CHAPTER 17

COST OF CAPITAL
1. The overall approach

How do we find a suitable discount rate?

- weigh the costs of each type of long term
finance


- Weighted Average Cost of Capital (WACC)
1. The overall approach
Traded debt Non-traded debt
Irredeemable Redeemable Convertible Bank loans
Debt
Sources of long-term finance
Preference shares Equity
2. Estimating the cost of capital

Key ideas in estimating cost of capital

A. Cost of a debt or equity instrument is:

- The rate that discounts the future streams of cash-flows to

- The present price of the instrument

B. The cost of debt or equity instrument is implicit in the price.

C. To evaluate cost of a debt or equity instruments we will use
- prices
- streams of cash-flows (interest, dividends etc.)
2. Estimating the cost of equity

COST OF EQUITY 2 models

A. The Dividend Valuation Model (DVM)
- constant dividends
- constant growth in dividends

B. The Capital Asset Pricing Model (CAPM)

2. Estimating the cost of equity

The Dividend Valuation Model (DVM)

The cost of equity finance is the return the investors expect to
achieve on their shares.

Assumptions:

- Stream of cash-flows is the stream of dividends paid out by
the company

- Dividends will be paid in perpetuity

- Dividends will be constant or growing at a fixed rate

2. Estimating the cost of equity

The Dividend Valuation Model (DVM)

Assuming constant dividends




Where:

D = the constant dividend from year 1 to infinity

P
0
= share price now (year 0)

r
e
= shareholders required return, expressed as decimal
0
0
P
D
r
r
D
P
e
e
= =
2. Estimating the cost of equity

The Dividend Valuation Model (DVM)

Assuming constant growth in dividends




Where:
g = constant rate of growth in dividends
D
1
= the dividend to be received in one year
D
0
(1+g) = the dividend just paid adjusted for one years growth
P
0
= share price now (year 0)
r
e
= shareholders required return, expressed as decimal
g r
D
g r
g D
P
e e

=

+
=
1 0
0
) 1 (
2. Estimating the cost of equity

The Dividend Valuation Model (DVM)

Assuming constant growth in dividends




Where:
g = constant rate of growth in dividends
D
1
= the dividend to be received in one year
D
0
(1+g) = the dividend just paid adjusted for one years growth
P
0
= share price now (year 0)
r
e
= shareholders required return, expressed as decimal
g
P
D
g
P
g D
r
e
+ = +
+
=
0
1
0
0
) 1 (
2. Estimating the cost of equity

The Dividend Valuation Model (DVM)

Ex-dividend (ex-div) vs Cum-dividend price
Cum-div
Ex-div
Dividend
declared
Share goes
ex-div
Dividend
paid
Share goes
ex-div
2. Estimating the cost of equity

The Dividend Valuation Model (DVM)


Use ex-dividend (ex-div) price

In some question the cum-dividend price is
given and a dividend is due shortly

Cum div share price Dividend due = Ex div share price
2. Estimating the cost of equity

The Dividend Valuation Model (DVM)

Estimating annual growth

- extrapolating based on past dividend
patterns

- assuming growth is dependent on the level of
earnings retained in the business
2. Estimating the cost of equity

The Dividend Valuation Model (DVM)

Estimating growth (g) from past dividends






Also known as geometric average.
1
1
0

|
|
.
|

\
|
=
n
ago years n Dividend
D
g
2. Estimating the cost of equity

The Dividend Valuation Model (DVM)

The earnings retention model (Gordons growth model)




where:
r = the accounting rate of return
b = earnings retention rate
r b g =
3. Estimating the cost of preference shares


Use DVM since preference shares pay constant dividend





Where:

D = the constant dividend from year 1 to infinity

P
0
= share price now (year 0)

K
p
= cost of preference share
0
0
P
D
K
K
D
P
p
p
= =
4. Estimating the cost of debt

Types of debt
Traded debt Non-traded debt
Irredeemable Redeemable Convertible Bank loans
Loan notes bonds loan stock marketable debt
used interchangeably
4. Estimating the cost of debt

Cost of irredeemable debt

Cost of debt to company.




Where:
I = annual interest starting in one years time
MV = market value of the loan note now (year 0 )
K
d
(1-T) = post-tax cost of debt to the company
T = corporate taxation
MV
T I
T K
d
) 1 (
) 1 (

=
4. Estimating the cost of debt

Cost of redeemable debt

The company will:
- pay interest for a number of years and then
- repay the principal (sometimes at a premium or a discount
to the original loan).

