COST OF CAPITAL/ FINANCE

Expected learning outcomes

1) Introduction to cost of capital
2) Estimating cost of capital
3) Weighted average cost of capital
4) Marginal cost of capital

Introduction
A company grows by making investments that are expected to increase revenues and profits. The
company acquires the capital or funds necessary to make such investments by borrowing or
using funds from owners. By applying this capital to investments with long term benefits, the
company is producing value today, but how much value? The answer depends not only on the
investments ’ expected future cash flows but also on the cost of the funds. Borrowing is not
costless. Neither is using owners ’ funds.
The cost of this capital is an important ingredient both in investment decision making by the
company ’ s management and in the valuation of the company by investors.
If a company invests in projects that produce a return in excess of the cost of capital, the
company has created value; in contrast, if the company invests in projects whose returns are less
than the cost of capital, the company has actually destroyed value.
Therefore, the estimation of the cost of capital is a central issue in corporate financial
management. For the analyst seeking to evaluate a company’s investment program and its
competitive position, an accurate estimate of a company ’ s cost of capital is important as well.

Cost of capital estimation is a challenging task. As we have already implied, the cost of capital is
not observable but rather must be estimated. Arriving at a cost of capital estimate requires a host
of assumptions and estimates. Another challenge is that the cost of capital that is appropriately
applied to a specific investment depends on the characteristics of that investment: The riskier the
investment’s cash flows, the greater its cost of capital will be. In reality, a company must
estimate project - specific costs of capital. What is often done, however, is to estimate the cost of
capital for the company as a whole and then adjust this overall corporate cost of capital upward
or downward to reflect the risk of the contemplated project relative to the company ’ s average
project.

Definition of cost of capital

The cost of capital is the rate of return that the suppliers of capital — bondholders and owners
— require as compensation for their contribution of capital. Another way of looking at the cost
of capital is that it is the opportunity cost of funds for the suppliers of capital: A potential
supplier of capital will not voluntarily invest in a company unless its return meets or exceeds
what the supplier could earn elsewhere in an investment of comparable risk.

This is the price the company pays to obtain and retain finance. To obtain finance a company
will pay explicit costs which are commonly known as floatation costs. These include:
Underwriting commission, Brokerage costs, cost of printing a prospectus, Commission costs,

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legal fees, audit costs, cost of printing share certificates, advertising costs etc. For debt there are
legal fees, valuation costs (i.e. security, audit fees, Bankers commission etc.) such costs are
knocked off from:

i) The market value of shares if these have only been sold at a price above par value.
ii) For debt finance – from the par value of debt.

I.e. if flotation costs are given per share then this will be knocked off or deducted from the
market price per share. If they are given for the total finance paid they are deducted from the
total amount paid.

Cost of Retaining Finance

This will include dividends for share capital and interest for debt finance (tax deducted) or
effective cost of debt. However, when computing the cost of finance apart from deducting
implicit costs ( opportunity cost of using existing resources within a company - essentially the
potential return lost by not investing those funds elsewhere), explicit costs (direct monetary cost
a company incurs when raising capital like interest payment) are the most central elements of
cost of finance.

A company typically has several alternatives for raising capital, including issuing equity,
debt, and instruments that share the characteristics of debt and equity. Each source selected
becomes a component of the company ’ s funding and has a cost (required rate of return) that
may be called a component cost of capital .

Note. When we are using the cost of capital in the evaluation of investment opportunities, we are
dealing with a marginal cost — what it would cost to raise additional funds for the potential
investment project. Therefore, the cost of capital that the investment analyst is concerned with is
a marginal cost.

Importance of Cost of Finance.

