Cost of Capital

Introduction
why do we need to calculate/compute cost of capital?
becasue we want to do financial evaluations and for those financial evaluations we will be requiring cost of capital of the project or the company. common method of financial
evaluation is npv.
 Cost of Capital --is fundamental calculation for investment appraisal for example
npv

A fundamental calculation for all companies is to establish its financing costs, both individually for

each component of finance and in total terms. These will be of use both in terms of assessing the

financing of the business and as a cost of capital for use in investment appraisal.

Overall Return

A combination of two elements determine the return required by an investor for a given financial

instrument.

1. Risk-free return – The level of return expected of an investment with zero risk to the investor.-- example
include gilts(government securites) are considered risk free investment and return on those known as risk free returns.

2. Risk premium – the amount of return required above and beyond the risk-free rate for an

investor to be willing to invest in the company

 Cost of Capital --comprise of 3 different costs and combinations of these 3 costs
is termed as WACC.

Weighted Average Cost of Capital (WACC)

Cost of Equity (Ke) Cost of Debt (Kd) Cost of Preference (Kp)

Cost of equity: (return required by ordinary share holders)

The rate of return that is paid to the equity holders of the company. The symbol used to represent

cost of equity is Ke.

Cost of debt: (expected return/required return by debt holder/ lender of the company)

The after-tax return paid to the debt holders of the company. The symbol used to represent after-

tax cost of debt is Kd(1 – t). --but if the tax is ignored we simple use Kd as a symbol for cost of debt.

Cost of preference shares:

The return paid to the preference shareholders of the company. The symbol used to represent

cost of preference shares is Kp.

 Cost of Capital
Cost of Equity-DVM

dvm method/model for the calculation/estimation of cost of equity Ke

 The Dividend Valuation Method
Ke = D0 (1+g) + g
D0= current dividend
g= growth rate
P0 P0 =ex dividend market price of share
NOTE; remember for calculation of cost of equity
we will always be required ex divided market price
Difference between cum dividend and ex dividend price and not the cum dividend market price of share.

Ex-dividend price (P0) is the market price excluding dividend and cum-dividend price is the

market price including dividend.

Cum-Dividend Price – Dividend = Ex-Dividend Price

Example

The company has just paid a dividend of $0.5 per share and the expected growth rate is

5%. The ex-dividend share price is $4.

Calculate the Cost of Equity using DVM

 Estimating Growth rate using Past Growth Method
sometimes we have to estimate growth rate and there are 2 different method of
growth rate estimation one of them is above stated. 𝑛 d𝑜
𝑔= −1
d𝑛

Where

do = current dividend, dn = dividend n years ago, n = Number of years ago

Example

Munero Ltd paid a dividend of 6p per share 8 years ago, and the current dividend is 11p.

The current share price is $2.58 ex div

g=(8((11/8)^1/2))-1
g=7.9%
Calculate the cost of equity now ke
ke=.(0.11*(1+1.79%)/2.58)+7.9%
Ke=12,47%
 Estimating Growth rate using Gordon’s Grown
g = rb
Where

r = return on reinvested funds

b = proportion of funds retained

Example

The ordinary shares of Titan Ltd are quoted at $5.00 ex div. A dividend of 40p is just about

to be paid. The company has an annual accounting rate of return of 12% and each year
g=rb

pays out 30% of its profits after tax as dividends.

r=12%
b=70%(of funds retained here)
g=12%*70%
g=8.41%

Calculate the cost of equity ke=(1.4(1+8.4%)/5)+8.4%

ke=17.07%
Cost of Capital
Cost of Equity-CAPM
use of capm to estimate Ke
 Capital Asset Pricing Model (CAPM)
A model that values financial instruments by measuring relative risk.

Unsystematic risk

The risk that can be eliminated by diversified by holding a well diversified portfolio is known as

unsystematic risk. This risk is related to factors that affect the returns of individual investments in

unique ways, this may be described as company specific risk. This risk is assumed to be zero

Systematic Risk

The risk that cannot be eliminated by diversification is referred to as systematic risk. To some

extent the fortunes of all companies move together with the economy. This may be described

as economy wide risk. --Risk of changing exchange rate is an example of systematic risk.
 Assumptions CAPM
 Investor hold a well diversified portfolio and hence the unsystematic risk is zero

 There is no transaction cost associated with the securities --investor can withdraw or re invest its investment in any security at any
point of time incurring no transaction cost.

