FINANCIAL MANAGEMENT

CLASS
Prepared By: A.K.M Mesbahul
Karim FCA
 Chapter – 05 : Cost of capital
Categories of long-term finance
These have already been summarized as:
 Equity shares
 Preference shares
 Debt

Calculating returns
- The cost of each source of long-term finance can be equated with the return which the providers of finance
expect on their investment.
- The return can be expressed as an interest rate and this will be used as the overall measure of cost, i.e. the cost
of money is the percentage return a firm needs to pay its investors.
- Essentially, the calculation is that of an internal rate of return (IRR) where Market value of investment = Returns
on investment discounted at investors' required rate of return

Determinants of the cost of finance

The two major determinants of a company's cost of finance are:
The risk-free rate of return or a rate of return that reflects the time value of money.
The reward for the risk taken by investors in advancing funds to the firm. For example, equity holders take more
risks than debt holders, and therefore expect higher rates of return.
The dividend valuation model
What gives a share value?

-The primary financial objective is assumed to be to maximise the wealth of equity shareholders.
- If we view wealth as the value of the shares, it is necessary to have a theory as to what determines the value of
an ordinary share.
- The benefit to shareholders from owning a share takes the form of future dividends and capital gain. It is the
present value of these benefits that creates the price today.

Thus:
Price of shares now (P0) = Present value of future dividends + present value of share price on eventual sale.

What determines the share price on eventual sale?

-For an individual to make a capital gain, he must find another investor prepared to buy at the higher price. Why
should that another investor be prepared to do so? Obviously only in the expectation of enhanced dividends and a
possible capital gain for himself.

-However, the second capital gain in turn depends on finding yet another investor prepared to buy at the higher
price – and so on.
-Ultimately it can be seen that capital gains and losses are merely transferring of existing wealth between
members of the market.
-The only addition to the total wealth of the market as a whole, and therefore, the only determinant of current
value, are the dividends paid by the company, including any terminal dividend on liquidation.

-Thus, the current share price is totally determined by the anticipated dividends, discounted at the investor's
required rate of return (the cost of equity).

P0 = Present value of future dividends

The pattern of future dividends
-In order to arrive at a price, the future dividends need to be estimated. The most convenient assumptions are that
dividends either remain constant, or grow at some fixed annual rate, g.
- It can be shown that the market value of equity (share price X number of shares) can be expressed in relatively
straightforward terms. Working from the method of valuing a perpetuity;

Where P0 = ex-dividend market value of equity

D0 = dividend paid at time 0
ke = equity investors' required rate of return
There are obvious flaws in such simple models of anticipated dividend behavior. In particular, note the following
points:
-g must be less than ke. If g equals ke the share price becomes infinitely high, a nonsense result. However, note
that a growth rate this high to perpetuity is impossible.
-In practice companies are likely to experience periods of varying growth rates.
Dividend valuation model
Question:
A company's shares are quoted at CU 2.50 ex-div. The dividend just paid was 50p. No growth in dividends is
expected and dividends are forecast to continue indefinitely.
(a) What rate of return, ke, do the investors anticipate?
(b) Using the data above, but with an anticipated annual growth rate in dividends of 10%, what is k e?
(c) Investors in a company are known to require a rate of return of 15%. Current dividends are 30p per share,
just paid. No increase is anticipated. Estimate the share price.
(d) As in (c), but dividends are expected to grow at 5% pa. Again, find P 0.

Solution:
Cum-div and ex-div share prices
Dividends are paid periodically on shares. During the period prior to the payment of dividends, the price rises in
anticipation of the payment. At this stage the price is cum-div. This may be expressed diagrammatically.

-Share goes ex-div shortly before the dividend is paid. Any person acquiring the share after this point will not
receive the dividend, which will be paid to the original shareholder.
-The reason is that the time it takes for the company to amend its register of members requires a cut-off point
before the dividend is paid.
-Thus, when a share is quoted cum-div, the price includes both the underlying ex-div value of the share and the
dividend due shortly.
-As the dividend valuation model considers the present value of future dividends, the ex-div share price for P0 must
be used.

IQ. The market value of a company's shares is CU2.20. It is about to pay a dividend of 20p, which is expected to
remain constant in future.
Requirement
What is the cost of equity?

Solution:
IQ. A company currently pays a dividend of 12p which is expected to grow at 5% per annum. The ex-dividend share
price is CU1.75.
Requirement
What is its cost of equity?

Estimating growth rates

(a) Historical pattern
The anticipated growth rate, g, is an unknown, representing a subjective estimate made by individual investors. It
cannot be calculated precisely, but an important factor in investors' estimates will be the historical pattern of
growth in dividends. However, the past is often a weak indicator of the future.
Question:

Solution:
Gordon growth model (or earnings retention model)
This growth estimate is based on the idea that retained profits are the only source of funds. With no re-invested
profits, the investment base of the company would not increase. Practically, this means no new funds invested in
new products, new markets, new factories, stores and so on. Therefore, profit will not grow, and by implication
dividends (taking a long-term view) will not grow.

