LESSON THREE: COST OF CAPITAL

1.0 INTRODUCTION
The firm's mix of different securities is known as its capital structure. A firm
can issue dozens of distinct securities in countless combinations that maximizes
its overall market value. It is important to ask ourselves whether these attempts
to affect its total valuation and its cost of capital by changing its financial mix,
are worthwhile. This will be discussed in this lesson.

1.1 COST OF CAPITAL

Cost of capital refers to the discount rate that is used in determining the present
value of the estimated future cash proceeds and eventually deciding whether the
projects is worth undertaking or not. The cost of capital is usually visualized as
composed of several elements. These elements are the cost of each component
(different sources from which funds are raised) of capital which is its cost. The
cost of each source or component is called specific cost of capital. When
specific costs are combined to arrive at overall cost of capital, it is referred to as
the weighted cost of capital.

Usually the cost of debt is lower than the cost of equity. This is so because
debt is a fixed obligation while equity is not. However, firms cannot operate on
debts alone since this will subsequently increase the risk of bankruptcy (that is
the firm being unable to meet its fixed obligations). This risk of bankruptcy is
also associated with the stability of sales and earnings. A firm with relatively
unstable earnings will be reluctant to adopt a high degree of leverage since
conceivably it might be unable to meet its fixed obligations at all.
1.2 MEASUREMENT OF SPECIFIC COSTS

i) Cost of Debt:
Debt can either be perpetual/irredeemable or redeemable

a) Cost of Perpetual Debt

It is the rate of return which the lenders expect. The coupon interest rate or the
market yield on debt can easily represent an approximation of the cost of debt.
The coupon rate of interest on debt is before tax cost of debt. Since the
effective cost of debt is the tax adjusted rate of interest, the before tax cost of
debt should be adjusted for the tax effect. Thus the cost of debt to a firm can
be given by the following formula:

Kd = Annual interest charges

Market value of outstanding debt

Where Kd is the yield of the company's debts. The market value of outstanding
debt will therefore be given by the following formulae.

Market value of debt = Annual interest charges

Kd

Kd is the before tax cost of debt. However, the effective cost of debt is the after
tax cost because interest on debt is tax deductible. The effective cost of debt
(Kb) therefore is
 Kb = Kd (I - T)

Where Kb is the effective (after tax) cost

T is the corporate tax rate
Illustration 1.
A company has 10% perpetual debt of Ksh. 1,000,000. The tax rate is 35%.
Determine the cost of capital (before tax as well as after tax) assuming the debt
is issued at
i) Par
ii) 10% discount
iii) 10% premium
Suggested Solution
i) Debt issued at par
Before tax cost kd=10%
After tax cost kb=kd(1-t)
= 10% (1-.35) = 6.5%
ii) Issued at discount
Before tax cost kd= 100,000/900,000 =11.11%
After tax kb = 11.11 %(1-.35) = 7.22%
iii) Issued at Premium
Before tax cost kd = 100,000/1100,000 =9.09%
After tax cost kb= 9.09% (1-.35) = 5.91%

b) Cost of Redeemable Debt

In the case of calculating cost of redeemable debt, account has to be taken in
addition to interest payments, of the repayment of the principal. When the
 amount of principal is re-paid in one lump sum at maturity, the cost of debt
will be given by the following formula;
n
COn COP
CIo=∑ ❑+
t=i (1+ Kd)n ( 1+ Kd ) n

Where;
CIo = Net cash proceeds from issue of the debenture
CO1, CO2……..Con= cash outflows on interest payment
Cop = Principal repayment in the year of maturity
Kd= cost of Capital
Illustration 2
A company has issued 10% debentures aggregating to ksh. 100,000. The floatation
cost is 4%. The company has agreed to repay the debentures at par in 5 equal
annual instalments starting at the end of year 1. The company’s rate of tax is
35%. Find the cost of debt.