The cost of capital is important because of its application in the following areas:
i) Long-term investment decisions – In capital budgeting decisions, using NPV method, the
cost of capital is used to discount the cash flows. Under IRR method the cost of capital is
compared with IRR to determine whether to accept or reject a project.
ii) Capital structure decisions – The composition/mix of various components of capital is
determined by the cost of each capital component.
iii) Evaluation of performance of management – A high cost of capital is an indicator of high
risk attached to the firm. This is usually attributed to poor performance of the firm.
iv) Dividend policy and decisions – E.g if the cost of retained earnings is low compared to
the cost of new ordinary share capital, the firm will retain more and pay less dividend.
Additionally, the use of retained earnings as an internal source of finance is preferred
because:

 It does not involve any floatation costs

 It does not dilute ownership and control of the firm, since no new shares are issued.

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v) Lease decisions – A firm may finance the acquisition of an asset through leasing or
borrowing long-term debt to buy an asset. In lease decisions, the cost of debt (interest
rate on loan borrowed) is used as the discounting rate.

Factors That Influence The Cost Of Finance

1. Terms of reference – if short term, the cost is usually low and vice versa.
2. Economic conditions prevailing – If a company is operating under inflationary
conditions, such a company will pay high costs in so far as inflationary effect of finance
will be passed onto the company.
3. Risk exposed to venture – if a company is operating under high risk conditions, such a
company will pay high costs to induce lenders to avail finance to it because the element
of risk will be added on the cost of finance which may compound it.
4. Size of the business – A small company will find it difficult to raise finance and as such
will pay heavily in form of cost of finance to obtain debt from lenders.
5. Availability – Cost of finance (COF) prices will also be influenced by the forces of
demand and supply such that low demand and low supply will lead to low cost and high
cost of finance respectively.
6. Effects of taxation – Debt finance is cheaper by the amount equal to tax on interest and
this means that debt finance will entail a saving in cost of finance equivalent to tax on
interest.
7. Nature of security – If security given depreciates fast, then this will compound implicit
costs (costs of maintaining that security).
8. Company’s growth stage – Young companies usually pay less dividends in which case
the cost of this finance will be relatively cheaper at the earlier stages of the company’s
development.

METHODS/MODELS OF COMPUTING COST OF CAPITAL

Each source of capital has a different cost because of the differences among the sources, such as
seniority, contractual commitments, and potential value as a tax shield. We focus on the costs of
three primary sources of capital: debt, preferred equity, and common equity
The following models are used to establish the various costs of capital or required rate of return
by the investors:

COST OF EQUITY
The cost of common equity, Ke , usually referred to simply as the cost of equity, is the rate of
return required by a company ’ s common shareholders. A company may increase common
equity through the reinvestment of earnings that is, retained earnings or through the issuance of
new shares of stock.

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Dividend yield/Gordon’s model.

Dividend yield/Gordon’s Model – This model is used to determine the cost of equity capital.
 Cost of equity - Ke
 Cost of preference share capital (perpetual) – Kp

a) Cost of equity (Ke)– This can be determined with respect to:

We can have Zero growth firms- or constant growth firm ( based on the dividends
characteristics)
Zero growth firm
d0
Ke= P0
Where: d0 = DPS dividend per share
p0 = Current MPS (market price per share)

d 0 ( 1+ g )
Constant growth firm – P0 = Keg

d 0 ( 1+g )
Ke= +g
Therefore P0

Capital Asset Pricing Model Approach - In the capital asset pricing model (CAPM) approach,
we use the basic relationship from the capital asset pricing model theory that the expected return
on a stock, E ( R i ), is the sum of the risk - free rate of interest, R F , and a premium for bearing
the stock ’ s market risk,
E(R I )=Rf + β ¿ E(Rm) - Rf)

where
Bi -return sensitivity of stock i to changes in the market return
E ( Rm ) - expected return on the market
E(Rm) -R f expected market risk premium
A risk - free asset is defined here as an asset that has no default risk. A common proxy for the
risk - free rate is the yield on a default - free government debt instrument. In general, the
selection of the appropriate risk - free rate should be guided by the duration of projected cash
flows. If we are evaluating a project with an estimated useful life of 10 years, we may want to
use the rate on the 10 - year Treasury bond.

