Cost of capital

▪ Cost of capital is the minimum rate of return acceptable on

investment considered to be sufficient to reward all investors
in the business.
▪ For an all equity financed business, the cost of capital is the
cost of equity (Ke or re).

1
Introduction cont.’

▪ For a firm financed with equity and debt, the cost of capital is the
weighted average cost of capital (WACC).
𝑽𝒆 𝑽𝒅
▪ WACC = re + rd ( 1 – tax rate)
𝑽𝒆+𝑽𝒅 𝑽𝒆+𝑽𝒅

2
 𝑽𝒆 𝑽𝒅
WACC = re + rd ( 1 – tax)
𝑽𝒆+𝑽𝒅 𝑽𝒆+𝑽𝒅
▪ Where:
▪ re = cost of equity;
▪ rd = cost of debt
▪ Ve = value of equity;
▪ Vd= Value of debt
▪ Ve/(Ve + Vd) = equity proportion
▪ Vd/(Ve + Vd) = debt proportion
▪ Equity proportion + debt proportion =1 (100%) 3
Activity 1
▪ LP Co is currently 35% debt financed. The cost of equity is 12.5%
while the cost of debt before tax is 9%.
▪ Company tax is 33%. Calculate WACC
▪ Solution:
▪ Debt proportion =35%,
▪ Equity proportion = 65%
▪ Cost of equity = 12.5%,
▪ Cost of debt before tax = 9%, Tax = 33%
▪ WACC = (12.5%*0.65) + 9%*(1 – 0.33)*(0.35)
▪ = 10.24% 4
Activity 2
▪ DC Co is currently financed by K30m equity and K20m debt. The
cost of debt after tax is 6% while the cost of equity 15%.
▪ Company tax is 25%. Calculate WACC
▪ Solution:
▪ Value of Equity = K30m,
▪ Value of debt = K20m
▪ Cost of equity = 15%,
▪ Cost of debt after tax = 6%, Tax = 25%
▪ WACC = (15%*30m/50m) + (6%*20m/50m)
▪ = 11.40% 5
Cost of individual capital elements
▪ Equity shares = CAPM or DVM
▪ Preference shares = Yield on Preference shares.
▪ Debt :
o Perpetual debt = Interest yield
o Redeemable debt = IRR (YTM)
o Convertible debt = IRR (YTM)
o Bank loan = Interest attached to the loan
o With debt beta = CAPM 6
Cost of Equity (Ke or re)
▪ Based on Capital Asset Pricing Model (CAPM);
▪ re = rf + β*(rm – rf)
▪ Where; rf = return on the risk free asset (yield on
government securities)
▪ rm = return on the market portfolio
▪ β= beta coefficient or value
▪ rm – rf = market risk premium
7
Assumptions of CAPM
▪ Investors are rational and want to maximise their utility; they do not take
risk for risk’s sake.
▪ All information is freely available to investors and, having interpreted it,
investors arrive at similar expectations.
▪ Investors are able to borrow and lend at the risk-free rate.
▪ Investors hold diversified portfolios, eliminating all unsystematic risk.
▪ Capital markets are perfectly competitive (no taxes and transaction costs;
no entry or exit barriers to the market; and securities are divisible.
▪ Investment occurs over a single, standardised holding period.
8
Advantages of CAPM

▪ Considers systematic risk, which reflects the pool of portfolio held by

investors.
▪ Utilises and generate a theoretically derived relationship between
required return and systematic risk.
▪ Yields better results compared to dividend growth model (DGM).

9
Disadvantages of CAPM

▪ Uses the risk free rate (government security), which changes daily and
creates volatility.
▪ Uses equity risk premium (return on the market, which are historical
figures and is more difficult.) Thus, does not represent future returns.
▪ Uses beta, which are historical and not constant, but change over time.

Thus, determination of beta is problematic.

