COST OF CAPITAL

ELEMENT OF THE COST OF CAPITAL

The cost of capital is the return that investors expect to be paid for putting funds into the
company. In order words, it is the cost incurred by a company for raising money to finance its
activities.

The elements of cost of capital are:

➢ The risk-free rate of return – return required from an investment which is completely
free from risk, example return on government securities.
➢ The risk premium – return to compensate for financial risk (having debts in capital
structure) and business risk (return to compensate for uncertainty about the future
and about a firm’s business prospects).

COST OF EQUITY – USING DIVIDEND VALUATION MODEL

With constant annual dividends

Where a company is expected to pay a constant divided in perpetuity the cost of equity can be
calculated as:

Ke = D/P0(ex-div)

With dividend growing at a constant annual rate (g)

Where a company is expected to pay divided at a constant growth rate in perpetuity the cost
of equity can be calculated as:

The Dividend Growth model is:

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

Where

Ke = Cost of equity g = Constant growth rate

D0 = Current dividend P0 = Ex- div market price

Illustration 1

A company is expected to pay a constant dividend of 40 pence per share. The current ex-div
market price is £3 per share.

➢ What is the cost of equity?

➢ What is the cost of equity, if anticipated growth in dividends is 10% per annum?

Cum-div and ex-div share prices

Ex-div price = cum-div share price - dividend just about to be paid

 present value

Cum div price = ex-div price + dividend due

Estimating growth rate

The growth ‘g’ can be estimated using either historical pattern or Gordon’s growth model
depending on the information available.

Historic pattern

A growth rate may be estimated from historic dividend pattern, as follows:

G= ((D0/Dn)^1/n) – 1

Where:

Dn = dividend in the past. That is the base dividend.

D0 = the current dividend. That is the last dividend paid.

N = number of years of growth.

Illustration 2

Temidayo plc currently pays a dividend of 32p. Five years ago the dividend was 20p.

Estimate the growth rate.

Illustration 3

The dividends of Akinwale plc over the last five years are given below:

Year Dividends

1 180,000

2 210,000

3 220,000

4 245,000

5 280,000

Akinwale plc’s current ex-div market price is £4 and it has in issue 1,000,000 ordinary shares.

Calculate the company’s cost of equity.

Gordon’s growth model

In Gordon’s growth model, growth is measured as follows:

g = rb
 later

Where:

R = the accounting rate of return/return on re-invested fund

= (Earnings/Book value of equity capital employed)*100

B = the earnings retention rate/proportion of funds/profit retained

= (Earnings – dividend/earnings)*100

Illustration 4

Consider the following Olamide plc

Current cum-div market price £2.5

Current dividend 40 pence

Dividend pay-out ratio 60%

Average return on investment 10%

Calculate the cost of equity.

COST OF PREFERENCE SHARE CAPITAL

The cost of irredeemable preference share capital, paying an annual dividend d in perpetuity,
and having a current ex-div price of Po can be calculated as follows:

Kps = (D(net)/P0(ex-div))*100

Dividends are constant and there is no growth.

Illustration 5

Titi has in issue 100,000 6% Preference shares of £1 each with a market price of 40p.

What is the cost of preference share capital?

COST OF IRREDEEMABLE DEBT CAPITAL

The cost of irredeemable loan notes paying an annual interest in perpetuity and having a
current market price will be calculated as follows:

Kd = Interest(1 – t)/Market value of debt(ex-div)

Where:

T = rate of corporation tax.

I = annual interest

Illustration 6

Yemi J company has in issue 5% irredeemable loan notes currently quoted at £105.5 cum-
interest per £100 nominal. Assume a corporation tax of 30%.

Calculate the cost of the debenture.

COST OF REDEEMABLE DEBT CAPITAL

The cost of redeemable loan notes/debentures is the internal rate of return of the net cash
flows of the capital.

Illustration 7

Dr Iredele 5% loan note is currently quoted at £95.84 (ex-int). It is redeemable at the end of 3
years at £100.

Taking corporation tax at 50%, and ignoring the timing lag for tax savings, calculate Kd.

Cost of convertible

The cost of convertible debt is calculated in a similar manner to the calculation of the cost of
redeemable debt, EXCEPT that in the final year, one must include the:

➢ redemption value of the debt, or

➢ conversion value of the debt

Whichever is the GREATER?

Illustration 8

Bunmi plc 8% convertible debentures have a current market value of £106 per cent. The
debenture will be converted into equity shares in 3 years’ time at the rate of 40 shares per £100
of debentures. The market price is expected to be £3.5 on the date of conversion.

What is the cost of capital to the company for the convertible debentures?

Assume a corporation tax of 33%.

COST OF SHORT-TERM FUNDS

The cost of short-term funds such a bank loans and overdrafts is the current interest being
charged on such funds reduced for the tax effect on the interest.

Kd = I (1-t)

Illustration 9

Emeka company has 8% bank loan with a book value of £3,000,000.

Calculate the cost of this bank loan. Assume 30% tax rate.
WEIGHTED AVERAGE COST OF CAPITAL (WACC)

The weighted average cost of capital (WACC) is the average cost of the different elements
within the capital structure of a company, using the market value of each of the different
elements as the basis of the weightings.

Although book values are often easier to obtain they are of doubtful economic significance,
that is, it is more meaningful to use market values.

WACC can be calculated as

WACC = Ke(Ve/Ve+Vd) + Kd(1 – t)(Vd/Ve+Vd)

Where:

Ke = Cost of equity

Kd = Cost of debt

Ve = Market value of equity in the firm

Vd = Market value of debt in the firm

Illustration 10

The management of Okeowo is trying to decide upon a cost of capital discount rate to apply to
the evaluation of investment projects.

The company has an issued share capital of 500,000 ordinary £1 shares, with a current market
value cum div of £1.17 per share. It has also issued £200,000 of 10% debentures, which are
redeemable at par in 2 years and have a current market value of £105.30 per cent and £1 00,000
of 6% preference shares, currently priced at 40p per share. The preference dividend has just
been paid, and the ordinary dividend and debenture interest are due to be paid in the near
future. (The preference dividend is shown net).

The ordinary share dividend will be £60,000 this year, and the directors have publicised their
view that earnings and dividends will increase by 5% per annum into the indefinite future.

The fixed assets and working capital of the company are financed by:

Ordinary shares of £1 500,000

6% £1 Preference shares 100,000

Debentures 200,000

Reserves 380,000

1,180,000
Required:

Calculate the WACC. Assume corporation tax at 50% per annum, payable one year in arrears

Assumptions in the use of WACC

WACC can be used as a cut-off or discount rate for calculating NPVs of projected cash flows
for new investments, but the following criteria should be met.

➢ There is no significant change in capital structure of the company as a result of the

investment.
➢ The operating risk of the company does not change as a result of the investment.
➢ The project to appraise is small relative to the size of the company. It represents a
marginal investment.