Example
Valence Industries wants to know its cost of equity. Its chief financial offi cer (CFO) believes the
risk-free rate is 5 percent, equity risk premium is 7 percent, and Valence’s equity beta is 1.5.
What is Valence’s cost of equity using the CAPM approach?

Solution

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 E(R I )=Rf + β ¿ E(Rm) - Rf)
E(R I )=5 % +1.5 ¿7)
= 15.5%
The expected market risk premium, E ( R M R F ), is the premium that investors demand
for investing in a market portfolio relative to the risk - free rate. When using the CAPM to
estimate the cost of equity, in practice we typically estimate beta relative to an equity market
index.

Cost of perpetual preference share capital (Kp)

The cost of preferred stock is the cost that a company has committed to pay preferred
stockholders as a preferred dividend when it issues preferred stock. In the case of nonconvertible,
non callable preferred stock that has a fixed dividend rate and no maturity date (fixed rate
perpetual preferred stock ), we can use the formula for the value of a preferred stock.

Recall, value of a preference share = Constant DPS

Kp
Kp = DPS /P0
Where:

DPS= Preference dividend per share

P0 = Market price of a preference share

Therefore, the cost of preferred stock is the preferred stock’s dividend per share divided by the
current preferred stock ’ s price per share.
Unlike interest on debt, the dividend on preferred stock is not tax deductible by the company;
therefore, there is no adjustment to the cost for taxes.

A preferred stock may have a number of features that affect the yield and hence the cost of
preferred stock. These features include a call option, cumulative dividends, participating
dividends, adjustable rate dividends, or convertibility into common stock. When estimating a
yield based on current yields of the company’s preferred stock, we must make appropriate
adjustments for the effects of these features on the yield of an issue. For example, if the company
has callable, convertible preferred stock outstanding, yet it is expected that the company will
issue only non callable, nonconvertible preferred stock in the future, we would have to either use
the current yields on comparable companies ’ non callable, nonconvertible preferred stock or
estimate the yield on preferred equity using methods outside the scope of this chapter.

Cost of perpetual debenture (Kd) / debt–

The cost of debt is the cost of debt financing to a company when it issues a bond or takes out a
bank loan. Debentures pay interest charges, which an allowable expenses for tax purposes.

Recall, Value of a debenture (Vd) = Interest charges p.a. in ∞

Cost of debt (Kd)

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 Int .
( 1−T )
Therefore Kd = V d

Where:Kd = % cost of debt

T = Corporate tax rate
Vd = Market value of a debenture

COST OF REDEEMABLE DEBENTURES/DEBT

Redeemable fixed return securities have a definite maturity period. The cost of such securities is
called yield to maturity (YTM) or redemption yield (RY).
The yield to maturity ( YTM ) is the annual return that an investor earns on a bond if the
investor purchases the bond today and holds it until maturity. In other words, it is the yield, r d ,
that equates the present value of the bond’s promised payments to its market price. For a
redeemable debenture Kd (cost of debt) = YTM = RY, can be determined using approximation
method as follows:

1
Int (1−T )+ ( M −V d )
n
K d / VTM / RY = 1
( M +V d ) 2

Where:Int. = Interest charges p.a.

T = Corporate tax rate
M = Par or maturity value of a debenture
Vd = Current market value of a debenture
n = Number of years to maturity

Issues in Estimating the Cost of Debt

Fixed - Rate Debt Versus Floating - Rate Debt Up to now, we have assumed that the interest on
debt is a fixed amount each period. We can observe market yields of the company’s existing debt
or market yields of debt of similar risk in estimating the before - tax cost of debt. However, the
company may also issue floating - rate debt in which the interest rate adjusts periodically
according to a prescribed index, over the life of the instrument.
Estimating the cost of a floating - rate security is difficult because the cost of this form of capital
over the long term depends not only on the current yields but also on the future yields. The
analyst may use the current term structure of interest rates and term structure theory to assign an
average cost to such instruments.