10
Implication of CAPM on security pricing

▪ The calculation of the required rate of return of a security will only

consider systematic risk to be relevant, as unsystematic risk can be
eradicated by portfolio diversification.
▪ Shares with high levels of systematic risk are expected, on average, to
yield higher rates of return.
▪ There should be a linear relationship between systematic risk and return,
and securities that are correctly priced should plot on the security
market line (SML).
11
Calculating the beta value of an asset (1)
▪ Beta measures the responsiveness of the asset’s return to changes in
the market.
▪ Thus, the relationship between the individual assets performance
with the market will influence the beta value calculation.
𝑪𝒐𝒗𝒂𝒓𝒊𝒂𝒏𝒄𝒆 (𝒙,𝒎) 𝑪𝒐𝒗 (𝒙,𝒎)
▪ Beta x = = 𝟐
𝑽𝒂𝒓𝒊𝒂𝒏𝒄𝒆 𝒎 σ

▪ Cov(x,m) = Covariance between asset ‘x’ returns and the market

returns.
▪ σ2 = Variance of the market returns (standard deviation squared)
12
Calculating the beta value of an asset (2)
𝑪𝒐𝒓𝒓𝒆𝒍𝒂𝒕𝒊𝒐𝒏 𝒙 𝒘𝒊𝒕𝒉 𝒎𝒂𝒓𝒌𝒆𝒕 ∗𝑺𝒕𝒅 𝒅𝒆𝒗 𝒐𝒇 𝒓𝒆𝒕𝒖𝒓𝒏 𝒙
▪ Beta x =
𝒔𝒕𝒅 𝒅𝒆𝒗 𝒐𝒇 𝒎𝒂𝒓𝒌𝒆𝒕 𝒓𝒆𝒕𝒖𝒓𝒏

σ𝒙
▪ =ρ*
σ𝒎

▪ ρ is the correlation coefficient between asset x and the market.

▪ σx is the standard deviation of asset x
▪ σm is the standard deviation of the market returns (m)

13
Activity 3 .
▪ Calculate the beta of FJ plc, which is listed on LuSE. Based on data over
the past ten years, the correlation between FJ plc, and LuSE is 0.90. FJ plc
has a standard deviation of returns of 62.80% and LuSE has a standard
deviation of returns of 53.41%.
▪ The yield on treasury bills is 6%, average return on LuSE is 13.0%. FJ
pays tax at 25% while the firms corporate debt gross yield is 8%. FJ is
currently 20% geared.
▪ Required:
▪ Calculate the cost of capital for FJ plc 14
Extracts from activity 3 .
Variable Value (figure)

Correlation coefficient 0.90

Std deviation of the FJ returns 62.80
Std deviation of LuSE returns 53.41
Risk free rate of returns 6.0%
Average returns on LuSE 13.0%
Gross yield on debt 8.0%
Corporate tax rate 25.0%
Gearing ratio (debt ratio) 20.0%
15
Solution to activity 3.
𝟎.𝟗𝟎 ∗𝟔𝟐.𝟖𝟎
▪ Beta Fj = = 1.058
𝟓𝟑.𝟒𝟏

▪ Cost of equity = rf + B*(rm – rf)

▪ = 6% + 1.058*(13%-6%)
▪ = 13.41%
▪ WACC = 13.41%(0.80) + 8%*(1 – 0.25)(0.20)
▪ = 10.73% + 1.20%
▪ = 11.93%
16
Cost of Equity (Ke or re) cont.

▪ Based on Dividend Valuation Model (DVM);

▪ The cost of equity is the discount rate which equates the sum of
the present values of all future dividends to the current share
price.
▪ Assumptions on dividend are;
▪ Dividend is constant i.e. forms a perpetuity
▪ Dividend growth rate is constant (g)
17
▪ Non-constant growth r
re; based on non-constant dividend growth.

▪ Based on the historic growth rate;

𝒏 𝑳𝒂𝒕𝒆𝒔𝒕 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅
g= { } -1
𝑬𝒂𝒓𝒍𝒊𝒆𝒔𝒕 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅

▪ g = approximate growth rate.

▪ n = period of growth or intervals between dividends.
❑ Cost of equity is then calculated using the constant growth rate
assumption with do
18
rp; Cost of Preference shares.

▪ Preference shares are issued with a fixed rate of dividend.

Assuming the shares are irredeemable, dividend forms a
perpetuity. Thus;

𝑫
▪ rp = x 100
𝑷𝒐 (𝒆𝒙−𝒅𝒊𝒗)

▪ Where;
▪ rp = Yield on preference shares or cost of preference shares
▪ Po =current preference share price (ex-dividend)
▪
19
D = dividend on preference shares
rb; Cost of a bank loan.

