Cost of Capital

COST OF CAPITAL & CAPITAL STRUCTURE, ACCA
8. Cost of Capital & Capital Structure

1. Introduction
• The cost of capital is the cost of using the funds of creditors and owners.
• Creating value requires investing in capital projects that provide a return greater than the project’s
cost of capital.
- When we view the firm as a whole, the firm creates value when it provides a return
greater than its cost of capital.
• Estimating the cost of capital is challenging.
- We must estimate it because it cannot be observed.
- We must make a number of assumptions.
- For a given project, a firm’s financial manager must estimate its cost of capital.
2. Costs of the Different sources of capital

Costs of
Capital
Cost of Cost of Common
Cost of Debt Equity
Preferred Equity
Return on Capital Asset
Yield to Maturity Pricing Model
Preferred Stock
Variations Dividend
Debt Rating because of Discount Model
Callability, etc.
Bond Yield plus
Risk Premium
Flotation Costs
• A flotation cost is the investment banking fee associated with issuing securities.
• There are two treatments for flotation costs:
1. Adjust the price of the security in the return calculation by the flotation cost, or
2. Adjust the NPV of the project for the monetary cost of flotation.
• Adjusting the NPV is preferred because the flotation costs occur immediately rather than affect
the company throughout the life of the project.
Problem
Suppose a company has a project with an NPV of Rs.100 million. If the company issues Rs.1 billion of
equity to finance this project and the flotation costs are 1.2%, what is the NPV after adjusting for flotation
costs?
Solution
NPV = Rs.100 million – Rs.12 million = Rs.88 million
Taxes and the Cost of capital

• Interest on debt is tax deductible; therefore, the cost of debt must be adjusted to reflect this
NOTES COMPILATION FOR PRIVATE CIRCULATION 8.1
deductibility.
- We multiple the before-tax cost of debt (rd) by the factor (1 – t), with t as the marginal tax
rate.
- Thus, rd × (1  t) is the after-tax cost of debt.
• Payments to owners are not tax deductible, so the required rate of return on equity (whether
preferred or common) is the cost of capital.
The cost of Debt
Direct method
I+(M-V)/n
ki = (m+V)/2
I = Interest;
M=par value, usually $1,000 per bond
V=value or net proceeds from the sale of a bond
n=term of the bond in years
kd = ki (1-t)
Example 1: F plc has in issue 8% irredeemable debentures quoted at 90 p.c. ex int.

(a) What is the return to investors (kd ) ?
(b) What is the cost to the company, if the rate of corporation tax is 30%?
Hints: 8.89%; 6.22%
Example 2: Assume that the Carter Company issues a $1,000, 8 percent, 20-year bond whose net
proceeds are $940. The tax rate is 40 percent. Then, the before-tax cost of debt, ki, is:
Hints: 5.14%
However, direct method of cost of debt gives close to cost of debt as it ignores the time value of money,
hence rarely in use.
Alternative approaches
Yield-to-maturity approach: Calculate the yield to maturity on the company’s current debt.
Example 3: XYZ Company has bonds outstanding with 7 years left before maturity. The bonds are
currently selling for $800 per $1,000 face value. The interest is paid annually at a rate of 12 percent. The
firm’s tax rate is 40 percent. Calculate the after-tax cost of debt using (a) the shortcut method, and (b) the
regular method.
Hints: 9.9% (short-cut); 10.2%
Example 4: Consider a company that has Rs.100 million of debt outstanding that has a coupon rate of
5%, 10 years to maturity, and is quoted at Rs.98. What is the after-tax cost of debt if the marginal tax rate
is 40%? Assume semi-annual interest.
Hints: rd = 0.0526 (1 – 0.4) = 3.156%
Debt-rating approach: Use yields on comparably rated bonds with maturities similar to what the
company has outstanding.
Example 5: Consider a company that has non-traded Rs.100 million of debt outstanding that has a debt-
rating of AA. The yield on AA debt is currently 6.2%. What is the after-tax cost of debt if the marginal
tax rate is 40%?
Hints: rd = 0.062 (1 – 0.4) = 3.72%. The cost of debt capital is 3.72%
Issues in estimating the cost of debt

• The cost of floating-rate debt is difficult because the cost depends not only on current rates but
also on future rates.
- Possible approach: Use current term structure to estimate future rates.
• Option-like features affect the cost of debt.
- If the company already has debt with embedded options similar to what it may issue, then
we can use the yield on current debt.
- If the company is expected to alter the embedded options, then we would need to estimate
the yield on the debt with embedded options.
• Nonrated debt makes it difficult to determine the yield on similarly yielding debt if the
company’s debt is not traded.
- Possible remedy: Estimate rating by using financial ratios.
• Leases are a form of debt, but there is no yield to maturity.
- Estimate by using the yield on other debt of the company.
The Cost of Preferred Stock

The cost of preferred stock that is non-callable and non-convertible is based on the perpetuity formula:

Example 6: Suppose a company has preferred stock outstanding that has a dividend of Rs.1.25 per share
and a price of Rs.20. What is the company’s cost of preferred equity?
Hints : 6.25%
Example 7: Suppose that the Carter Company has preferred stock that pays a $13 dividend per share and
sells for $100 per share in the market. The flotation (or underwriting) cost is 3 percent, or $3 per share.
Then the cost of preferred stock is:
Hints: 13.4%
Example 8: A company’s $100, 8% preferred is currently selling for $85. What is the company’s cost of
preferred equity?
Hints: 9.4%
The Cost of Equity

Methods of estimating the cost of equity:
1. Dividend discount model
2. Capital asset pricing model
3. Bond yield plus risk premium
Using the Dividend Valuation Model to Estimate the Cost of Equity

• The dividend discount model (DDM) assumes that the value of a stock today is the present
value of all future dividends, discounted at the required rate of return.
• Assuming a constant growth in dividends:
which we can rearrange to solve for the required rate of return:
• We can estimate the growth rate, g, by using third-party estimates of the company’s dividend
growth or estimating the company’s sustainable growth.
• The sustainable growth is the product of the return on equity (ROE) and the retention rate (1
minus the dividend payout ratio, or 1 ):

1 x ROE
Example 9: Assume that the market price of the Carter Company’s stock is $40. The dividend to be paid
at the end of the coming year is $4 per share and is expected to grow at a constant annual rate of 6
percent. Then the cost of this common stock is:
Hints: 16%.
Example 10: Messman Manufacturing will issue common stock to the public for $30. The expected
dividend and the growth in dividends are $3.00 per share and 5%, respectively. If the flotation cost is 2%
of the issue’s gross proceeds, what is the cost of external equity, re?
Hints: 15.20%.
Estimating growth rate in dividends

Estimate of the dividend growth rate using one of two approaches:
 using the rate of growth in the past
 using the ‘rb’ model
Past Growth Rate

Example 11: Calculate cost of equity if company has 1,000 number of shares in 2006 and its market price
is $250.
Year Dividend ($)
2001 2,000.00
2002 2,400.00
2003 2,200.00
2004 2,700.00
2005 3,000.00
2006 3,200.00
Hints: g= 9.86%; Ke = 11.26%
Using Gordon Growth model

The growth can be estimate using the following formula:
g=rb
i.e. [ROE*Retention Ratio]
Where
b = the proportion of earnings retained in the company
r = the rate of return that the company can earn on re-investment
Example 12: Suppose the Gadget Company has a current dividend of Rs.2 per share. The current price of
a share of Gadget Company stock is Rs.40. The Gadget Company has a dividend payout of 20% and an
expected return on equity of 12%. What is the cost of Gadget common equity?
Hints: g = 9.6%; re = 15.08
Example 13: Z plc has in issue $1 shares with a market value of $2.80 per share. A dividend of 20c per
share has just been paid (earnings per share were 32c).
The company is able to invest so as to earn a return of 18% p.a.
(a) Estimate the rate of growth in dividends
(b) Estimate the cost of equity
Hints: 6.75%; 14.375%
Example 14: Spencer Supplies’ stock is currently selling for $60 a share. The firm is expected to earn
$5.40 per share this year and to pay a year-end dividend of $3.60.
a. If investors require a 9% return, what rate of growth must be expected for Spencer?
b. If Spencer reinvests earnings in projects with average returns equal to the stock’s expected rate of
return, then what will be next year’s EPS? (Hint: g = ROE × Retention ratio.)
Hints: 3%; 5.562%
Example 15: Armon Brothers, Inc., is attempting to evaluate the costs of internal and external common
equity. The company’s stock is currently selling for $62.50 per share. The company expects to pay $5.42
per share at the end of the year.
The dividends for the past 5 years are given below:
Year Dividend
20X5 $5.17
20X4 $4.92
20X3 $4.68
20X2 $4.46
20X1 $4.25
The company expects to net $57.50 per share on a new share after flotation costs. Calculate: (a) the
growth rate of dividends; (b) the flotation cost (in percent); (c) the cost of retained earnings (or internal
equity); and (d ) the cost of new common stock (or external equity).
Hints: 5%; 8%; 13.67%14.43%
Using the bond yield plus risk premium approach to estimating the cost of equity
• The bond yield plus risk premium approach requires adding a premium to a company’s yield
on its debt:
re = rd + Risk premium
- This approach is based on the idea that the equity of the company is riskier than its debt,
but the cost of these sources move in tandem.
Using the CAPM to estimate the Cost of Equity