Expected cahs-flow stream:
- interest paid to redemption;
- repayment of principal.

Market price = PV of interest and redemption payment
4. Estimating the cost of debt

Cost of redeemable debt

Cost of redeemable debt to the company - the IRR of the following

MV Price paid to invest in debt instrument (x)
T
1-n
Interest received (1-T) x
Tn Capital repayment x
4. Estimating the cost of debt

Cost of redeemable debt at current market price

Use the formula for irredeemable debt
MV
T I
T K
d
) 1 (
) 1 (

=
4. Estimating the cost of debt

Cost of convertible debt

A form of loan note that allows the investor to choose between
taking the redemption proceeds or converting the loan note
into a pre-set number of shares.

Method:

(1) Calculate the value of the conversion option (estimated value
of shares on option date);
(2) Compare the conversion option with the cash option. Assume
all investors will choose the option with the higher value.
(3) Calculate the IRR of the flows as for redeemable debt


4. Estimating the cost of debt

Cost of non-tradeable debt

Includes bank loans and other non-tradeable fixed interest loans

Simply adjust for tax relief

Cost to company = I(1-T)


5. Estimating the cost of capital

Weighted Average Cost of Capital (WACC)

1. Calculate weights for each source of capital
2. Estimate cost of each source of capital
3. Multiply the proportion of each source in the total sources of
capital by the cost of that source
4. Sum the results of step 3 to get the WACC




V
d
and V
e
= the market values of debt and equity
K
e
= the cost of equity
K
d
(1-T) = the (post-tax) cost of debt
) 1 ( T K
V V
V
K
V V
V
WACC
d
d e
d
e
d e
e

+
+
(

+
=
5. Estimating the cost of capital

The average is known as Weighted Average Cost of Capital (WACC)

Choice of weights

- Book values (BVs)
- Market values (MVs)

Whenever possible choose market values
7. Cost of equity Capital Asset Pricing Model (CAPM)

A. CAPM relies on the following assumptions:



- Investors would require a rate of return at least
equal to the risk-free rate


- To compensate for any extra-risk taken, they
require a premium
7. Estimating the cost of equity the Capital Asset Pricing Model

Capital Asset Pricing Model (CAPM)

Shows how the minimum required rate of return on a quoted
security depends on its risk.


premium Risk return free Risk return quired + = Re
CAPM - works out a formula for the risk premium
7. Cost of equity Capital Asset Pricing Model (CAPM)

B. CAPM relies on the following assumptions (continued)


- Investors are risk averse;

- Investors deal with risk by way of diversification;
- Invest in companies whose returns are negatively correlated

- Eliminate company specific risk (unsystematic risk)

- Only face the systematic risk (market risk)

7. Estimating the cost of equity the Capital Asset Pricing Model

Reducing risk by combining investments - Diversification
Total
portfolio
risk
No. of securities
Systematic risk
(Market risk)
Unsystematic risk
(firm specific risk)
15-20
securities
1 security
7. Cost of equity Capital Asset Pricing Model (CAPM)

C. CAPM relies on the following assumptions (continued)

- Investors judge investments by the correlation of their returns with the
average market return
) ( Re
f m f
R R R return quired + = |
Rf = risk-free rate of return
Rm = average return on the market
= relative level of systematic risk (relative to the market)
7. Estimating the cost of equity the Capital Asset Pricing Model

Capital Asset Pricing Model (CAPM)

Interpretation of beta

is a measure of the systematic risk of an investment relative to that
of the market.

>1 the investment is riskier than the average
- returns have same direction as average market returns but change quicker

0< < 1 the investment is less risky than the average
- returns have same direction as average market returns but change quicker

= 0 the investment is risk free
- no volatility in returns in respect to the average market returns
7. Estimating the cost of equity the Capital Asset Pricing Model

Capital Asset Pricing Model (CAPM)

Useful in calculating risk-adjusted cost of equity for projects with risk
profiles that are different than the current risk profile of the
business.

Find a beta factor by reference to the beta factor of a similar
company operating in the new business are

CAPM gives you beta and the required rate of return
- this helps compute the cost of equity

But if the project is financed with both equity and debt we need to
weigh the cost of the two sources of finance