Suggested solution
Net proceeds from the sale of debenture = 100000- 4/100 * 100,000
= 100,000 – 4,000 = Ksh. 96,000
We use trial and error technique to calculate Kd
Year Cash flow PVIF10% PVs
1 10,000 0.9091 9,091
2 10,000 0.8246 8,246
3 10,000 0.7513 7,513
4 10,000 0.6830 6,830
5 10,000 0.6210 6,210
Total 100,000- 37890
= 62110
Exercise:
Try 7% and 8%

C) Cost of Preferred Stock

This is the market determined return or simply yield. It depends on the stated
dividends
Preferred dividend is not tax deductible and therefore no tax adjustment is
required when considering the cost of preferred stock. The cost is therefore:

Dp
Kp = Pr

Where Dp is the annual preferred dividend

Pr is market price of preferred stocks (net of floatation costs)
Illustration 3
A company has in issue 15% preference share of ksh.1 each at a book value of
ksh.1M. if new preference shares have to be sold, each share will sale at
ksh. 0.9 per share. What is the cost of preference share?
Suggested solution
Dp
Using the formula Kp = Pr the cost will be equal to
0.15
Kp = 0.90 ∗100=16.66 %
d) Cost of Equity
Equity can be divided into two:

(i) Retained Earnings

(ii) External Equity

i) Cost of Retained Earnings

The cost of retained earnings is the rate of return shareholders require on the firm's
common stock. This is an opportunity cost. The firm should earn on its retained
earnings at least as much as its stockholders themselves could earn on alternative
investments of equivalent risk. We can use several methods to estimate the cost of
retained earnings. These are:

(a) The CAPM approach

The cost of equity could be estimated directly using the CAPM . Under this
approach we assume that common shareholders view only market risk as being
relevant. The cost of retained earnings therefore can be given as:

Kr = Kf + (Km - Kf) ßi

Where Kr is the cost of retained earnings

Km is the required rate of return on the market

Kf is the risk free rate
 ßi is the stock's beta coefficient (it is a measure of systematic
risks)

If we can be able to estimate the risk free rate, the market rate and the
stock's beta, then we can easily estimate the cost of retained earnings (or
the cost of external equity).
Illustration 4
ABC. Plc. Share had been found to be 1.25 reflecting the fact that its excess return
varies more than proportionately in relation to the excess return in the
market. The directors believe that this relationship will continue into the
future. If the market index return is 15% and the return of treasury bills is
12% calculate the cost of equity of ABC. Plc
Suggested solution
Using the above CAPM formula
Kr = Kf + (Km - Kf) ßi
= 0.12 + (0.15 - 0.12) 1.25
= 0.12 + 0.0375
= 0.1575 or 15.75%

(b) The DCF Approach (Dividend Yield Model)

The second method is the discounted cash flow (DCF) method. Shareholders
usually expect their dividends to increase over time instead of remaining
the same indefinitely. Since the market price of the share is taken to be the
discounted future cash receipts from the share, then intrinsic value of
share is the present value of its expected dividend stream:
 Given
D1 D2 D∞ D1
Po = + + .. . + ∞ =
the
(1 + K r )1 (1 + K r )2 (1 + K r ) Kr - g
above
equation

D1
Kr = +g
Po

Where;
g is a constant growth rate
D1 is the dividend expected to be paid at the end of year one
Po is the market value of shares
NB/ where the dividends have just been paid or is a recent or current dividend, this
is do and must be adjusted for growth rate during year 1 to become
Do(1+g)
Illustration 5
A company’s ordinary shares are currently being sold at ksh.4 per share on the stock
market. The company is expected to pay a dividend of ksh. 0.60 per share
at the end of the year. Future dividends are expected to grow at an annual
 rate of 6% of the prior year’s dividends. Estimate the cost of ordinary
shares of the company
Suggested solution
Kr= D1/po +g
= 0.60/4 + 0.06
= 0.15 +0.06
= 0.21 or 21%

ii) Cost of Newly issued external equity

When a firm sells shares in the market it incurs floatation costs. This
causes a difference between the cost of retained earnings and external
equity.
If
D1
Ke = +g
Po (1 - F )

we use the DCF method, then

Where F is the floatation costs expressed as a percentage of market price
of shares.
Illustration 6
The issue price of a share is ksh.3 issue cost are ksh. 0.15 per share. If the new
shareholders expect annual dividend of ksh.0.5 at the end of year. What is
the cost of the new equity?
D1 0.5
Ke= Po (1−f ) + g = 3(1−0.15) =0.19607∨19.61 %

Computation of Weighted Average Cost of Capital (WACC)

 The WACC is the overall cost of using the various forms of fund. It can
be given by:

WACC = Net operating Earnings (NOE)

Total Market Value of the firm

It can also be expressed as

Where
Ko = Kd ( VD ) + K ( VP ) + K ( VE )
p e

Ko is the weighted average cost of capital

Kd is the cost of debt
Kp is the cost of preference shares
Ke is the cost of equity

D, P, E are the proportions of debt, preferred stocks

V V V and equity in capital structure

For easy analysis we shall assume that the firm uses only debt and equity. The
overall cost of capital will therefore be given by:

Ko = Kd ( ) ( )
D
V
Ke
E
V
= K e¿ (K e - Kd )
D
¿
V

With this background we can look at what happens to Kd, Ke and Ko as the
degree of leverage (denoted by D/E changes). This will be done by looking at
the theories of capital structure.

