Chapter 8: Cost of capital

• The weighted average cost of capital

– The cost of ordinary share capital, with debt financing
– The cost of preference shares
– The cost of debt financing
• Investment and financing decision
• Required rate of return for an individual
investment project

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 Cost of capital
• What is the cost of capital for an individual
investment project?
– The rate of return that an investor can obtain on similar
alternative investments, i.e. investments with a similar
term and risk profile: the opportunity cost for the
investor.
– Companies with a similar risk profile

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 Cost of capital
• What is the global cost of capital of a company?
– ‘Weighted Average Cost of Capital’ - WACC
– The rate of return required by all financiers of the
company, which is the minimum that must be realised by
all assets that the company owns and manages
– The return, required by all financiers together, according
to their proportional share in the financial structure of the
company

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 The cost of ordinary share capital
• The company is fully financed with equity capital
– CAPM:
E ( R ) = RF + b  ( E ( RM ) − RF )
– bassets = bequity
Cov ( Ri , R M )  i , M
bi = = 2
Var ( R M ) M
– Calculation beta on the basis of
• Monthly returns for 5 years
• Weekly returns for 2 to 5 years
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 The cost of ordinary share capital
• The company is also partly financed with debt
𝑑𝑒𝑏𝑡 𝑒𝑞𝑢𝑖𝑡𝑦
𝛽𝑎𝑠𝑠𝑒𝑡𝑠 = 𝛽𝑑𝑒𝑏𝑡 + 𝛽𝑒𝑞𝑢𝑖𝑡𝑦
𝑑𝑒𝑏𝑡+𝑒𝑞𝑢𝑖𝑡𝑦 𝑑𝑒𝑏𝑡+𝑒𝑞𝑢𝑖𝑡𝑦

𝑒𝑞𝑢𝑖𝑡𝑦
𝛽𝑎𝑠𝑠𝑒𝑡𝑠 = 𝛽𝑒𝑞𝑢𝑖𝑡𝑦
𝑑𝑒𝑏𝑡+𝑒𝑞𝑢𝑖𝑡𝑦

𝑑𝑒𝑏𝑡
𝛽𝑒𝑞𝑢𝑖𝑡𝑦 = 𝛽𝑎𝑠𝑠𝑒𝑡𝑠 1+
𝑒𝑞𝑢𝑖𝑡𝑦

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 The cost of ordinary share capital
• Other determinants of Beta
– cyclicality in firm’s earnings
• cyclicality (systematic risk)
• ↔ variability (systematic + unsystematic risk)
• A higher cyclicity implies a higher beta
– operational leverage
• Fixed costs versus variable costs
• A higher proportion of fixed costs in total costs implies a higher
beta, since a change in sales will have a greater impact on profit

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 Operational leverage

Total costs

Fixed costs

Sales

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Operational leverage

 Profit

 Sales

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 Operational leverage

Total costs

Fixed costs

Sales

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Operational leverage

 Profit

 Sales

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 The cost of ordinary share capital
• Stability of beta
– Beta is not stable over time
• Beta calculated on the basis of the rates of return in the recent past
is not necessarily a good predictor of the future required rate of
return
• Sector beta or weighted average of company specific beta and
sector beta

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 The cost of ordinary share capital
• Choice of beta can have a significant impact on a
company's valuation!
– See http://curiousfinance.blogspot.be/2015/08/the-art-or-is-
it-science-of-company.html
• Acquisition of Rural-Metro by ‘private equity’ firm
Warburg Pincus.
– Afterwards, the shareholders of Rural-Metro took the
directors and the banks who supervised the acquisition to
court, because they would have sold the company for too
low a price.