▪ Bank loans are non tradable. They are issued with a specific
rate of interest fixed or variable.
▪ Since interest is tax deductible, the effective cost of a bank loan
is the after tax cost calculated as;
▪ After tax cost = pretax cost ( 1 – tax rate)

20
rd; Cost of irredeemable bonds.

▪ Irredeemable bonds are issued with a fixed rate of interest and

no maturity date.
▪ Interest payable forms a perpetuity.
𝑪∗(𝟏 −𝒕𝒂𝒙 𝒓𝒂𝒕𝒆)
▪ rd = x 100
𝑷𝒐 (𝒆𝒙−𝒊𝒏𝒕.)

▪ C = (coupon payment) = Coupon rate x par value

▪ Po = market price of the bond (ex-int.) 21
rd; Cost of redeemable bonds (YTM).

▪ Redeemable bonds are issued with a fixed rate of interest and a

specific maturity date.
▪ The cost of this instrument is the yield to maturity (YTM) or
internal rate of return(IRR).
▪ Use of interest net of tax produces an after tax cost of debt.

22
rd; (YTM) formula.

𝒂
▪ YTM (IRR) = A + ∗ 𝑩 −𝑨
𝒂 −𝒃

▪ Where;
▪ A = lower discount rate with positive NPV (a)
▪ B = Higher discount rate with negative NPV (b)

23
rd; Cost of debt based on CAPM.

▪ Where debt beta is known, the cost of debt before tax can be
calculated using CAPM as;
▪ rd = rf + βd*(rm – rf)
▪ Where: βd =debt beta
▪ After tax cost = pretax cost ( 1 – tax rate)

24
Activity 4.

▪ A business is financed by K60m equity and K40m debt. The cost of

debt before tax is 10% while the dividend just paid is 4.2 ngwee per
share. The dividend has grown steadily from 2.0 ngwee paid 5 years
ago. The current share price is 97.5 ngwee per share. Company tax is
30%.
▪ Required:
▪ Calculate the cost of equity and determine the WACC.
25
Solution to activity 4.
𝟓 𝟒.𝟐𝟎
▪ g= – 1 = 16%
𝟐.𝟎
𝟒.𝟐𝟎∗(𝟏.𝟏𝟔)
▪ re = = + 0.16 = 21.0%
𝟗𝟕.𝟓
▪ Capital Cost (%) Proportion Cost * Proportion
element

▪ Equity 21 60/100 12.60%

▪ Debt 10*(1-0.3) 40/100 2.80%
WACC 15.40%
26
Activity 5
Miguel Business Solutions (MBS) is funded with 80m (K1) ordinary shares,
8% K30m preference share capital and K40m of debt trading at par.
Preference shares are irredeemable and quoted at K85 per K100 nominal
value. The dividend growth rate at the company is constant at 6% per
annum forever. Latest dividend is 20 ngwee per share and the share price is
212n. The debt beta is 0.75. The company faces a tax rate of 30%. The risk
free interest is 4.6% and the stock market risk premium is 6%.
Required:
Calculate WACC for MBS. 27
Solution to activity 5 (1):
𝟐𝟎∗(𝟏.𝟎𝟔)
▪ Cost of equity = + 0.06 = 16%
𝟐𝟏𝟐
𝟖%∗𝑲𝟏𝟎𝟎
▪ Cost of preference share = ∗ 𝟏𝟎𝟎 = 9.41%
𝟖𝟓
▪ Cost of debt (CAPM) = 4.6% + 0.75*(6%) = 9.10%

▪ Value of capital elements: K’m

▪ Equity = 80m * K2.12 = 169.60
▪ Debt = 40.00
▪ Preference shares (K30m/K100)*K85 = 25.50
▪ Total capital 235.10 28
Solution to activity 5 (2):

Capital Value Proportion Cost Cost *

element K’m % proportion
Equity 169.6 0.7214 16.00 11.54

Preference 25.50 0.1085 9.41 1.02

Debt 40.00 0.1701 9.1*0.7 1.08

WACC 13.64%
29