Illustration 7
The management of XYZ Plc. Is planning an investment program and in need to
decide on the appropriate cost of capital for evaluating investment projects. The
company has in issue 1M ordinary shares of ksh. 0.5 each with a current market
price of ksh. 0.90 per share Cum-div. it also has in issue Ksh. 500,000 15%
irredeemable debentures with a current market value of Ksh. 105 (par value of ksh.
100) and ksh. 300,000, 11% preference shares of Ksh.1 each, currently priced at
ksh.0.80 per share. The preference dividends have just been paid but the ordinary
dividend and debenture interest are due to be paid in a not too distant future. The
ordinary share dividend will be ksh. 120,000 this year and management has made its
views known that earnings and dividends will grow by 6% per annum into
perpetuity.
The extract from the company’s balance sheet is as follows;
Ksh.
Ordinary share of Ksh. 50 each 500,000
16% preference shares 300,000
Debentures 500,000
Reserves 200,000
1,500,000
Advise the management of XYZ. Plc. On the cost of capital to use stating any
assumptions deemed necessary. Assume company tax of 30%
Suggested Solution
i) Cost of Debentures (irredeemable)
Kd(1-t)
annual interest
Kd¿ market value of outstandingdebt
15
Kd¿ 105−15 =0.1667

0.1667 (1-0.30) = 0.1667 * 0.7 = 0.1167 or 11.67%

ii) Cost of preference share
Dp
Kp = Pr
11% of Ksh .1
Kp = 0.80
0.11
Kp = 0.80 ∗100=13.75 %

ii) Cost of Ordinary Shares

Given a 6% per annum indefinite constant growth rate, this cost may be estimated
as follows,

Dividends end of this year (1+ g)

+g
current market price−dividends end of this year
120,000 (1+0.06)
= +0.06
900,000−120,000
= 0.1631 + 0.06
= 0.223
= 22.3%
iii) WACC

Item Market value Cost of capital Net Operating

Ksh. Earnings
Ksh.
Debentures 525,000 11.67% 61,268
Preference 240,000 13.75% 33,000
Shares
Ordinary Shares 780,000 22.30% 173,000
1,545,000 268,208

268208
Ex- div WACC = 1545000 =0.1736∨17.36 %

Assumptions under WACC

 i) The capital structure (financial Proportions) of the company is
known and the company will continue to finance new projects in
this proportions
ii) The cost of individual sources , as computed will not change in
future
iii) The risk of the project under consideration is not different from the
average risk of all other projects undertaken by the company
iv) New projects are financed by new funds to be obtained for the
projects
v) The cost of capital used reflects the marginal cost of new funds to
finance the project
Justification for the use of WACC
The reason that has been advanced for the use of WACC is that a company will be
able to enhance its market value (and therefore the shareholders wealth) by
financing new investments in the proportions specified and accepting only those
projects that yield more than WACC

Illustration 8
JSK. Plc. is financed by a mix of equity and debt. The capital structure has always
been equity (3/5) and debt (2/5). The cost of equity is 15% and that of debt is 10%.
A new investment opportunity has just emerged. The project will cost Ksh. 1M and
provide a return before interest of Ksh. 150,280 for an indefinite future period.
Should the company accept the project?

Suggested Solution
WACC is calculated as follows;
3/5 *15% +2/5 *10%
= 9% + 4%
= 13%
Return before interest is ksh. 150,280
PV future cash flows is 150280/0.13
NPV= 1,156,000 – 1,000,000
= 156,000
Fund deemed to be provided by lenders = 2/5 *Ksh.1M
= Ksh. 400,000.
Interest on this amount is Ksh. 40,000
Amount available to the ordinary shareholders is Ksh. 156,000 – Ksh. 40,000 =
Ksh. 116,000
Share of equity finance = 3/5 * Ksh. 1M = Ksh. 600,000
Return to the ordinary shareholders will be 116000/600,000 =19.33%
This return exceeds the cost of equity of 15%