 The market is fully efficient--- all the information related to company/project is immediatly flown into stock market. So all investors have all the relevant
information required about the investment at all times.

 All the companies in the stock market are going concerns

 All the investors are knowledgeable and they make rational decisions

 Dividends are irrelevant

 The Beta factor and Cost of Equity to include systematic risk in
calculation of ke CAPM will

β (beta) factor
be using beta factor.

The method adopted by CAPM to measure systematic risk is an index β. The β factor is the
measure of a share’s volatility in terms of market risk /systematic risk.

The risk-free security

This carries no risk and therefore no systematic risk and therefore has a βeta of zero.
Generally, the government securities like Treasury Bills or GILTs are considered risk free --the returns generated
on risk free security will
be known as risk free
Risk Premium Return return.

It is the difference between the market return and risk free rate of return
(Rm-Rf=risk premium return.
Ke = Rf + (Rm - Rf) β
where
Ke = required return from individual security
β = Beta factor of individual security
Rf = risk-free rate of interest
Rm = return on market portfolio
 Example Cost of Equity-CAPM

The market return is 15%. Kite Ltd has a beta of 1.2 and the risk free return is 8%

Required:

What is the cost of capital?

Ke=8%+(15%-8%)*1.2
Ke= 16.4%
 Cost of Capital
Cost of Debt-Non tradable & Irredeemable
 Cost of Debt – Non-tradable
The Amount of Debt which cannot be traded in any market is known as non-tradable debt

Bank loans and other non-traded loans have a cost of debt equal to the coupon rate

adjusted for tax.

Kd(net)/kd(1-t)= Interest (Coupon) rate x (1 – T)

Example

Trout has a loan from the bank at 12% per annum. Corporation tax is charged at 30%.

Required:

What is the cost of debt net?

Kd(net)= 12%*(1-30%)
kd(net) or kd(1-t)= 8.4%
 Cost of Debt – Irredeemable
 Generally the par value of such debt is $100 --general par value is overridden/ignored if specific par value is priovided in exam.

 Interest paid on the debt is stated as a percentage of nominal value ($100 as stated). This

is known as the coupon rate. It is not the same as the cost of debt.

 Since they are traded in the market they should have a market price.

 They do not have any redemption date

 If the interest is due but yet to be paid then the prices are cum-interest price else they are

ex-interest price --for calculation purposes we will be requiring ex interest price not cum interest price.
𝑖(1−𝑡)
𝐾𝑑(𝑛𝑒𝑡) = 𝑋100%
𝑃𝑜
where i = interest paid
t = marginal rate of tax
P0 = ex interest (similar to ex div) market price of the loan stock.
 Example (Cost of Debt – Irredeemable)
The 10% irredeemable loan notes of Rifa plc are quoted at $120 ex-interest. Corporation tax is

payable at 30%
i=% of nominal value of debt
since no nominal value specifically given assume it to be
Required: 100$ and interest rate is 10% so we have interest paid of 10%

What is the cost of debt net?

kd(net)= (10*(1-30%))/120*100%
kd(net) or kd(1-t)= 5.83%
 Cost of Capital
Cost of Debt-Redeemable
 Cost of Debt – Redeemable
 Generally the par value of such debt is $100 --generally par is overiden/ignored if specific value is given

 Interest paid on the debt is stated as a percentage of nominal value ($100 as stated). This

is known as the coupon rate. It is not the same as the cost of debt.

 Since they are traded in the market they should have a market price.

 At redemption date they can be redeemed at par, discount or at premium

 If the interest is due but yet to be paid then the prices are cum-interest price else they are

ex-interest price --ex interest price is required for calculation always.

 The Kd(net) for redeemable debt is given by the IRR of the relevant cash flows
 Cost of Debt – Redeemable (Calculation)
The relevant cash flows would be

Years Cashflows
0 Market Value of Loan Note (P0)
1-n Annual Interest Payment i(1-T)
n Redemption Value

Example

Woodwork Ltd has 10% loan notes quoted at $102 ex interest redeemable in 5 years’ time at

par. Corporation tax is paid at 30%.