The capital asset pricing model (CAPM) states that the expected return on equity, E(Ri) , is the sum of the
risk-free rate of interest, RF, and a premium for bearing market risk, bi [E(RM) – RF]:
E(Ri) = RF + bi [E(RM) – RF]
Where,
RF is the risk free rate of return
bi is the return sensitivity of stock i to changes in the market return
E(RM) is the expected return on the market
E(RM) – RF is the expected market risk premium or equity risk premium (ERP)
Risk Free Rate

Since we cannot, in practice, find a truly riskless rate upon which to base the CAPM, what rate should we
use? A survey of highly regarded companies show that about two-thirds of them use the rate on 10-year
Treasury bonds. The reasons being:
1. Common stocks are long-term securities. Therefore, it is reasonable to think that stock returns embody
relatively long-term inflation expectations similar to those reflected in bonds rather than the short-term
expectations in bills.
2. Short-term Treasury bill rates are more volatile than are long-term Treasury bond rates.
3. In theory, the CAPM is supposed to measure the required return over a particular holding period. Long
term bond is a reasonable average for the risk-free rate.
Risk Premium
The risk premium is driven primarily by investors’ attitudes toward risk, and there are good reasons to
believe that investors’ risk aversion changes over time.
Three approaches may be used to estimate the market risk premium:
(1) Calculate historical premiums and use them to estimate the current premium;
(2) Use the current value of the market to estimate forward-looking premiums; and (predicting sales,
earnings, payouts, etc.)
(3) Survey experts [Surveys of CFO, rating agencies, etc.)
Estimating Beta
The CAPM is based on a comparison of the systematic risk of individual investments with the risks of all
shares in the market.
The total risk involved in holding securities (shares) divides into risk specific to the company
(unsystematic) and risk due to variations in market activity (systematic).
Unsystematic risk can be diversified away, while systematic or market risk cannot. Investors may mix a
diversified market portfolio with risk-free assets to achieve a preferred mix of risk and return.
Basis for
Systematic Risk Unsystematic Risk
Comparison
Systematic risk refers to the hazard which is Unsystematic risk refers to the risk
Meaning associated with the market or market associated with a particular security,
segment as a whole. company or industry.
Nature Uncontrollable Controllable
Factors External factors Internal factors
Affects Large number of securities in the market. Only particular company.
Interest risk, market risk and purchasing
Types Business risk and financial risk
power risk.
Beta factor is the measure of the systematic risk of a security relative to the average market portfolio.
The higher the beta factor, the more sensitive the security is to systematic risk (the more volatile its
returns in response to factors that affect market returns generally).
Beta coefficient (β) = Covariance (Re, Rm)/ Variance(Rm)
OR
Beta coefficient (β) = Correlation (Re, Rm) x Re/Rm
Where:
Re=the return on an individual stock
Rm =the return on the overall market
Covariance=how changes in a stock’s returns arerelated to changes in the market’s returns
Variance=how far the market’s data points spreadout from their average value
If an investment has a β of 1 It has 1 times the risk of the market – i.e. it has the same risk
as the market.
If an investment has a β > 1 Then it is more risky than the market
If an investment has a β < 1 Then it is less risky than the market.
If an investment has a β of 0 Then it has zero risk, or we say that it is risk-free
Example 16: Based on data over the past five years, TSLA and SPDR S&P 500 ETF Trust (SPY) have a
covariance of 0.032, and the variance of SPY is 0.015.
Hints: β = 2.13. Therefore, TSLA is theoretically 113% more volatile than the SPDR S&P 500 ETF
Trust.
Example 17: Based on data over the past five years, the correlation between Apple, and market is 0.83.
Apple has a standard deviation of returns of 23.42% and market has a standard deviation of returns of
32.21%. Calculate the beta of Apple. Hints: β = 0.6035
Cost of equity under CAPM

Example 18: If the risk-free rate is 3%, the expected market risk premium is 5%, and the company’s
stock beta is 1.2, what is the company’s cost of equity? Hints: 9%
Example 19: Booher Book Stores has a beta of 0.8. The yield on a 3-month T-bill is 4% and the yield on
a 10-year T-bond is 6%. The market risk premium is 5.5%, and the return on an average stock in the
market last year was 15%. What is the estimated cost of common equity using the CAPM? Hints: 10.4%
Example 20: The earnings, dividends, and stock price of Shelby Inc. are expected to grow at 7% per year
in the future. Shelby’s common stock sells for $23 per share, its last dividend was $2.00, and the
company will pay a dividend of $2.14 at the end of the current year.
a. Using the discounted cash flow approach, what is its cost of equity?
b. If the firm’s beta is 1.6, the risk-free rate is 9%, and the expected return on the market is 13%, then
what would be the firm’s cost of equity based on the CAPM approach?
c. If the firm’s bonds earn a return of 12%, then what would be your estimate of cost of equity using the
over-own-bond-yield-plus-judgmental-risk-premium approach?
Hints: 16.3%; 15.4%; 16%
Arbitrage Pricing Model (APT) [Alternatives to the CAPM]

Alternative models may be used to capture expected returns to risk factors not incorporated in the CAPM.
For example, we can use a multi-factor model to estimate the cost of equity:
Factor risk Factor risk Factor risk
E(Ri) = RF + bi1 1 + bi2 2 + … + βij j
premium premium premium
where
βij = stock i’s sensitivity to changes in the jth factor
Factor risk
j = the expected risk premium for the jth factor
premium
Example 21: Gross domestic product (GDP) growth: ß = 0.6, RP = 4%; Inflation rate: ß = 0.8, RP = 2%;
Gold prices: ß = -0.7, RP = 5%; Standard and Poor's 500 index return: ß = 1.3, RP = 9%; The risk-free
rate is 3%. Using the APT formula, the expected return is calculated as:
Hints: 16.3%; 15.4%; 16%
We can also use the historical equity risk premium approach, which requires estimating the average
annual return over a historical period.
- Issues:
- Level of risk of stocks may change.
- Risk aversion of investors may change.
Country Risk Premium

• The country risk premium is the additional risk premium associated with doing business in a
developing nation.
• The additional premium, added to the required rate of return estimated from the CAPM, is the
country equity premium, or the country spread.
• To estimate the country risk premium:
- Use the sovereign yield spread, which is the difference in government bond yields.
- Adjust the sovereign yield spread by a factor that is the ratio of the
- annualized standard deviation of the developing nation’s equity index to the
- annualized standard deviation of the sovereign bond market in the developed
market currency.
Cost of Retained Earnings

The cost of retained earnings, ks, is closely related to the cost of existing common stock, since the cost of
equity obtained by retained earnings is the same as the rate of return investors require on the firm’s
common stock. Therefore, ke = ks
However, cost of retained earnings does not involve flotation cost as it does not incur additional cost of
issue. Thus, flotation cost is ignored in computation of cost of retained earnings formula being cost of
equity.
4. Cost of Capital
• The cost of capital is the rate of return that the suppliers of capital—bondholders and owners—
require as compensation for their contributions of capital.
- This cost reflects the opportunity costs of the suppliers of capital.
• The cost of capital is a marginal cost: the cost of raising additional capital.
• The weighted average cost of capital (WACC) is the cost of raising additional capital, with the
weights representing the proportion of each source of financing that is used.
- Also known as the marginal cost of capital (MCC).
WACC = wdrd (1  t) + wprp + were

where
wd is the proportion of debt that the company uses when it raises new funds
rd is the before-tax marginal cost of debt
t is the company’s marginal tax rate
wp is the proportion of preferred stock the company uses when it raises new funds
rp is the marginal cost of preferred stock
we is the proportion of equity that the company uses when it raises new funds
re is the marginal cost of equity
Weights of the Weighted Average

