FINANCIAL MATHEMATICS

UNIT 6

Cost of Capital
Learning Outcomes
• Discuss and calculate the concept of cost of capital.

Footnote Cost of Capital 2

11.1 Introduction
• The cost of capital is the rate of return that an organisation must pay to
satisfy the providers of funds, as it reflects the riskiness of the finance
used.

Cost of capital = Required rate of return

• The cost of capital is the minimum return that an organisation must

earn.
• Cost of capital is the cut-off rate, which separates viable and non-viable
investments.

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11.1 Introduction
• Cost of capital must be equal to the return that investors require to reward them
for the risk taken by investing in a security (i.e. share).
• The cost of capital consists of three elements:
• Risk-free rate of return;
• Premium for business risk; and
• Premium for financial risk.

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11.2 Pooling of Funds
• The pooling of funds principle states that the various sources of finance
available to an entity are grouped together (i.e. pooled) and used in total to
fund various projects.
• Projects are not necessarily funded out of just debt or equity, but sometimes
a combination (i.e. from the pool of funds).
• Entities often establish a long-term capital structure (refer unit 5) and
decide in advance how much debt and equity (as a percentage) to include in
their capital structure.

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11.3 Cost of Capital
• Cost of capital is the cost to a business of raising finance.
• Entities must therefore aim to achieve a return in excess (i.e. above) their cost of
capital.
• Entities that do not achieve a return in excess of their cost of capital will be unable
to attract future capital in order to help them grow and expand.

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11.3.1 Cost of Equity
• Equity can be raised externally (via a share issue) or internally (via
retained earnings).
• It is generally more expensive to raise equity externally (because of
transaction costs).
• Retained earnings is, however, not a free source of finance (as there is an
opportunity cost of the dividend forgone from retaining profits).
• Calculating the cost of equity can be quite difficult.
• There are 2 methods that can be used to calculate the cost of equity:
• Dividends; and
• CAPM.

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11.3.1.1 Dividend Valuation Model
• The dividend valuation model assumes that the market price of a share is the
present value of the future dividend income.
• If a share pays a constant annual dividend in perpetuity (i.e. to infinity), the
share price can be calculated as:
P0 = _d_ OR ke = _d_
ke P0

ke = cost of equity capital;

d = constant net annual dividend (in perpetuity); and
P0 = market price of equity (ex-dividend)

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11.3.1.1 Dividend Growth Model
• The dividend growth model assumes that investors expect dividends to grow
(constantly) over time, rather than remain fixed in perpetuity.
• If a dividend increases by a constant annual growth rate the share price
can be calculated as:

P0 = _d0(1 + g)_ OR ke = _d0(1 + g)_

+g
ke - g P0

ke = cost of equity capital;

d0 = current net dividend;
P0 = market price of equity (ex-dividend); and
g = expected constant annual growth rate in dividend.

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11.3.1.1 Dividend Growth Model
• The dividend growth model can also be reflected as:

k e = d1
+g
P0
• Where d1 = d0(1 + g)

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 11.3.1.1 Estimating Growth Rate
• Two approaches can be used to estimate the growth rate (g) in dividends:
• Extrapolate growth from historical data (refer to example 11.4 in the textbook for an
example); or
• Derive a future growth rate using Gordon’s growth model.
• Gordon demonstrated that the future dividend growth rate (g) can be
estimated as:
• g = bR

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 11.3.1.1 Estimating Growth Rate
• Where:
• b = proportion of earnings retained each year; and
• R = average rate of return on investment (i.e. accounting rate of return).
• Assumptions of Gordon’s growth model:
• The organisation must be all equity financed;
• Retained earnings are the only source of additional investment;
• A constant proportion of each year’s profits is retained for re-investment; and
• Projects financed from retained earnings generate a constant rate of return.

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11.3.1.2 CAPM
• Systematic or market risk is:
• The risk that effects the market as a whole and may be described as inherent to
political and economic events.
• Unsystematic or non-market risk is:
• The risk that can be diversified away by investing in a portfolio – as the investments
that perform well should cancel out the investments that perform badly.
• Unsystematic risk (of up to 95%) can be reduced through diversification.