Required:

What is the cost of debt net? 6.54%

 Cost of Debt – Convertible
A loan note with an option to convert the debt into shares at a future date with a

predetermined price. In this situation, the holder of the debt has the option therefore the

redemption value is the greater of either:

 The share value on conversion or

 The cash redemption value if not converted

Example

Woodwork Ltd has 10% loan notes quoted at $102 ex interest redeemable in 5 years’ time at par

or they can be converted into 40 Ordinary shares. Corporation tax is paid at 30%.

Required:

What is the cost of debt net? 7.21%

 Cost of Capital
Weighted Average Cost of Capital
 Weighted Average Cost of Capital
working can be done in tabular form. First column for specifying different sources of finance and then we multiply each source proportion of finance with its respective cost and third
column is to sum all which is wacc.
important to note in column 2 that to make proportions we will use market values and not net book values.

Source Proportion (in Market Values) X Cost WACC

Equity Proportion of Equity X Ke X%
Debt Proportion of Debt X Kd(net) X%
Preference Share Proportion of Preference X Kp X%
WACC X%
 Example WACC
Bar plc has 20m ordinary 25p shares quoted at $3, and $8m of loan notes quoted at $85. The

cost of equity has already been calculated at 15% and the cost of debt (net of tax) is 7.6%.

Required:

Calculate WACC? Ve=market value of equity

Vd= market value of debt
Ke= cost of equity
Kd(net or 1-t)= cost of debt after tax.
14 or 14.2 %
 Cost of Capital
Capital Structure Theories

capital structure= proportion of debt and equity in total capital.

 Capital Structure Theories
These theories explain the impact on the cost of capital of the company due to change in the

capital structure of the company. It includes the following theories:

 The Traditional View

 Modigliani-Miller (MM) Theory (without tax)

 Modigliani-Miller (MM) Theory (with tax)

by default if gearing level increases as since financial risk of comapny will increase and so Ke will increase, But when gearing level is relatively low, this increase will have relatively low

The Traditional View

impact but as this gearing level rises the impact on Ke will------------------------------------------------------------------------------------------------increase at an increasing rate. So this means initially
at lower level of gearing when gearing is increasing Ke will-----------------------------------------------------------------------------------------------increase but with lower impact but as the company
becomes high geared, the impact of Ke will be at an increasing rate.
^
Cost of equity: At relatively low levels of gearing the increase in gearing will have relatively

low impact on Ke. As gearing rises the impact will increase Ke at an increasing rate
-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Cost of debt: There is no impact on the cost of debt until the level of gearing is prohibitively

high. When this level is reached the cost of debt rises.

because kd is cheaper ke is increasing but with a relatively low impact. and hence overall wacc will fall as
gearing level increases initially
Key point As the gearing level increases initially the WACC will fall. However, this will happen ^
because after an appropriate gearing level the impact of increase of ke is high
and also kd to increase as well, and hence this results in overall wacc to increase
upto an appropriate gearing level. After that level WACC will start to rise. There is an optimal ^

level of gearing at which the WACC is minimized and the value of the company is
maximized.--company should maintain specific and
appropriate gearing level at which wacc is minimum
and overall value of company is maximised.
as gearing level increases(proportion of debt increases) the Ke
Cost of increases but at relatively low base but after an appropriate
capital
Ke gearing level the Ke will rise. Kd is initially constant, but after a
specific(appropriate) gearing level ,when gearing becomes
very high the over all kd rises, and the wacc is initially falling as
level of debt increases but after certain gearing level wacc will
WACC start to rise once again.

Kd
x axis we have gearing level.
 The MM theory (Without Tax)
Assumptions:

 Perfect capital market exist where individuals and companies can borrow unlimited amounts
at the same rate of interest.

 There are no taxes or transaction costs.

 Debt is risk free.

 The market is strongly efficient

 The investors are knowledgeable and rational

 The MM theory (Without Tax)
Cost of equity: Ke rises at a constant rate to reflect the level of increase in risk associated with

gearing.--Ke will rise as gearing level increases, but(increase) at a constant rate, so it can be represented as straight line on the graph.