Debt with Option like Features- How should an analyst determine the cost of debt when the
company uses debt with optionlike features, such as call, conversion, or put provisions? Clearly,
options affect the value of debt. For example, a callable bond would have a yield greater than a
similar non-callable bond of the same issuer because bondholders want to be compensated for
the call risk associated with the bond. In a similar manner, the put feature of a bond, which
provides the investor with an option to sell the bond back to the issuer at a predetermined price,
has the effect of lowering the yield on a bond below that of a similar nonputable bond. If the
company already has outstanding debt that incorporates optionlike features that the analyst

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believes are representative of the future debt issuance of the company, the analyst may simply
use the yield to maturity on such debt in estimating the cost of debt. If the analyst believes that
the company will add or remove option features in future debt issuance, the analyst can make
market value adjustments to the current YTM to reflect the value of such additions and/or
deletions.

Leases- A lease is a contractual obligation that can substitute for other forms of borrowing. This
is true whether the lease is an operating lease or a capital lease, though only the capital lease is
represented as a liability on the company ’ s balance sheet. If the company uses leasing as a
source of capital, the cost of these leases should be included in the cost of capital. The cost of
this form of borrowing is similar to that of the company’s other longterm borrowing

WEIGHTED AVERAGE COST OF CAPITAL (W.A.C.C.)

This is also called the overall or composite cost of capital cost of capital for the entire company
The cost of capital of a company is the required rate of return that investors demand for the
average - risk investment of a company. The most common way to estimate this required rate of
return is to calculate the cost of each of the various sources of capital and then calculate a
weighted average of these costs. This weighted average is referred to as the weighted average
cost of capital ( WACC ) ( existing capital).
The WACC is also referred to as the marginal cost of capital ( MCC ) because it is the cost that
a company incurs for additional capital. The weights in this weighted average are the proportions
of the various sources of capital that the company uses to support its investment program.
Therefore, the WACC, in its most general terms, is

W.A.C.C=
Ke ( VE )+ K ( VP )+ K (1−T )( DV )
p d

Where:Ke, Kp and Kd = Percentage cost of equity, preference share capital and debt capital
respectively
E, P and D = Market value of equity, preference share capital and debt capital
respectively.
NB: Market value = Market price of a security x No. of securities.
V ( value of the firm) = Total market value of the firm = E + P + D.

Weights of the Weighted Average

How do we determine what weights to use? Ideally, we want to use the proportion of each source
of capital that the company would use in the project or company. If we assume that a company
has a target capital structure and raises capital consistent with this target, we should use this
target capital structure. The target capital structure is the capital structure that a company is
striving to obtain. If we know the company ’ s target capital structure, then, of course, we should
use this in our analysis. Someone outside the company, however, such as an analyst, typically
does not know the target capital structure and must estimate it using one of several approaches:

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Method 1: Assume the company’s current capital structure, at market value weights for
the components, represents the company’s target capital structure.
Method 2: Examine trends in the company’s capital structure or statements by management
regarding capital structure policy to infer the target capital structure.
Method 3: Use averages of comparable companies ’ capital structures as the target capital
structure.

In the absence of knowledge of a company’s target capital structure, we may take Method 1 as
the baseline. Note that in applying Method 3, we use unweighted, arithmetic average, as is often
done for simplicity. An alternative is to calculate a weighted average, which would give more
weight to larger companies. Suppose we are using the company ’ s current capital structure as a
proxy for the target capital structure. In this case, we use the market value of the different capital
sources in the calculation of these proportions. For example, assume a company has the
following market values for its capital.

Bonds outstanding $ 5 million

Preferred stock 1 million
Common stock 14 million
Total capital $ 20 million
The weights that we apply would be
w d 0.25
w p 0.05
w e 0.70

Illustration
The following is the capital structure of XYZ Ltd as at 31/12/2002.