Growth therefore comes about by retaining and reinvesting profits on which a return is earned.
The relationship between these variables is shown by:
g = rb
Where: g = growth in future dividends
r = the current accounting rate of return
b = the proportion of profits retained

If all measures are constant, then it may be shown that g, the rate of growth of dividends, is equal to the rate of
growth of profits is equal to the rate of growth of share price and so on.

Question:
Solution

Problems with the Gordon growth model

The major problem with this model is:
 Its reliance on accounting profits
 The assumption that r and b will be constant
 Inflation can substantially distort the accounting rate of return if assets are valued on an historical cost basis
 The model also assumes all new finance comes from equity
Question:

Solution:
Shortcomings of the dividend valuation model (DVM)
 Underlying assumptions
– Shares have value because of the dividends. This is not always true – some companies have a deliberately low
payout policy which can attract investors who prefer capital gains to an income stream. Som e companies pay no
dividends at all, for example Microsoft up until recently paid no dividends but Microsoft shares weren't worth
nothing.
– Dividends either do not grow or grow at a constant rate – the former is unrealistic; the latter is true in the long
term if one takes the view we are estimating a long-term average. Nevertheless, short-term variations in growth
would change the value.
– Estimates of future dividends based on historic data e.g. growth rate, retention rates, implicitly assume dividend
patterns will remain unchanged – it would be more useful to consider the future facing a company when making
this estimate, e.g. market conditions, investor confidence, economic conditions and so on.

 Data used
– The share price is used in the DVM to help estimate the cost of equity to the company or the required rate of
return to the investor.
Share prices change on a daily basis, and not always in a perfectly efficient or rational manner. For example, the
share price of a small company, with a dominant family as shareholders and little trading, may have a more erratic
share price than a large company whose shares trade in a very active market.
– The growth in future dividends.
This is perhaps more likely to be linked to the growth in future earnings, than to past dividends. Earnings do not
feature as such in the dividend valuation model. However, earnings should be an indicator of the company's long-
term ability to pay dividends and therefore, in estimating the rate of growth of future dividends, the rate of growth
of the underlying profits must also be considered. For example, if dividends grow at 10% while earnings grow at
5%, before long the firm will run out of funds with which to pay dividends. Similarly, if dividends grow at 5% and
profits at 10%, the firm will soon accumulate excess funds
Impact of bonus issues and rights issues
Bonus (or scrip or capitalisation) issues raise no new money for a company. Shareholders are given more shares in
proportion to their existing holdings. The total value of all the company's shares does not change but the value per
share drops in proportion to the additional shares. The fall in price (supposedly) makes the shares more attractive
to buy/sell.
Care needs to be taken in estimating dividend growth rates when a bonus issue has taken place.

Example :
CAPM and the cost of equity
CAPM was introduced as one way of estimating the required return on a share and thus the cost of equity capital
for a company. The basic idea behind the CAPM is to assess how risky the business is, and 'price' that risk
accordingly.
The Capital Asset Pricing Model (CAPM) provides a relationship between risk and return:

Example:
Cost of preference shares

Preference dividends are normally quoted as a percentage. Thus 10% CU1 preference shares will provide an annual
dividend of 10% of the CU1 nominal value
Cost of debt
Irredeemable securities
If securities are irredeemable, the company does not intend to repay the principal but to pay interest forever. In
this case the present value of a perpetuity equation may be used as introduced above:
Securities redeemable at other than current market price
Where there is a difference between the current market price and the redemption price, there are two elements
to the cost of that security:
 Interest payments, i.e. an income return;
 A capital gain or loss represented by the difference between the current market price and the
redemption price.
Effect of taxation
An important aspect in evaluating the cost of finance is the effect of tax. Loan interest is an allowable expense for
corporation tax, effectively reducing the cost of loan finance to the company.
Question:

Solution:
Question:

Solution:
Combined cost of capital or weighted average cost of capital

In order to provide a measure for evaluating these projects, the cost of the pool of funds is required. The general
approach is to calculate the cost of each source of finance, then to weight these according to their importance in
the financing mix. This is referred to as the combined or weighted average cost of capital (WACC).

Example:
Question:

Solution:

When to use the weighted average cost of capital

1. The historical proportions of debt and equity are not to be changed
2. The operating risk of the firm is not to be changed
3. The finance is not project specific

Other problems with the weighted average cost of capital

1. Which sources of finance to include
2. Loans without market values
3. Cost of capital for small companies