Cost of debt: There is no impact on the cost of debt. --because of assumption debt is freely available and is risk free(regardless of level of
gearing kd will remain constant.

(which is a constant increase)

Key point The increase in Ke directly compensates for the substitution of expensive equity with
^

overall

cheaper debt. Therefore, the WACC is constant regardless of the level of gearing
^

CONCLUSION; According to MM theorey without tax there will

be no impact on WACC because of change in capital struture.
Cost Ke So company can use any proportion of debt and equity in
of capital with out impacting wacc.
capital
x-axis- gearing level
so on y axis ke increasing at a WACC
constant rate so represented
by straight increasing line, kd
will remain constant(same), Kd
resulting in overall wacc also
remaining constant ir-respective
of proportion of debt in capital.

Gearing
(D/E)
 The MM theory (With Tax)
the model to include the impact of tax in the existing MM Theory. Debt in this circumstance has

the added advantage of being paid out pre-tax. The effective cost of debt will be lower as a

result.

Key point As the level of gearing rises the overall WACC falls. The company benefits from having

the highest level of debt possible.--the capital structure is one having highest level of debt possible.

Remember for all capital

structure theories that if the wacc Cost Ke
is minimised this should of
automatically means that value of
capital ke will still be increasing at a constant rate here but kdnet is
business will be high (the project
lower and results in wacc to fall constantly as gearing level
will generate greater npv).
increases.

WACC
According to MM theorey with tax ideal capital structure is one
which includes maximum possible debt.

Kd(1-t)

Gearing (D/E)
 Cost of Capital
Asset Beta and Equity Beta
 CAPM & MM Combined
capm says that investor requires return against
systematic risk.

Systematic Risk the systematic risk which includes both business and financial risk is
called equity beta

Equity Beta (βe)

equity beta= a beta which represents business and financial risk both.
asset beta= beta of business risk.
mm has divided systematic risk
into 2 parts.

Business Risk Financial Risk

Asset Beta (βa)

Business Risk
for eg a service sector has certain systematic risk, which should be different form a manufacturing sector.

^
Risk due to nature of the business operations or the type of industry.

Financial Risk --if a business is 100% equity financed than systematic risk=(only comprise of) business risk.

Risk due to inclusion of debt in the financial structure. This Risk will be zero if the company or

investment is 100% equity financed.

 Equity Beta and Asset Beta geared company= a company which have
Equity Beta (βe) taken debt as a source of fiannce.

It is the Beta of a geared Company so it has both Financial and Business Risk

Asset Beta (βa)

It is the Beta of an un-geared Company so it has Business Risk only.

The Formula

𝑽𝒆
𝜷𝒂 = 𝑿 𝜷𝒆
𝑽𝒆 + 𝑽𝒅 (𝟏 − 𝑻)

Where:

Ve = Market Value of Equity and Vd = Market Value of Debt

 Should Company’s WACC be Used for Investment

Appraisal?
If the Investment’s Business risk and Financial Risk are similar to the company, then we use the

company’s WACC to appraise the investment. However, if any of the risk is different then we

have to calculate investment specific cost of capital.

 Project Specific Cost of Capital- Financial Risk Different
if financial risk of project and company is different than project specific cost of capital is also known as marginal cost of capital.

 Chose the βe of the company.

 Calculate the βa using the company’s current financial structure (Un-gearing Beta).
𝑉𝑒
𝛽𝑎 = 𝑋 𝛽𝑒
𝑉𝑒 + 𝑉𝑑 (1 − 𝑇)

 Calculate βe of the investment using capital structure to be used for the investment. (Re-

gearing Beta)
𝑉𝑒 + 𝑉𝑑 (1 − 𝑇)
𝛽𝑒 = 𝑋 𝛽𝑎
𝑉𝑒

 Use βe to calculate Ke using CAPM

 Calculate WACC ---which will be known as project specific cost of capital.

 Project Specific Cost of Capital- Business Risk Different

 Identify a proxy company having same Business Risk

 Chose the βe of that proxy company.