Shs.M
Ordinary share capital Sh.10 par value 400
Retained earnings 200
10% preference share capital Sh.20 par 100
value
12% debenture Sh.100 par value 200
900

Additional information:
1. Corporate tax rate is 30%
2. Preference shares were issued 10 years ago and are still selling at par value MPS = Par
value
3. The debenture has a 10 year maturity period. It is currently selling at Sh.90 in the
market.
4. Currently the firm has been paying dividend per share of Sh.5. The DPS is expected to
grow at 5% p.a. in future. The current MPS is Sh.40.

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Required:
a) Determine the WACC of the firm.
b) Explain why market values and not book values are used to determine the weights.
c) What are the weaknesses associated with WACC when used as the discounting rate, in
project appraisal.

a) Compute the cost of each capital component.

Cost of equity (Ke) – Since the growth rate in dividends is given, use the constant growth
rate dividend model to determine the cost of equity.

d0 = Sh.5 P0 = Sh.40 g = 5%

d 0 ( 1+g ) 5 ( 1+0 . 05 )
Ke= + g= +0 . 05=0 . 18125=18 . 13 %
P0 40

Cost of perpetual preference share capital (K p) – preference shares are still selling at par
thus MPS = par value. If this is the case, Kp = coupon rate = 10%.

MPS = Par value = Sh.20

Dp = 10% x Sh.20 = Sh.2

DPS d p Sh . 2
K p= = = =10 %
MPS P p Sh .20

Cost of debentures (Kd) – the debenture has a 10 year maturity period. It is thus a
redeemable fixed return security thus the cost of debt is equal to yield to maturity.

Redemption yield:

Interest charges p.a. = 12% x Sh.100 par value = Sh.12

Maturity period (n) = 10 years
Maturity value (m) = Sh.100
Current market value (Vd) = Sh.90
Corporate tax rate (T) = 30%

1
Int (1−T )+ ( M−V d )
n
K d =YTM =RY =
( M +V d ) ½

1
Sh . 12(1−0 .3 )+(100−90 )
10
=9 .9 %≈10 %
= (100+90 )½

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ii) Compute the market value of each capital component
Market value of Equity (E) = MPS x No. of ordinary shares
Sh.400 MDSC
Sh.40 x
= Sh.10 parvalue = 1,600

Market value of preference share capital (P)

= Par value, since MPS = Par value per share = 100

Market value of debt (D) = Vd x No. of debentures

Sh.200 Mdebentures
Sh.90 x
= Sh .100 parvalue = 180

V value of the firm = E + P + D = = total Market Value = 1,880

1600+100+180= 1880

iii) Compute W.A.C.C using Ke = 18.13%, Kp = 10%, Kd (1-T) = 10%

a) Using weighted average cost method,, WACC =

=
Ke ( VE )+ K ( VP )+ K (1−T )( DV )
p d

=
18.13% ( 1,600
1,880 )
+10% (
1,880 )
100
+10 % (
1,880 )
180

= 15.43 + 0.5319 + 0.9574

= 0.169193

≈ 16.92%

b) By using percentage method,

WACC = Total monetary cost
Total market value (V)

Where:Monetary cost = % cost x market value of capital

Monetary cost of E = 18.13% x 1,600 = 290.08
Monetary cost of P = 10% x 100 = 10.00
Monetary cost of D = 10% x 180 = 18.00
318.08

Total market value (V) 1,880

318 .08
x100
Therefore WACC = 1,880 = 16.92%

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b) In computation of the weights or proportions of various capital components, the
following values may be used:

 Market values
 Book values
 Replacement values
 Intrinsic values

Market Value – This involves determining the weights or proportions using the current market
values of the various capital components. The problems with the use of market values are:

The market value of each security keep on changing on daily basis thus market values can be
computed only at one point in time.