• The weights should reflect how the company will raise additional capital.
• Ideally, we would like to know the company’s target capital structure, which is the capital
structure that is the company’s goal, but we cannot observe this goal.
• Alternatives
- Assess the market value of the company’s capital structure components.
- Examine trends in the company’s capital structure.
- Use capital structures of comparable companies (e.g., weighted average of comparable’
capital structure).
Example 22: Suppose the NN Company has a capital structure composed of the following, in billions:
Debt Rs. 10 mi and Equity Rs. 40 mi.
If the before-tax cost of debt is 9%, the required rate of return on equity is 15%, and the marginal tax rate
is 30%, what is Widget’s weighted average cost of capital?
Hints: 13.25%. When the NN Company raises Rs.1 more of capital, it will raise this capital in the
proportions of 20% debt and 80% equity, and its cost will be again 13.25%.
Example 23: The Gamma Products Corporation has the following capital structure, which it considers
optimal:
Bonds, 7% (now selling at par) $ 300,000
Preferred stock, $5.00 240,000
Common stock 360,000
Retained Earnings 300,000
$1,200,000
Dividends on common stock are currently $3 per share and are expected to grow at a constant rate of 6
percent. Market price share of common stock is $40, and the preferred stock is selling at $50. Flotation
cost on new issues of common stock is 10 percent. The interest on bonds is paid annually. The company’s
tax rate is 40 percent.
Calculate: (a) the cost of bonds; (b) the cost of preferred stock; (c) the cost of retained earnings (or
internal equity); (d ) the cost of new common stock (or external equity); and (e) the weighted average cost
of capital.
Hints: 4.20%; 10%; 13.95%; 14.83%; 10.943%
Example 24: The Conner Company has the following capital structure:
Mortgage bonds, 6% $ 20,000,000
Common stock (1 million shares) 25,000,000
Retained earnings 55,000,000
$100,000,000
Mortgage bonds of similar quality could be sold at a net of 95 to yield 6.5 percent. Their common stock
has been selling for $100 per share. The company has paid 50 percent of earnings in dividends for several
years and intends to continue the policy. The current dividend is $4 per share. Earnings are growing at 5
percent per year. If the company sold a new equity issue, it would expect to net $94 per share after all
costs. Their marginal tax rate is 50 percent.
Conner wants to determine a cost of capital to use in capital budgeting. Additional projects would be
financed to maintain the same relationship between debt and equity. Additional debt would consist of
mortgage bonds, and additional equity would consist of retained earnings. (a) Calculate the firm’s
weighted average cost of capital based on book value and market value, and (b) explain why we use the
particular weighting system.
Hints: (a) 8.08% (Book value); 8.48% (market value).
Example 25: The treasure of a new venture, Start-Up Scientific, Inc., is trying to determine how to raise
$6 million of long-term capital. Her investment adviser has devised the alternative capital structures
shown below:
Alternative A Alternative B
$2,000,000 9% debt $4,000,000 12% debt
$4,000,000 Equity $2,000,000 Equity
If alternative A is chosen, the firm would sell 200,000 shares of common stock to net $20 per share.
Stockholders would expect an initial dividend of $1 per share and a dividend growth rate of 7 percent.
Under alternative B, the firm would sell 100,000 shares of common stock to net $20 per share. The
expected initial dividend would be $0.90 per share, and the anticipated dividend growth rate
12 percent.
Assume that the firm earns a profit under either capital structure and that the effective tax rate is 50
percent. (a) What is the cost of capital to the firm under each of the suggested capital structures? Explain
your result. (b) Explain the logic of the anticipated higher interest rate on debt associated with alternative
B. (c) Is it logical for shareholders to expect a higher dividend growth rate under alternative B? Explain
your answer.
Hints: (a) WACC 9.5% in both alternatives.
(b) The interest rate on debt is higher for alternative B because the financial risk is greater due to the
increased use of leverage. As a result, the probability of not being able to meet the high fixed payment
increases, causing the bond market to have a higher required rate of return to offset this greater risk.
(c) It is logical for shareholders to expect a higher dividend growth rate under alternative B because of
the additional financial risk and increased fixed interest requirement. Equity holders will demand a
higher return to compensate them for the additional financial risk. Dividends per share should grow at a
faster rate than alternative A because earnings per share grow faster due to the greater amount of
leverage (smaller base). In addition, assuming a given payout rate, it follows that dividends per share
would also grow faster than alternative A.
Example 26: Ciron Limited has the following capital structure:

9% Debentures Rs. 275,000
11% Preference Shares Rs. 225,000
Equity Shares (face value Rs. 10 per share) Rs. 500,000
Rs. 1,000,000
Additional information:
i) Rs. 100 per debenture redeemable at par have 2% floatation cost and 10 years of maturity. The market
price per debenture is Rs. 105.
ii) Rs. 100 per preference share redeemable at par has 3% floatation cost and 10 years of maturity. The
market price per preference share is Rs. 106.
iii) Equity share has Rs. 4 floatation cost and market price per share of Rs. 24. The next year expected
dividend is Rs. 2 per share with annual growth of 5%. The firm has a practice of paying all earnings in the
form of dividends.
iv) Corporate income-tax rate is 35%.
Required: Calculate Weighted Average Cost of Capital (WACC) using market value weights.
Hints: 12.81% [5.56%, 10.53%, 15%] W- 288,750; 238,500; 1,200,000
Applying the Cost of capital to capital Budgeting and Security Valuation

• The investment opportunity schedule (IOS) is a representation of the returns on investments.
• We assume that the IOS is downward sloping: the more a company invests, the lower the
additional opportunities.
- That is, the company will invest in the highest-returning investments first, followed by
lower-yielding investments as more capital is available to invest.
• The marginal cost of capital (MCC) schedule is the representation of the costs of raising
additional capital.
- We generally assume that the MCC is upward sloping: the more funds a company raises,
the greater the cost.
Optimal Investment Decision

Marginal cost of capital
Investment opportunity schedule
Cost
or
Return
Optimal
Capital
Amount of New Capital
Example 27: Georgebear has the following capital structure.

After-tax cost Market value
Source % $m
Equity 12 10
Preference 10 2
Bonds 7.5 8
20 20.0
WACC = 10%
Georgebear's 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, 1/3 of which will be financed by equity,
2/3 of which will be financed by bonds. 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 bonds
will remain the same, while the after-tax cost of the new bonds will be 9%.
Required
Calculate the company's new weighted average cost of capital, and its marginal cost of capital.
Hints: New WACC = 10.96%; Marginal Cost of Capital = 17.3%
Using the MCC in capital Budgeting and Analysis

• The WACC is the marginal cost for additional funds and, hence, additional investments.
• In capital budgeting
- We use the WACC, adjusted for project-specific risk, to calculate the net present value
(NPV).
- Using a company’s overall WACC in evaluating a capital project assumes that the project
has risk similar to the average project of the company.
• In analysis
- Analysts can use the WACC in valuing the company by discounting cash flows to the
firm.
Using the MCC in Capital Budgeting and Analysis
• Capital budgeting issues:
• If the project has risk that is similar to that of the firm as a whole, then using the WACC in
discounting project cash flows to calculate the NPV is appropriate.
• What if the project is not of average risk? Without adjustment, profitable projects with below-
average risk would likely be rejected and unprofitable projects with higher-than-average risk
may be accepted.
• Security valuation issues:
• When discounting cash flows of the entire company (e.g., free cash flows to the firm), use the
WACC.
• When discounting equity cash flows (e.g., dividends or free cash flows to equity), use the cost of
equity.
CAPITAL STRUCTURE
1. Introduction
• The capital structure decision affects financial risk and, hence, the value of the company.
• The capital structure theory helps us understand the factors most important in the relationship
between capital structure and the value of the company.
2. The Capital Structure Decision