 Calculate the βa using the Proxy company’s current financial structure (Un-gearing Beta).
𝑉𝑒
𝛽𝑎 = 𝑋 𝛽𝑒
𝑉𝑒 + 𝑉𝑑 (1 − 𝑇)

 Calculate βe of the investment using capital structure to be used for the investment. (Re-

gearing Beta) remember in this case where business risk is different if project specific or investment specific capital structure was not given than in that situation we can
use own company capital structure this is based on assumption that only business risk is different from our companny and not the financial risk. But priority
is given to investment specific cost of capital.
𝑉𝑒 + 𝑉𝑑 (1 − 𝑇)
𝛽𝑒 = 𝑋 𝛽𝑎
𝑉𝑒

 Use βe to calculate Ke using CAPM

 Calculate WACC
 Example – Project Specific cost of capital

Techno, an all equity agro-chemical firm, is about to invest in a diversification in the consumer

pharmaceutical industry. Its current equity beta is 0.8, whilst the average equity β of

pharmaceutical firms is 1.3. Gearing in the pharmaceutical industry averages 40% debt, 60%

equity. Corporate debt is available at 5%.

Rm = 14%, Rf = 4%, corporation tax rate = 30%.

Required:

What would be a suitable discount rate for the new investment if Techno were to finance the

new project with 30% debt and 70% equity?

 Cost of Capital
Combined Cost of Capital
A compnay has its own cost of capital and company when undertaking a project, project may have their project specific cost of capital , Once the company accepts the project the project
will merge into the company and due to this combination, post project cost of capital will be affected.
Combined Cost of Capital
(in case of m and a)
Sometimes we need to estimate post project (post Acquisition) Cost of Capital.

If the project’s Business and Financial Risk of the project is similar to the previous operations of

the business then it’s WACC after Acquisition will not change.

we can estimate combine cost of capital or post project cost of capital by

If the Business Risk is similar but only the Financial risk is different then ^ we can use the

Company’s Asset Beta and by using the post project gearing we can first estimate Beta equity

and eventually WACC.

However, if the Business Risk is different then, the post project WACC will be different.
 Calculating Combined Cost of Capital
there is a company pre project or pre
accquisation,
company is considering a project this could be
a target and
(specifically for a condition, when business risk is
different).
after accepting project it is post project or
post accquisation company meaning both project
and company are combined.

Company Project Post Project

(Post Acquisition)
(Pre Acquisition) (Target Co.)

βe (Co.) βe (Project)
from beta equity from beta equity
of company of project calculate
calculate beta beta asset of project.
asset of
company.

βa (Co.) βa (Project)
<--multiplying each of beta >
asset with total business
proportion.
X Proportion of Business X Proportion of Business
Proportionate βa (Co.) + Proportionate βa (Project) = Weighted Avg βa (sum of proportionate beta asset of
comapny and project also known as
from this we will estimate
for example proportion could be taken on the basis of total capital employed etc.. combined beta asset)
weigted avg beta of equity

Weighted Avg βe
after estimating this above
we can estimate cost of
equity using capm and
finally
we can
Ke using CAPM & WACC
estimate wacc.
Example
Techno, an agro-chemical firm, is about to invest in a diversification in the consumer

pharmaceutical industry. Its current equity beta is 1.8 and the firm has 50 million share with the share

price of $2 each. The firm also have Debt Worth $50 million.

The average equity β of pharmaceutical firms is 1.3 and the Gearing in the pharmaceutical industry

averages 40% debt, 60% equity.

This new Pharmaceutical project will require an additional investment of $20 million and the

company intends to finance 50% by raising debt from the bank and remaining by issuing new

ordinary shares.

Corporate debt is available at 5%. Rm = 14%, Rf = 4%, corporation tax rate = 30%.

What would be the cost of capital of Techno after the new investment assuming that the share price

will not be effected by the investment.

 Solution
we should be writting,(column headings) one heading should be investing company name other column/heading should be investment or project and last be combines cost of capital

Tecno co. project (=)combined cost of capital.

rest step is same as previous slide.

ke=21.8%
weighted average asset beta=1.29
which is 1.21 of company and ,08 of
project
over all new wacc 15.35%
where equity % in this wacc is 14.1%
debt is 1.25%