for an efficient portfolio
 Risk-return relationship for an individual asset or security
 Identification of under and over-valued assets traded in the market
 Pricing of assets not yet traded in the market
 Effect of leverage on cost of equity
 Capital budgeting decisions and cost of capital and
 Risk of the firm through diversification of project portfolio.

b) (i) Capital Asset Pricing Model (CAPM), Ke = rf + βe (rm - rf)

= 8% + 1.2 (12% - 8%) = 12.8%

𝐷0 2.00
P0 = 𝐾𝑒 = .128 = Tk.15.63

(ii) (a) The inflation premium increases by 2 percent: Market rate (1+ Inflation premium) = 12%
(1+.02) = 12.24%
Capital Asset Pricing Model (CAPM), Ke = rf + βe (rm - rf)
= 8% + 1.2 (12.24% - 8%) = 13.09%

2 Amitav Deb Nath ACA

(b) Beta of A’s equity rises to 1.3
Capital Asset Pricing Model (CAPM), Ke = rf + βe (rm - rf)
= 8% + 1.3 (12.24% - 8%) = 13.51%

c) P0 = {D0 (1+g)/ (Ke – g)

=> 30 = 2.00/ (.15 – g)
=> 4.5 – g = 2 So, g = 2.5%

Dec 2013

2 (c)
i) At the various level of gearing the weighted average cost of capital of Marzan will be as
follows: The after tax cost of debt is 10% (1- .03) = 7%

Gearing Calculation WACC%

ratio
0 20%
20 (0.8x21.625)+ (0.2x7) 18.7%
40 (0.6 x 24.333) + (0.4 x 17.4%
7)
50 (0.5 x 26.5) + (0.5 x 7) 16.8%
60 (0.4 x 29.75) + (0.6 x 7) 16.1%

ii) Significance of the results:

The implication of part (i) is that WACC falls continuously as the gearing ratio increases. This is
consistent with M&M's 1963 proportions on gearing. MM suggests that the optimal capital
structure in a taxed world is 99.9% debt. Whether the contention is true is a vexed issue. Both
M&M's 1958 article, which argued that there was no c capital structure but assumed no
corporation tax, and their 1963 correction to allow for corporate taxes, are variance with the
traditional view. The debate regarding the effects of gearing on the weighted average cost is
essentially empirical.

iii) Possible consequences of a high gearing:

The general understanding is that with the introduction of corporation tax with debt interest is
an allowable for tax purpose and the weighted average cost of capital shall continuously decline.
The total value of firm is maximized where the gearing ratio is 99.9%. This conclusion may not be
acceptable to many finance man they do not allow extremely high debt/equity ratio. The reasons
are as follows:
 The numerical analysis carried out assumes a constant cost of debt and unaffected by the
level of gearing. But in practical with the increase of debt, risk will also increase and at a
point of time cost of debt will be equal to cost of equity.
 The firm having low profit earning capacity may not suitable for high geared capital
structure as it increases financial risk and decreases earnings per share.
 High gearing may lead unexpected influence by lenders through imposing of covenants
on management/ shareholders decisions.
 There is chance of bankruptcy due to high gearing. Hence, chance of financial distress
increase due to high gearing which may outweigh the tax advantages.

3 Amitav Deb Nath ACA

June 2013

(a) Calculation of weighted average cost of capital (WACC)

Cost of equity:
Cost of equity using capital asset pricing model = 4.7 + (1.2 x 6.5) = 12.5%

Cost of convertible debt:

Annual after-tax interest payment = 7 x (1 – 0.3) = Tk.4.90 per bond
Share price in six years' time = 5.50 x 1.066 = Tk.7.80
Conversion value = 7.80 x 15 = Tk. 117.00 per bond
Conversion appears likely, since the conversion value is much greater than par value.

The future cash flows to be discounted are therefore six years of after-
tax interest payments and the conversion value received in year 6:

Time Flow 10% df 10% PV 5% df 5% PV

t0 (107.11) 1 (107.11) 1 (107.11)
t1-6 4.9 4.355 21.34 5.076 24.87
T6 117 0.564 66.00 0.746 87.28
-19.77 5.04
After-tax cost of debt = 5 + [(5 x 5.04)7(5.04 + 19.77)] = 6.0%.

Cost of bank loan:

After-tax interest rate = 8 x (1 – 0.3) = 5.6%

This can be used as the cost of debt for the bank loan.

Market values:
Market value of equity = 20m x 5.50 = Tk.110 million
Market value of convertible debt = 29m x 107.11/100 = Tk.31.06 million
Book value of bank loan = Tk.2m
Total market value = 110 + 31.06 + 2 = Tk.143.06 million
WACC = [(12.5 x 110) + (6.0 x 31.06) + (5.6 x 2)]/143.06 = 11.0%

(b) The weighted average cost of capital. (WACC) can be used as a discount rate in investment
appraisal provided that the risks of the investment project being evaluated are similar to the
current risks of the investing company. The WACC would then reflect these risks and represent
the average return required as compensation for these risks.

WACC can be used in investment appraisal provided that the business risk of the proposed
investment is similar to the business risk of existing operations. Essentially this means that WACC
can be used to evaluate an expansion of existing business. If the business risk of the investment
project is different from the business risk of existing operations, a project specific discount rate
that reflects the business risk of the investment project should be considered. The capital asset
pricing model (CAPM) can be used to derive such a project-specific discount rate.

4 Amitav Deb Nath ACA

Dec 2012

1(b) 'Playing the float' means writing a check knowing you have insufficient funds and hoping you can
make a deposit before the check clears. The delays involved in the various fund transfers and payment
systems available and the use of these delays for managing short term financing by local companies.