Development of the theory of capital structure, beginning with the capital structure theory of Miller and
Modigliani:
Costs of
Asymmetric
Agency Information
Costs
Costs of
Financial
Benefit from Distress
Tax
Capital Deductibility
Structure of Interest
Irrelevance
The Weighted average Cost of Capital

The weighted average cost of capital (WACC) is the marginal cost of raising additional capital and is
affected by the costs of capital and the proportion of each source of capital:
WACC = rWACC = 1
where
rd is the before-tax marginal cost of debt
re is the marginal cost of equity
t is the marginal tax rate
D is the market value of debt
E is the market value of equity
V=D+E
2.1 Conventional theory

When there is only equity, the WACC starts at the cost of equity. As the more expensive equity finance is
replaced by cheaper debt finance, the WACC decreases. However, as gearing increases further, both debt
holders and equity shareholders will perceive more risk, and their required returns both increase.
Inevitably, WACC must increase at some point.
This theory predicts that there is an optimum gearing ratio at which WACC is minimized.
The traditional view is as follows.
(a) As the level of gearing increases, the cost of debt remains unchanged up to a certain level of gearing.
Beyond this level, the cost of debt will increase.
(b) The cost of equity rises as the level of gearing increases and financial risk increases. There is a non-
linear relationship between the cost of equity and gearing.
(c) The weighted average cost of capital does not remain constant, but rather falls initially as the
proportion of debt capital increases, and then begins to increase as the rising cost of equity (and possibly
of debt) becomes more significant.
(d) The optimum level of gearing is where the company's weighted average cost of capital is minimized.
2.2 Net operating income view of WACC: Proposition I without Taxes: Capital Structure
Irrelevance
• Franco Modigliani and Merton Miller (MM) developed a theory that helps us understand how
taxes and financial distress affect a company’s capital structure decision.
• The assumptions of their model are unrealistic, but they help us work through the effects of the
capital structure decision:
1. Investors have homogeneous expectations regarding future cash flows.
2. Bonds and stocks trade in perfect markets.
3. Investors can borrow and lend at the risk free rate.
4. There are no agency costs.
5. Investment and financing decisions are independent of one another.
MM Proposition I
The market value of a company is not affected by the capital structure of the company.
• Based on the assumptions that there are no taxes, costs of financial distress, or agency costs, so
investors would value firms with the same cash flows as the same, regardless of how the firms are
financed.
• Reasoning: There is no benefit to borrowing at the firm level because there is no interest
deductibility. Firms would be indifferent to the source of capital and investors could use financial
leverage if they wish.
Example: 28
Assume that a firm has $6,000 in debt at 5 percent interest that the expected level of EBIT is $2,000, and
that the firm’s cost of capital, ko, is constant at 10 percent. The firm has 850 shares in issue. The market
value (V) of the firm is computed as follows:
V= EBIT/ko = $2,000
The cost of external equity (ke) is computed as follows:
EAC = EBIT – I = $2,000 - ($6,000 - 5%) = $2,000 - $300 = $1,700
S = V - B = $20,000 - $6,000 =$14,000
Ke = EAC/S = $1,700/$14,000 = 12:14%
Market value per share = 1,700/(850*12.14%) = $16.47
Assume now that the firm increases its debt from $6,000 to $10,000 and uses the proceeds to retire $4,000
worth of stock i.e. 243 number of shares leaving 607 number of shares in issue and also that the interest
rate on debt remains 5 percent.
The value of the firm now is:

V= EBIT ko = $20,000
The cost of external equity is
EAC= EBIT - I = $2,000 - ($10,000 - 5%) = $2,000 - $500 = $1,500
S = V - B = $20,000 - $10,000 = $10,000
ke = EAC/S = $1,500/$10,000 = 15%
Market value per share = 1,500/(607*15%) = $16.47
2.3 Proposition II without Taxes: Higher Financial Leverage
MM Proposition II:
The cost of equity is a linear function of the company’s debt/equity ratio.
• Because creditors have a claim to income and assets that has preference over equity, the cost of
debt will be less than the cost of equity.
• As the company uses more debt in its capital structure, the cost of equity increases because of the
seniority of debt:
where r0 is the cost of equity if there is no debt financing.

• The WACC is constant because as more of the cheaper source of capital is used (that is, debt), the
cost of equity increases.
Introducing Taxes into the MM Theory

When taxes are introduced (specifically, the tax deductibility of interest by the firm), the value of the firm
is enhanced by the tax shield provided by this interest deduction. The tax shield:
- Lowers the cost of debt.
- Lowers the WACC as more debt is used.
- Increases the value of the firm by tD (that is, marginal tax rate times debt)
Without Taxes With Taxes
Value of the Firm VL = VU VL = VU + tD
WACC rWACC = rWACC = 1
Cost of Equity 1
Bottom line: The optimal capital structure is 99.99% debt.
Introducing costs of financial distress

• Costs of financial distress are costs associated with a company that is having difficulty meeting
its obligations.
• Costs of financial distress include the following:
- Opportunity cost of not making optimal decisions
- Inability to negotiate long-term supply contracts.
- Loss of customers.
• The expected cost of financial distress increases as the relative use of debt financing increases.
- This expected cost reduces the value of the firm, offsetting, in part, the benefit from
interest deductibility.
- The expected cost of distress affects the cost of debt and equity.
Bottom line: There is an optimal capital structure at which the value of the firm is maximized and the cost
of capital is minimized.
Agency Costs
• Agency costs are the costs associated with the separation of owners and management.
• Types of agency costs:
- Monitoring costs
- Bonding costs
- Residual loss
• The better the corporate governance, the lower the agency costs.
• Agency costs increase the cost of equity and reduce the value of the firm.
• The higher the use of debt relative to equity, the greater the monitoring of the firm and, therefore,
the lower the cost of equity.
Costs of Asymmetric Information

• Asymmetric information is the situation in which different parties have different information.
- In a corporation, managers will have a better information set than investors.
- The degree of asymmetric information varies among companies and industries.
• The pecking order theory argues that the capital structure decision is affected by management’s
choice of a source of capital that gives higher priority to sources that reveal the least amount of
information.
The Optimal Capital Structure

Costs to Financial
Taxes Distress Optimal Capital Structure?
No No No
Yes No Yes, 99.99% debt
Yes Yes Yes, benefits of interest deductibility are offset by the expected costs
of financial distress
We cannot determine the optimal capital structure for a given company, but we know that it depends on
the following:
• The business risk of the company.
• The tax situation of the company.
• The degree to which the company’s assets are tangible.
• The company’s corporate governance.
• The transparency of the financial information.
Trade-off Theory: Value of the Firm

The trade-off theory states that the optimal capital structure is a trade-off between interest tax shields and
cost of financial distress:
Value of firm = Value if all-equity financed + PV (tax shield) - PV(cost of financial distress)
The trade-off theory can be summarized graphically. The cost of financial distress is illustrated in the
diagram as the difference between the two curves.
In summary, the trade-off theory states that capital structure is based on a trade-off between tax savings
and distress costs of debt. Firms with safe, tangible assets and plenty of taxable income to shield should
have high target debt ratios. The theory is capable of explaining why capital structures differ between
industries, whereas it cannot explain why profitable companies within the industry have lower debt ratios
(trade-off theory predicts the opposite as profitable firms have a larger scope for tax shields and therefore
subsequently should have higher debt levels).
Deviating from Target

A company’s capital structure may be different from its target capital structure because of the following:
- Market values of outstanding issues change constantly.
- Market conditions that are favorable to one type of security over another.
- Market conditions in which it is inadvisable or too expensive to raise capital.
- Investment banking fees that encourage larger, less frequent security issuance.
Pecking order theory

Pecking order theory has been developed as an alternative to traditional theory. This theory is based on
the view that companies will not seek to minimize their WACC. Instead they will seek additional finance
in an order of preference, or 'pecking order'.
Pecking order theory states that firms will prefer retained earnings to any other source of finance, and
then will choose debt, and last of all equity. The order of preference will be:
 Retained earnings
 Straight debt (bank loans or bonds)
 Convertible debt
 Preference shares
 Issue new equity shares
Reasons for following pecking order