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 The cost of ordinary share capital
• Valuation of Rural-Metro
– Shareholders
• Beta calculated op the basis of weekly returns over 2 years =
1.20
• Share value = $ 21.42
– Supervising bank
• Beta calculated op the basis of monthly returns over 5 years =
1.454
• Share value = $ 16.91
– Difference in company's valuation: $ 100 million

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 The cost of preference shares
• Preference shares
– hybrid financial instrument
– the return of preference shares is usually limited to a
predetermined preference dividend
– payment of the preferred dividend depends on the profit
situation of the company and is not a legal obligation
– usually cumulative in nature

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 The cost of preference shares
• Preference shares
– before a company can pay a dividend to ordinary
shareholders, it must first pay the preferred dividends
– In case of liquidation, the preferred shareholders come
after creditors, but before ordinary shareholders

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 The cost of preference shares
• Cost
– since preferred share capital has no expiration date, the
cost of capital can be calculated as a perpetuity :

rp = Dp/I0
• rp = cost of the preference share capital
• Dp = preferred dividend
• I0 = net receipt at the issue of the preference shares

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 The cost of preference shares
• Example
– a preference share with nominal value € 100, net receipt
at the issue of the preference shares € 98.5 and a
preferred dividend of 13% gives:
rp = (100 x 13%) / 98.5 = 13.2%

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 The cost of debt financing
• rD: interest expenses on financial debts
– company realizes a tax advantage on the interest
payments, depending on the tax rate t
– interest costs are tax deductible
→ Cost of debt after taxes: rD x (1-t)
• What costs would the company pay today on new
debt financing, given its current risk profile and
current market interest?

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 The weighted average cost of capital
• Example
Market value Proportion Cost Weighted cost
Debt capital 60 mlj 60 % 7,0 % (*) 4,2
Preference share capital 10 mlj 10 % 13,0 % 1,3
Ordinary share capital 30 mlj 30 % 15,0% 4,5
100 mlj 100% 10,0 %

(*) 7% = 11.67% x (1-0.4)

• Operational debt versus financial debt!

– Trade payables and bank debt
• Trade payables are a (negative) part of net working capital
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 The weighted average cost of capital
• Example: Duvel Moortgat, introduced at the
Brussels Stock Exchange in June 1999
• The cost of ordinary share capital of Duvel
Moortgat
• E(ri) = rF + bi x (rM - rF)

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 The weighted average cost of capital
– rF: 4.31% (return on Belgian government bonds at 10
years)
– rM - rF: 3.24% (the average risk premium for Belgian
listed companies)
– estimated b for share Duvel Moortgat: 0.8
→ E(ri) = 4.31% + 0.8 x (3.24%) = 6.90%

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 The weighted average cost of capital
• The weighted average cost of capital (WACC) of
Duvel Moortgat
WACC = EQ/(EQ+D) x rE + D/(EQ+D) x rD x (1-t)
• rE= 6.90%
• Cost of debt rD= 5.40%
• Tax rate t = 40.17%
→ The WACC fluctuates between 6.6% and 6.9%,
depending on the assumed financial structure

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 Required rate of return for an individual
investment project
• The total risk of a portfolio consists of the weighted
average of the systematic risks of the components
→ the systematic risk of the global business activity is equal
to the weighted average of the systematic risks of the sub-
activities.
→ the global cost of capital of a company is not necessarily
relevant to evaluate all investment projects of this
company

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 Finally…
• Uncoupling of the investment decision from the
financing decision !

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 Finally…
• A company is considering 2 projects A and B
– Project A with return 6% and Project B with return 10%
– Overall company financing: 50% debt and 50% equity
– But the investment in A is financed with a loan while the
investment in B is financed with internally available cash
– rD = 8% -> 8% * (1 - 40%) = 4.8%
– rE = 11% (the cost of using internally available cash is the
cost of equity!)
– WACC = 7.9%!
• 50% * 4.8% + 50% * 11%

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 Problem 1
• A company has 20 million ordinary shares, currently listed
on the stock exchange at a price of 25 € per share. It has
also issued a bond loan that is currently trading at 95% of
its nominal value of € 180 million. The required return on
this loan is currently 10% and the required return on
equity amounts 20%. What is the weighted average cost of
capital of this company if you know that the tax rate is
40%?

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 Problem 2
• The beta of equity of sugar producer De Wever is 1.29.
The proportion debt/equity is equal to 1 for this company.
The expected market return is 13% and the risk-free
interest rate is 7%. The required return on the company's
debt is also 7%. The corporate tax rate is 35%. What is
the cost of equity capital? What is the weighted average
capital cost?

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