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11.3.1.2 CAPM
• Systematic risk is measured using beta factors.
• Beta is the volatility of the share price to market movements (i.e. the
slope of the regression line in relation to the horizontal axis).
• The beta of a risk-free asset = 0.
• Beta is the measure of the systematic risk of a security relative to the
market portfolio.
• In brief, beta is calculated as:
Change in individual security market return
Change in average market return

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11.3.1.2 CAPM
• The Capital Asset Pricing Model (CAPM) incorporates risk into the
calculation of the cost of equity.
• CAPM is used to calculate the cost of equity as:
ke = Rf + β(Rm – Rf)

ke = cost of equity capital;

Rf = risk free rate of return;
Rm = expected return on the market portfolio;
β = beta co-efficient of the individual security;
(Rm – Rf) = market risk premium.

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11.3.2 Cost of Preference Shares
• The cost of preference share capital is related to the amount of dividend
payable on the preference share. The dividend on preference shares is not
tax deductible.
• The cost of non-redeemable preference shares is calculated as:
kpref = _d_
P0

Kpref = cost of preference share capital;

d = fixed annual dividend (in perpetuity); and
P0 = current market price (ex-dividend)

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11.3.2 Cost of Preference Shares
• The cost of redeemable preference shares is calculated using an internal
rate of return (IRR) approach. This can be solved on a financial calculator
using annuity principles rather than using interpolation, as follows:
• PV = x
• FV = x
• N=x
• PMT = x
• COMP I/YR
• N.B. – Remember not to make an adjustment for tax as preference dividends
are not tax deductible.

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11.3.3 Cost of Debt
• When debt is issued, the coupon rate is fixed according to the interest rate
currently being offered in the market at that time for debt of a similar nature
and maturity.
• Once issued, the market value of the debt will depend on the relationship of
the coupon rate and the required rate of return at any particular time.
• An inverse relationship exists between the return and the price (or market
value) of debt.

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11.3.3.1 Cost of Non-Redeemable Debt
• Interest on debt is tax deductible. Thus the cost of debt is the after-tax cost
of interest.
• The cost of non-redeemable debt is calculated as:
kd net = i(1 - t)
P0
• kd net = after tax cost of debt;
• i = annual interest payment;
• t = rate of company tax; and
• P0 = market price of debt (ex-interest).

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11.3.3.2 Cost of Redeemable Debt
• The cost of redeemable debt is calculated using an internal rate of return
(IRR) approach. This can be solved on a financial calculator using annuity
principles rather than using interpolation, as follows:
• PV = x
• FV = x
• N=x
• PMT = x
• COMP I/YR
• N.B. – Remember to make an adjustment for tax as the interest on debt is tax
deductible.

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11.4 WACC
• The weighted average cost of capital (WACC) assumes that when an
organisation raises money, the money raised is added into a pool of funds
(as discussed previously).
• WACC is the overall return that an entity must generate on its existing
assets to maintain the value of its various sources of finance.
• WACC is obtained by:
1.Calculating the after-tax component cost of each category;
2. Establishing the relevant weighting for each component; and
3.Multiplying the component by its weighting, and then adding all
contributions together.

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11.4.1 Calculating WACC
• Market values for each component (i.e. ordinary share, etc.) should be used,
but book values are often used instead.
Component Cost Weighting Contribution
Ordinary shares X Y XxY
Preference shares X Y XxY
Debt X _Y_ XxY
WACC 100 ZZ
• The cost is always the after-tax cost.
• A formula (refer to textbook) can also be used.

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11.4.2 Assumptions of WACC
• Always use market values unless told otherwise.
• Assumptions in the use of WACC, include:
• A reasonably constant capital structure;
• New investments should not carry a significantly different risk profile from the existing
organisation;
• The new investment is marginal (small) to the organisation; and
• All cash flows are constant perpetuities.

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11.5 WACC in Investment Decisions
• Entities should only make investments when the expected return is greater
than the WACC.
• This will increase the market value of the ordinary shares in the long-term.
• Not accepting projects with IRR’s in excess (i.e. higher than) of the WACC
will weaken the long-term prospects of an entity.
• If a new investment has different risk characteristics to the entity’s current
investments, then WACC may not be the appropriate discount rate to use. A
risk-adjusted discount rate may be more appropriate.

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11.6 Marginal Cost of Capital
• A marginal cost of capital may be a more appropriate discount rate to use
if a company is considering a large investment project (that would
significantly affect the capital structure).

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QUESTIONS?