(a) It is easier to use retained earnings
(b) There are no issue costs if retained earnings are used, and the issue costs of debt are lower than those
of equity.
(c) Investors prefer safer securities; preference in payment of return and principal.
(d) Some managers believe that debt issues have a better signaling effect than equity issues because the
market believes that managers are better informed about shares' true worth than the market itself is. Their
view is that the market will interpret debt issues as a sign of confidence, that businesses are confident of
making sufficient profits to fulfil their obligations on debt and that the shares are undervalued.
By contrast, the market will interpret equity issues as a measure of last resort that managers believe that
equity is currently overvalued and hence are trying to achieve high proceeds while they can.
However, an issue of debt may imply a similar lack of confidence to an issue of equity; managers may
issue debt when they believe that the cost of debt is low due to the market underestimating the risk of
default and therefore undervaluing the risk premium in the cost of debt. If the market recognises this lack
of confidence, it is likely to respond by raising the cost of debt.
Limitations of pecking order theory

 It fails to take into account taxation, financial distress, agency costs or how the investment
opportunities that are available may influence the choice of finance.
 Pecking order theory is an explanation of what businesses actually do, rather than what they should
do.
CAPM and MM combined – geared betas

The CAPM is consistent with the propositions of Modigliani and Miller. MM argue that as gearing rises,
the cost of equity rises to compensate shareholders for the extra financial risk of investing in a geared
company. This financial risk is an aspect of systematic risk, and ought to be reflected in a company's beta
factor.
Project Betas
Issues in estimating a beta:
• Judgment is applied in estimating a company’s beta regarding the estimation period, the
periodicity of the return interval, the appropriate market index, the use of a smoothing technique,
and adjustments for small company stocks.

• If a company is not publicly traded or if we are estimating a project’s beta, then we need to look
at the risk of the company or project and use comparables.
• When selecting a comparable for the estimation of a project beta, we ideally would like to find a
company with a single line of business, and that line of business matches that of the project.
- This ideal comparable is a pure play.
- We use the beta of the comparable company to estimate an asset beta (beta reflecting
only business risk) and then use it for the subject project or company.
Mathematical relationship between the 'ungeared' (or asset) and 'geared' betas is as follows.
β β β
1 1
Using comparable to estimate beta
Select a Comparable
Estimate the Beta for the
Comparable
Unlever the Comparable’s Beta to

Estimate the Asset Beta
Lever the Beta for the Project’s
Financial Risk
Levering and unlevering beta

To unlever beta, remove the comparable’s capital structure from the beta to arrive at the asset beta, which
reflects the company’s business risk:
β β β
To lever the beta, adjust for the project’s financial risk:
β β 1 1
Example: Levering and Unlevering Betas

Problem
Consider the following information for the Whatsit Project and its comparable, Thatsit Company:
Whatsit Project Thatsit Company
Debt Rs.10 Rs.100
Equity Rs.40 Rs.200
Equity beta ? 1.4
What is the asset beta and equity beta for the Whatsit Project based on the comparable company
information and a tax rate of 40% for both companies?
Solution
basset = 1.4 {1 [1 + (1 – 0.4)(100  200)]} = 1.4 × 0.76923 = 1.0769
bequity = 1.0769 [1 + (1 – 0.4)(10  40)] = 1.0769 × 1.15 = 1.2384
The beta of the Whatsit Project is 1.2384
Example: 28
Beckman Engineering and Associates (BEA) is considering a change in its capital structure. BEA
currently has $20 million in debt carrying a rate of 8%, and its stock price is $40 per share with 2 million
shares outstanding. BEA is a zero-growth firm and pays out all of its earnings as dividends. The firm’s
EBIT is $14.933 million, and it faces a 40% federal-plus-state tax rate. The market risk premium is 4%,
and the risk-free rate is 6%. BEA is considering increasing its debt level to a capital structure with 40%
debt, based on market values, and repurchasing shares with the extra money that it borrows. BEA will
have to retire the old debt in order to issue new debt, and the rate on the new debt will be 9%. BEA has a
beta of 1.0.
a. What is BEA’s unlevered beta? Use market value D/S when unlevering.
b. What are BEA’s new beta and cost of equity if it has 40% debt?
c. What are BEA’s WACC of the firm with 40% debt?
Hints: a. 0.870; b. b = 1.218; rs = 10.872%. c. WACC = 8.683%;
Example: 29
Elliott Athletics is trying to determine its optimal capital structure, which now consists of only debt and
common equity. The firm does not currently use preferred stock in its capital structure, and it does not
plan to do so in the future. To estimate how much its debt would cost at different debt levels, the
company’s treasury staff has consulted with investment bankers and, on the basis of those discussions,
has created the following table:
Market Debt to- Market Equity to- Market Debt to- Bond Before-Tax
Value Ratio Value Ratio Equity Ratio Rating Cost of Debt
(wd ) (ws ) (D/S) ( rd )
0.0 1.0 0.00 A 7.0%
0.2 0.8 0.25 BBB 8.0%
0.4 0.6 0.67 BB 10.0%
0.6 0.4 1.50 C 12.0%
0.8 0.2 4.00 D 15.0%
Elliott uses the CAPM to estimate its cost of common equity, rs. The company estimates that the risk-free
rate is 5%; the market risk premium is 6%, and the company’s tax rate is 40%. Elliott estimates that if it
had no debt, its “unlevered” beta, bU, would be 1.2. Based on this information, what is the firm’s optimal
capital structure, and what would be the weighted average cost of capital at the optimal capital structure?
Hints: 11.45%
Evaluating Capital Structure Policy

• Analysts consider a company’s capital structure
- Over time.
- Compared with competitors with similar business risk.
- Considering the company’s corporate governance.
• Analysts must also consider
- The industry in which the company operates.
- The regulatory environment.
- The extent to which the company has tangible assets.
- The degree of information asymmetry.
- The need for financial flexibility.
Past Questions with Hints

December 2017
1. The following statement of financial position information relates to Tufa Co, a company listed on a large
stock market which pays corporation tax at a rate of 30%.
$m $m
Equity and liabilities
Share capital 17
Retained earnings 15
–––
Total equity 32
Non-current liabilities
Long-term borrowings 13
Current liabilities 21
–––
Total liabilities 34
–––
Total equity and liabilities 66
–––
The share capital of Tufa Co consists of $12m of ordinary shares and $5m of irredeemable preference
shares.
The ordinary shares of Tufa Co have a nominal value of $0·50 per share, an ex-dividend market price of
$7·07 per share and a cum dividend market price of $7·52 per share. The dividend for 20X7 will be paid
in the near future.
Dividends paid in recent years have been as follows:
Year 20X6 20X5 20X4 20X3
Dividend ($/share) 0·43 0·41 0·39 0·37
The 5% preference shares of Tufa Co have a nominal value of $0·50 per share and an ex dividend market
price of $0·31 per share.
The long-term borrowings of Tufa Co consist of $10m of loan notes and a $3m bank loan. The bank loan
has a variable interest rate.
The 7% loan notes have a nominal value of $100 per loan note and a market price of $102·34 per loan
note. Annual interest has just been paid and the loan notes are redeemable in four years’ time at a 5%
premium to nominal value.
Required:
(a) Calculate the after-tax weighted average cost of capital of Tufa Co on a market value basis. (11
marks)
(b) Discuss the circumstances under which it is appropriate to use the current WACC of Tufa Co in
appraising an investment project. (3 marks)
(c) Discuss THREE advantages to Tufa Co of using convertible loan notes as a source of long-term
finance. (6 marks) (20 marks)
Hints:
(a) Cost of equity (%) 11·7; Cost of preference shares (%) 8·06; WACC 11.19%
June 2016
2. Dinla Co has the following capital structure.
$000 $000
Equity and reserves
Ordinary shares 23,000
Reserves 247,000 270,000
––––––––
5% Preference shares 5,000