Companies fund manager can manage its working capital considering these financial risks and liquidity
risk.

4(b)
To calculate the price of the share we shall use the constant growth model:

𝐸𝑃𝑆 𝑋 (1−𝑏)𝑋 (1+𝑔)

P=
𝐾𝑒−𝑔

EPS = Tk. 2.00, b = 0.5, g = 0.08085

Beta (βe) = 0.978

Ke = 5% + 0.978 X 6% = 10.868%

As the price of the share is:

P = 2 X 0.5 X (1 + 0.08085)/ (0.10868-0.08085) = Tk. 38.838

After financial reconstruction we have:

EPS = Tk. 2, b= 0.5, g = 0.0874; βe = 1.094

Ke = 5% + 1.094 x 6% = 11.564%

P= 2 X 0.5X (1 + 0.0874)/ (0.11564-0.0874) = Tk. 38.506

As a result of the financial reconstructing the share price decreased by 1 percent.

4(c)
a)(i) Using the dividend growth model, the share price of NN Ltd. will be the present value of its
expected future dividends, i.e. (66 x 1.03)/(0.12 – 0.03) = 755 paisa per share or Tk.7.55 per share

Number of ordinary shares = 100m shares

Value of NN Co = 100m x 7.55 = Tk. 755m

ii) Net asset value of NN Ltd.

Total assets less total liabilities = 143 - 29 - 20 - 25 = Tk.69m in calculating net asset value, preference
share capital is included with long-term liabilities, as it is considered to be prior charge capital.

b) The after-tax cost of debt of NN Ltd. can be found by IRR Method

The annual after-tax interest payment = 7 x (1 - 0.25) = 7 x 0.75 = Tk.5.25 per year

Time Flow 5% df 5% PV 4% df 4% PV
t0 (103.50) 1 (103.50) 1 (103.50)
t1-6 5.25 5.076 26.65 5.242 27.52

5 Amitav Deb Nath ACA

 T6 100 0.746 74.60 0.790 79.00
-2.25 3.02

After-tax cost of debt = 4 + [(1 x 3.02)/(3.02 + 2.25)] = 4 + 0.57 = 4.6%

c) Annual preference dividend = 8% x 50 paisa = 4 paisa per share

Cost of preference shares = 100 x (4/67) = 6%
Number of ordinary shares = 50/0.5 = 100m shares
Market value of equity = Ve = 100m shares x 8.30 = Tk.830m
Number of preference shares = 25/0.5 = 50m shares
Market value of preference shares = Vp = 0.67 x 50m = Tk.3.35m
Market value of long-term borrowings = Vd = 20 x 103.50/100 = Tk.20.7m
Total market value of company = (Ve + Vd + Vp) = (830 + 33.5 + 20.7) = Tk.884.2 m
WACC = (KeVe + KpVp + Kd( 1 - T) Vd)/(Ve + Vp + Vd)
= (12 x 830 + 6 x 33.5 + 4.6 x 20.7) / 884.2 = 11.6%

Dec 2011

a) Calculation of Cost of equity

𝐷𝑜 (1+𝑔)
Cost of Equity = 𝑃0
+g

Where g = rb
Retention rate (b) = 489/922 x 100 = 53%

Return on capital (i) = 922/(4,250 – 489) = 24.5%

g = 0.53x0.245 = 13%
D0 = 433/2,000 = 21.65p
P0 =400
Cost of equity = 21.65(1.13)/400 +0.13 = 0.191 = 19.1%

Assumptions used:
 The dividend valuation model has been used to calculate the cost of capital because there is
no debt within current liabilities so the firm is all-equity financed.
 The dividend growth rate uses the Gordon growth model.
 The proposed expansion is into related activities with no consequent change in business risk
and so the current cost of equity capital is appropriate. Tk.4 per share is a recent valuation
and is therefore approximate to current market value.
(b) Advantages & Disadvantages of right issue to fund proposed expansion:

Advantage:
 No change in control if fully taken up by existing shareholders
 Flexible nature of dividend payments as opposed to a fixed interest commitment
 Any new shareholders might find the firm's unlisted status unattractive
 No listing and reporting requirements

Disadvantage:
 How will existing shareholders react and do they have access to the required funds?

6 Amitav Deb Nath ACA

ii) DSE Listing
Advantage:
 Increased marketability of shares

Disadvantage:
 Lengthy process
 Listing and reporting requirements
 Cost involved
 Dilution of control

(c)(i)
 HH would obtain finance at a lower rate of interest than an ordinary bank loan, provided that
the firm's prospects were considered to be good post-expansion.
 This might encourage future outside investors with the prospect of a future share in profits.
 This would also introduce an element of short-term gearing, with potential beneficial cost of
capital implications.
 If the debt was subsequently converted it would also avoid subsequent redemption problems
 If the debt was subsequently converted it would enable HH to issue equity relatively cheaply
 There may be an argument that a convertible loan would come with fewer covenants than a
bank loan

(ii)
 The revised debt/equity ratio is not to be changed in future
 The firm's operating and business risk is not to be changed in future
 The new finance is not project specific

(d)
 Historic cost valuation
 Net realizable value of assets less net realizable value of liabilities (market value)
 Replacement cost
 Income-based approaches:
(i) the present value of future cash flows
(ii) use of the P/E ratio of similar quoted firms (P/E ratio x earnings)
(iii) Dividend valuation method.

7 Amitav Deb Nath ACA