6% Loan notes 11,000
Bank loan 3,000
––––––––
19,000
––––––––
289,000
––––––––
The ordinary shares of Dinla Co are currently trading at $4·26 per share on an ex dividend basis and have
a nominal value of $0·25 per share. Ordinary dividends are expected to grow in the future by 4% per year
and a dividend of $0·25 per share has just been paid.
The 5% preference shares have an ex dividend market value of $0·56 per share and a nominal value of
$1·00 per share. These shares are irredeemable.
The 6% loan notes of Dinla Co are currently trading at $95·45 per loan note on an ex interest basis and
will be redeemed at their nominal value of $100 per loan note in five years’ time.
The bank loan has a fixed interest rate of 7% per year. Dinla Co pays corporation tax at a rate of 25%.
Required:
(a) Calculate the after-tax weighted average cost of capital of Dinla Co on a market value basis. (8
marks)
(b) Discuss the connection between the relative costs of sources of finance and the creditor
hierarchy. (3 marks)
(c) Explain the differences between Islamic finance and other conventional finance. (4 marks)
(15 marks)
Hints:
(a) After-tax weighted average cost of capital =
((10·1 x 391,920) + (8·9 x 2,800) + (5·6 x 10,500) + (5·25 x 3,000))/408,220 = 9·9%
December 2015
3. Gemlo Co is a company listed on a large stock market. Extracts from its current statement of financial
position are as follows:
$m $m
Equity
Ordinary shares ($1 nominal) 15
Reserves 153
––––
168
6% Irredeemable loan notes 10
7% Loan notes 12
––––
22
––––
190
––––
Gemlo Co is planning an expansion of existing business operations costing $10 million in the near future
and is assessing its current financial position as part of preparing a business case in support of seeking
new finance. The business expansion is expected to increase the profit before interest and tax of Gemlo
Co by 20% in the first year.
The planned business expansion by Gemlo Co has already been announced to the stock market.
Information on the expected increase in profit before interest and tax has not yet been announced and the
company has not decided on how the expansion is to be financed.
The ordinary shares of the company are currently trading at $3·75 per share on an ex dividend basis. The
irredeemable loan notes have a cost of debt of 7%. The 7% loan notes have a cost of debt of 6% and will
be redeemed at a 5% premium to nominal value after seven years. The interest cover of Gemlo Co is 6
times.
Companies operating in the same business sector as Gemlo Co have an average debt/equity ratio of 40%
on a market value basis and an average interest cover of 9 times.
Required:
(a) Calculate the debt/equity ratio of Gemlo Co based on market values and comment on your
findings. (4 marks)
(b) Gemlo Co agrees with a bank that its business expansion will be financed by a new issue of 8% loan
notes. The company then announces to the stock market both this financing decision and the expected
increase in profit before interest and tax arising from the business expansion.
Required:
Assuming the stock market is semi-strong form efficient, analyse and discuss the effect of the
financing and profitability announcement on the financial risk and share price of Gemlo Co.
Note: Up to 2 marks for relevant calculations. (6 marks) (10 marks)
Hints:
(a) Debt/equity ratio based on market values = 100 x 21,639,000/56,250,000 = 38·5%
December 2015
4. KQK Co wants to raise $20 million in order to expand its business and wishes to evaluate one possibility,
which is an issue of 8% loan notes. Extracts from the financial statements of KQK Co are as follows.
$m
Income 140·0
Cost of sales and other expenses 112·0
––––––
Profit before interest and tax 28·0
Finance charges (interest) 2·8
––––––
Profit before tax 25·2
Taxation 7·6
––––––
Profit after tax 17·6
––––––
$m $m
Equity finance
Ordinary shares ($1 nominal) 25·0
Reserves 118·5 143·5
––––––
Non-current liabilities 36·0
Current liabilities 38·3
––––––
Total equity and liabilities 217·8
––––––
It is expected that investing $20 million in the business will increase income by 5% over the first year.
Approximately 40% of cost of sales and other expenses are fixed, the remainder of these costs are
variable. Fixed costs will not be affected by the business expansion, while variable costs will increase in
line with income.
KQK Co pays corporation tax at a rate of 30%. The company has a policy of paying out 40% of profit
after tax as dividends to shareholders.
Current liabilities are expected to increase by 3% by the end of the first year following the business
expansion.
Average values of other companies similar to KQK Co:
Debt/equity ratio (book value basis): 30%
Interest cover: 10 times
Operational gearing (contribution/PBIT): 2 times
Return on equity: 15%
Required:
(a) Assess the impact of financing the business expansion by the loan note issue on financial
position, financial risk and shareholder wealth after one year, using appropriate measures. (10
marks)
(b) Discuss the circumstances under which the current weighted average cost of capital of a
company could be used in investment appraisal and indicate briefly how its limitations as a
discount rate could be overcome. (5 marks) (15 marks)
Hints:
(a) The changes in key financial ratios can be compared with the average values of other companies
similar to KQK Co.
Current Forecast Average
Debt/equity ratio: 25·1% 36·2% 30%
Interest cover: 10 times 7·2 times 10 times
Operational gearing: 2·6 times 2·4 times 2 times
Return on equity: 12·3% 12·3% 15%
Dividend per share $0·28 $0·30
Return on capital employed 15·6% 15·0%
Impact on financial position and financial risk??
Impact on shareholder wealth??
December 2015
5. Grenarp Co is planning to raise $11,200,000 through a rights issue. The new shares will be offered at a
20% discount to the current share price of Grenarp Co, which is $3·50 per share. The rights issue will be
on a 1 for 5 basis and issue costs of $280,000 will be paid out of the cash raised. The capital structure of
Grenarp Co is as follows:
$m $m
Equity
Ordinary shares ($0·50 nominal) 10
Reserves 75
–––
85
8% Loan notes 30
––––
115
––––
The net cash raised by the rights issue will be used to redeem part of the loan note issue. Each loan note
has a nominal value of $100 and an ex interest market value of $104. A clause in the bond issue contract
allows Grenarp Co to redeem the loan notes at a 5% premium to market price at any time prior to their
redemption date.
The price/earnings ratio of Grenarp Co is not expected to be affected by the redemption of the loan notes.
The earnings per share of Grenarp Co is currently $0·42 per share and total earnings are $8,400,000 per
year. The company pays corporation tax of 30% per year.
Required:
(a) Evaluate the effect on the wealth of the shareholders of Grenarp Co of using the net rights issue
funds to redeem the loan notes. (8 marks)
(b) Discuss whether Grenarp Co might achieve its optimal capital structure following the rights
issue. (7 marks) (15 marks)
Hints:
(a) The wealth of shareholders of Grenarp Co has decreased as they have experienced a capital loss of
$0·26 per share ($3·37 – $3·11) compared to the theoretical ex rights price per share.
December 2014
6. Tinep Co is planning to raise funds for an expansion of existing business activities and in preparation for
this the company has decided to calculate its weighted average cost of capital. Tinep Co has the following
capital structure:
$m $m
Equity
Ordinary shares 200
Reserves 650
––––
850
Loan notes 200
––––––
1,050
––––––
The ordinary shares of Tinep Co have a nominal value of 50 cents per share and are currently trading on
the stock market on an ex dividend basis at $5·85 per share. Tinep Co has an equity beta of 1·15.
The loan notes have a nominal value of $100 and are currently trading on the stock market on an ex
interest basis at $103·50 per loan note. The interest on the loan notes is 6% per year before tax and they
will be redeemed in six years’ time at a 6% premium to their nominal value.
The risk-free rate of return is 4% per year and the equity risk premium is 6% per year. Tinep Co pays
corporation tax at an annual rate of 25% per year.
Required:
(a) Calculate the market value weighted average cost of capital and the book value weighted
average cost of capital of Tinep Co, and comment briefly on any difference between the two values.
(9 marks)
(b) Discuss the factors to be considered by Tinep Co in choosing to raise funds via a rights issue. (6
marks) (15 marks)
Hints:
(a) Market value WACC
K0 = ((10·9 x 2,340) + (4·7 x 207))/2,547 = 26,479/2,547 = 10·4%
Book value WACC
K0 = ((10·9 x 850) + (4·7 x 200))/1,050 = 10,205/1,050 = 9·7%
Comment
Market values of financial securities reflect current market conditions and current required rates of
return. Market values should therefore always be used in calculating the weighted average cost of capital
(WACC) when they are available. If book values are used, the WACC is likely to be understated, since the
nominal values of ordinary shares are much less than their market values. The contribution of the cost of
equity is reduced if book values are used, leading to a lower WACC, as evidenced by the book value
WACC (9·7%) and the market value WACC (10·4%) of Tinep Co.
June 2014
7. The equity beta of Fence Co is 0·9 and the company has issued 10 million ordinary shares. The market
value of each ordinary share is $7·50. The company is also financed by 7% bonds with a nominal value of
$100 per bond, which will be redeemed in seven years’ time at nominal value.
The bonds have a total nominal value of $14 million. Interest on the bonds has just been paid and the
current market value of each bond is $107·14.
Fence Co plans to invest in a project which is different to its existing business operations and has
identified a company in the same business area as the project, Hex Co. The equity beta of Hex Co is 1·2
and the company has an equity market value of $54 million. The market value of the debt of Hex Co is
$12 million.
The risk-free rate of return is 4% per year and the average return on the stock market is 11% per year.
Both companies pay corporation tax at a rate of 20% per year.
Required:
(a) Calculate the current weighted average cost of capital of Fence Co. (7 marks)
(b) Calculate a cost of equity which could be used in appraising the new project. (4 marks)
(c) Explain the difference between systematic and unsystematic risk in relation to portfolio theory
and the capital asset pricing model. (6 marks)
(d) Discuss the differences between weak form, semi-strong form and strong form capital market
efficiency, and discuss the significance of the efficient market hypothesis (EMH) for the financial
manager. (8 marks) (25 marks)
Hints:
(a) WACC = ((10·3 x 75) + (4·4 x 15))/90 = 9·3%
(b) Using the CAPM. Equity or market risk premium = 11 – 4 = 7%; Cost of equity = 4 + (1·182 x 7) = 4
+ 8·3 = 12·3%
December 2013
8. Card Co has in issue 8 million shares with an ex dividend market value of $7·16 per share. A dividend of
62 cents per share for 2013 has just been paid. The pattern of recent dividends is as follows:
Year 2010 2011 2012 2013
Dividends per share (cents) 55·1 57·9 59·1 62·0
Card Co also has in issue 8·5% bonds redeemable in five years’ time with a total nominal value of $5
million. The market value of each $100 bond is $103·42. Redemption will be at nominal value.
Card Co is planning to invest a significant amount of money into a joint venture in a new business area. It
has identified a proxy company with a similar business risk to the joint venture. The proxy company has
an equity beta of 1·038 and is financed 75% by equity and 25% by debt, on a market value basis.
The current risk-free rate of return is 4% and the average equity risk premium is 5%. Card Co pays profit
tax at a rate of 30% per year and has an equity beta of 1·6.
Required:
(a) Calculate the cost of equity of Card Co using the dividend growth model. (3 marks)
(b) Discuss whether the dividend growth model or the capital asset pricing model should be used to
calculate the cost of equity. (5 marks)
(c) Calculate the weighted average after-tax cost of capital of Card Co using a cost of equity of
12%. (5 marks)
(d) Calculate a project-specific cost of equity for Card Co for the planned joint venture. (4 marks)
(e) Discuss whether changing the capital structure of a company can lead to a reduction in its cost
of capital and hence to an increase in the value of the company. (8 marks) (25 marks)
Hints:
(a) Using the dividend growth model:
Ke = 0·04 + [(62 x 1·04)/716] = 0·04 + 0·09 = 0·13 or 13%
(c) WACC of Card Co = [(12 x 57,280) + (5·17 x 5,171)]/62,451 = 11·4%
(d) Project-specific cost of equity = 4 + (0·895 x 5) = 8·5%
June 2013
9. AMH Co wishes to calculate its current cost of capital for use as a discount rate in investment appraisal.
The following financial information relates to AMH Co:
Financial position statement extracts as at 31 December 2012
$000 $000
Equity
Ordinary shares (nominal value 50 cents) 4,000
Reserves 18,000 22,000
–––––––
Long-term liabilities
4% Preference shares (nominal value $1) 3,000
7% Bonds redeemable after six years 3,000
Long-term bank loan 1,000 7,000
––––––– –––––––
29,000
–––––––
The ordinary shares of AMH Co have an ex div market value of $4·70 per share and an ordinary dividend
of 36·3 cents per share has just been paid. Historic dividend payments have been as follows:
Year 2008 2009 2010 2011
Dividends per share (cents) 30·9 32·2 33·6 35·0
The preference shares of AMH Co are not redeemable and have an ex div market value of 40 cents per
share. The 7% bonds are redeemable at a 5% premium to their nominal value of $100 per bond and have
an ex interest market value of $104·50 per bond. The bank loan has a variable interest rate that has
averaged 4% per year in recent years.
AMH Co pays profit tax at an annual rate of 30% per year.
Required:
(a) Calculate the market value weighted average cost of capital of AMH Co. (12 marks)
(b) Discuss how the capital asset pricing model can be used to calculate a project-specific cost of
capital for AMH Co, referring in your discussion to the key concepts of systematic risk, business
risk and financial risk. (8 marks)
(c) Discuss why the cost of equity is greater than the cost of debt. (5 marks) (25 marks)
Hints:
(a) WACC calculation = [(12·1 x 37,600) + (10 x 1,200) + (4·8 x 3,135) + (2·8 x 1,000)]/42,935 = 11·3%
December 2012
10. The statement of financial position of BKB Co provides the following information:
$m $m
Equity finance
Ordinary shares ($1 nominal value) 25
Reserves 15 40
–––
7% Convertible bonds ($100 nominal value) 20
5% Preference shares ($1 nominal value) 10 30
–––
Current liabilities
Trade payables 10
Overdraft 15 25
––– –––
Total liabilities 95
–––
BKB Co has an equity beta of 1·2 and the ex-dividend market value of the company’s equity is $125
million. The ex-interest market value of the convertible bonds is $21 million and the ex-dividend market
value of the preference shares is $6·25 million.
The convertible bonds of BKB Co have a conversion ratio of 19 ordinary shares per bond. The conversion
date and redemption date are both on the same date in five years’ time. The current ordinary share price of
BKB Co is expected to increase by 4% per year for the foreseeable future.
The overdraft has a variable interest rate which is currently 6% per year and BKB Co expects this to
increase in the near future. The overdraft has not changed in size over the last financial year, although one
year ago the overdraft interest rate was 4% per year. The company’s bank will not allow the overdraft to
increase from its current level.
The equity risk premium is 5% per year and the risk-free rate of return is 4% per year. BKB Co pays
profit tax at an annual rate of 30% per year.
Required:
(a) Calculate the market value after-tax weighted average cost of capital of BKB Co, explaining
clearly any assumptions you make. (12 marks)
(b) Discuss why market value weighted average cost of capital is preferred to book value weighted
average cost of capital when making investment decisions. (4 marks)
(c) Comment on the interest rate risk faced by BKB Co and discuss briefly how this risk can be
managed. (5 marks)
(d) Discuss the attractions to a company of convertible debt compared to a bank loan of a similar
maturity as a source of finance. (4 marks) (25 marks)
Hints:
(a) After-tax WACC = ((10% x 125m) + (8% x 6·25m) + (6·43% x 21m))/152·25m = 9·4%
It is assumed that the overdraft can be ignored in calculating the WACC, even though it persists from
year to year and is a significant source of finance for BKB Co.
June 2012
11. Corhig Co is a company that is listed on a major stock exchange. The company has struggled to maintain
profitability in the last two years due to poor economic conditions in its home country and as a
consequence it has decided not to pay a dividend in the current year. However, there are now clear signs
of economic recovery and Corhig Co is optimistic that payment of dividends can be resumed in the future.
Forecast financial information relating to the company is as follows:
Year 1 2 3
Earnings ($000) 3,000 3,600 4,300
Dividends ($000) nil 500 1,000
The company is optimistic that earnings and dividends will increase after Year 3 at a constant annual rate
of 3% per year.
Corhig Co currently has a before-tax cost of debt of 5% per year and an equity beta of 1·6. On a market
value basis, the company is currently financed 75% by equity and 25% by debt.
During the course of the last two years the company acted to reduce its gearing and was able to redeem a
large amount of debt. Since there are now clear signs of economic recovery, Corhig Co plans to raise
further debt in order to modernise some of its non-current assets and to support the expected growth in
earnings. This additional debt would mean that the capital structure of the company would change and it
would be financed 60% by equity and 40% by debt on a market value basis. The before-tax cost of debt of
Corhig Co would increase to 6% per year and the equity beta of Corhig Co would increase to 2.
The risk-free rate of return is 4% per year and the equity risk premium is 5% per year. In order to
stimulate economic activity the government has reduced profit tax rate for all large companies to 20% per
year.
The current average price/earnings ratio of listed companies similar to Corhig Co is 5 times.
Required:
(a) Estimate the value of Corhig Co using the price/earnings ratio method and discuss the
usefulness of the variables that you have used. (4 marks)
(b) Calculate the current cost of equity of Corhig Co and, using this value, calculate the value of the
company using the dividend valuation model. (6 marks)
(c) Calculate the current weighted average after-tax cost of capital of Corhig Co and the weighted
average after-tax cost of capital following the new debt issue, and comment on the difference
between the two values. (6 marks)
(d) Discuss how the shareholders of Corhig Co can assess the extent to which they face the following
risks, explaining in each case the nature of the risk being assessed:
(i) Business risk;
(ii) Financial risk;
(iii) Systematic risk. (9 marks) (25 marks)
Hints:
(a) Price/earnings ratio valuation
The value of the company using this valuation method is found by multiplying future earnings by a
price/earnings ratio. Using the earnings of Corhig Co in Year 1 and the price/earnings ratio of similar
listed companies gives a value of 3,000,000 x 5
= $15,000,000.
(b) Value of company using the dividend valuation model
Market value from dividend valuation model = 398,597 + 711,780 + 8,145,929 = $9,256,306 or
approximately $9·3 million
(c) Current weighted average after-tax cost of capital
Current after-tax WACC = (12 x 0·75) + (4 x 0·25) = 10% per year
Revised after-tax WACC = (14 x 0·6) + (4·8 x 0·4) = 10·32% per year
Comment
The after-tax WACC has increased slightly from 10% to 10·32%. This change is a result of the increases
in the cost of equity and the after-tax cost of debt, coupled with the change in gearing. Although the cost
of equity has increased, the effect of the increase has been reduced because the proportion of equity
finance has fallen from 75% to 60% of the long-term capital employed. Although the after-tax cost of debt
has increased, the cost of debt is less than the cost of equity and the proportion of cheaper debt finance
has increased from 25% to 40% of the long-term capital employed.
December 2011
12. Recent financial information relating to Close Co, a stock market listed company, is as follows.
$m
Profit after tax (earnings) 66·6
Dividends 40·0
Statement of financial position information:
$m $m
Non-current assets 595
Current assets 125
––––
Total assets 720
––––
Current liabilities 70
Equity
Ordinary shares ($1 nominal) 80
Reserves 410
––––
490
6% Bank loan 40
8% Bonds ($100 nominal) 120
––––
160
––––
720
––––
Financial analysts have forecast that the dividends of Close Co will grow in the future at a rate of 4% per
year. This is slightly less than the forecast growth rate of the profit after tax (earnings) of the company,
which is 5% per year. The finance director of Close Co thinks that, considering the risk associated with
expected earnings growth, an earnings yield of 11% per year can be used for valuation purposes.
Close Co has a cost of equity of 10% per year and a before-tax cost of debt of 7% per year. The 8% bonds
will be redeemed at nominal value in six years’ time. Close Co pays tax at an annual rate of 30% per year
and the ex-dividend share price of the company is $8·50 per share.
Required:
(a) Calculate the value of Close Co using the following methods:
(i) net asset value method;
(ii) dividend growth model;
(iii) earnings yield method. (5 marks)
(b) Discuss the weaknesses of the dividend growth model as a way of valuing a company and its
shares. (5 marks)
(c) Calculate the weighted average after-tax cost of capital of Close Co using market values where
appropriate. (8 marks)
(d) Discuss the circumstances under which the weighted average cost of capital (WACC) can be
used as a discount rate in investment appraisal. Briefly indicate alternative approaches that could
be adopted when using the WACC is not appropriate. (7 marks) (25 marks)
Hints:
(a) Net asset valuation= $490 million.
Dividend growth model = $693 million
Earnings yield method= $606 million
(c) Calculation of weighted average after-tax cost of capital (WACC)
After-tax WACC = ((680m x 10) + (125·7m x 4·9) + (40 x 4·2))/845·7 = 9·0 % per year
June 2011
13. The finance director of AQR Co has heard that the market value of the company will increase if the
weighted average cost of capital of the company is decreased. The company, which is listed on a stock
exchange, has 100 million shares in issue and the current ex div ordinary share price is $2·50 per share.
AQR Co also has in issue bonds with a book value of $60 million and their current ex interest market
price is $104 per $100 bond. The current after-tax cost of debt of AQR Co is 7% and the tax rate is 30%.
The recent dividends per share of the company are as follows.
Year 2006 2007 2008 2009 2010
Dividend per share (cents) 19·38 20·20 20·41 21·02 21·80
The finance director proposes to decrease the weighted average cost of capital of AQR Co, and hence
increase its market value, by issuing $40 million of bonds at their par value of $100 per bond. These
bonds would pay annual interest of 8% before tax and would be redeemed at a 5% premium to par after
10 years.
Required:
(a) Calculate the market value after-tax weighted average cost of capital of AQR Co in the
following circumstances:
(i) before the new issue of bonds takes place;
(ii) after the new issue of bonds takes place.
Comment on your findings. (12 marks)

(b) Identify and discuss briefly the factors that influence the market value of traded bonds. (5
marks)
(c) Discuss the director’s view that issuing traded bonds will decrease the weighted average cost of
capital of AQR Co and thereby increase the market value of the company. (8 marks) (25 marks)
Hints:
The weighted average after-tax cost of capital before the new issue of bonds is 11%.
After the new issue of bonds, the weighted average after-tax cost of capital has decreased from 11% to
10·4% because the proportion of debt finance, which has a lower required rate of return than equity
finance, has increased. Gearing on a market value basis has increased from 20% (62·4/312·4) to 29%
(102·4/352·4).
The WACC calculation assumes that the cost of equity has not changed, when in reality the cost of equity
might be expected to rise in response to the increase in financial risk caused by the new issue of debt. The
share price of the company has also been assumed to be constant.

Cost of Capital

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COST OF CAPITAL & CAPITAL STRUCTURE, ACCA

8. Cost of Capital & Capital Structure

2. Costs of the Different sources of capital

Taxes and the Cost of capital

The cost of Debt

Example 1: F plc has in issue 8% irredeemable debentures quoted at 90 p.c. ex int.

Issues in estimating the cost of debt

The Cost of Preferred Stock

The Cost of Equity

Using the Dividend Valuation Model to Estimate the Cost of Equity

which we can rearrange to solve for the required rate of return:

minus the dividend payout ratio, or 1 ):

Estimating growth rate in dividends

Past Growth Rate

Using Gordon Growth model

Using the CAPM to estimate the Cost of Equity

Risk Free Rate

Cost of equity under CAPM

Arbitrage Pricing Model (APT) [Alternatives to the CAPM]

Country Risk Premium

Cost of Retained Earnings

WACC = wdrd (1  t) + wprp + were

Weights of the Weighted Average

Example 26: Ciron Limited has the following capital structure:

Applying the Cost of capital to capital Budgeting and Security Valuation

Optimal Investment Decision

Example 27: Georgebear has the following capital structure.

Using the MCC in capital Budgeting and Analysis

2. The Capital Structure Decision

The Weighted average Cost of Capital

2.1 Conventional theory

The value of the firm now is:

2.3 Proposition II without Taxes: Higher Financial Leverage

where r0 is the cost of equity if there is no debt financing.

Introducing Taxes into the MM Theory

Value of the Firm VL = VU VL = VU + tD

WACC rWACC = rWACC = 1

Bottom line: The optimal capital structure is 99.99% debt.

Introducing costs of financial distress

Costs of Asymmetric Information

The Optimal Capital Structure

Trade-off Theory: Value of the Firm

Deviating from Target

Pecking order theory

Reasons for following pecking order

Limitations of pecking order theory

CAPM and MM combined – geared betas

and adjustments for small company stocks.

Unlever the Comparable’s Beta to

Levering and unlevering beta

Example: Levering and Unlevering Betas

The beta of the Whatsit Project is 1.2384

Evaluating Capital Structure Policy

Past Questions with Hints

5% Preference shares 5,000

Comment on your findings. (12 marks)

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