The market value of each security may be incorrect due to cases of over or under valuation in the
market.
Book values – This involves the use of the par value of capital as shown in the balance sheet.
The main problem with book values is that they are historical/past values indicating the value of
a security when it was originally sold in the market for the first time.

Replacement values – This involves determining the weights or proportions on the basis of
amount that can be paid to replace the existing assets. The problem with replacement values is
that assets can never be replaced at ago and replacement values may not be objectively
determined.

Intrinsic values – In this case the weights are determine on the basis of the real/intrinsic value of
a given security. Intrinsic values may not be accurate since they are computed using
historical/past information and are usually estimates.

e) Weaknesses of WACC as a discounting rate

WACC/Overall cost of capital has the following problems as a discounting rate:

 It can only be used as a discounting rate assuming that the risk of the project is equal to the
business risk of the firm. If the project has higher risk then a percentage premium will be
added to WACC to determine the appropriate discounting rate.
 It assumes that capital structure is optimal which is not achievable in real world.

Marginal cost of finance (MCC)

This is cost of new finances or additional cost a company has to pay to raise and use additional
finance
is given by:

Total cost of marginal finance x 100

Cost of finance (COF)

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Cost of finance may be computed using the following information:

i) Marginal cost of each capital component.

ii) The weights based on the amount to raise from each source.

1. Marginal cost of equity

D1
x 100
Ke = P o −f (for zero growth firm)

Also cost of equity

D1
+g
Ke = P o −f (for normal growth firm)

Where:d1 = expected DPS = d0(1+g)

P0 = current MPS
f = floation costs
g = growth rate in dividend

2. marginal Cost of preference share capital:

Dp
x 100
Kp = o −f
P
Where:Kp = Cost of preference
Dp = Dividend per share
Po = MPS (Market price per share)
F = Flotation costs

3. Marginal Cost of debenture ( perpetual)

Int (1−T )
Kd=
V d −f

Where:Kd = Cost of debt

Int = interest
Po = Market price for debenture (at discount)
f = flotation costs
t = Tax rate

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 4. Just like WACC, weighted marginal cost of capital can be computed using:

i) Weighted average cost method

ii) Percentage method

Example:
XYZ Ltd wants to raise new capital to finance a new project. The firm will issue 200,000
ordinary shares (Sh.10 par value) at Sh.16 with Sh.1 floatation costs per share, 75,000 12%
preference shares (Sh.20 par value) at Sh.18 with sh.150,000 total floatation costs, 50,000 18%
debentures (sh.100 par) at Sh.80. Raised a Sh.5,000,000 18% loan paying total floatation costs
of Sh.200,000. Assume 30% corporate tax rate. The company paid 28% ordinary dividends
which is expected to grow at 4% p.a.

Required:
a) Determine the total capital to raise net of floatation costs
b) Compute the marginal cost of capital

Solution:
a) Sh.’000’
Ordinary shares 200,000 shares @ 3,200,000
Sh.16
Less floatation costs 200,000 shares (200,000) 3,000
@ Sh.1
Preference shares 75,000 shares @ 1,350,000
Sh.18
Less floatation cost (150,000) 1,200
Debentures 50,000 debentures @ 3,000,000
Sh.80 -____ 3,000
Floatation costs
Loan 5,000,000
Less floatation costs (200,000) 4,800
Total capital raised 12,000

b) Marginal cost of equity Ke

d 0 ( 1+ g )
Ke= +g
P0 −f

d0 = 28% x Sh.10 par = Sh.2.80

g = 4%

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f = Sh.1.00
P0 = Sh.16

2 . 80(1 .04 )
Ke= +0 . 04
Therefore marginal = 16−1 = 0.234 = 23.4%

Marginal cost of preference share capital Kp

Kp = dp
P0-f

dp = 12% x Sh.20 par = Sh.2.40

P0 = Sh.18
f = Floatation cost per share = Sh.150,000 = Sh.2.00
75,000 shares
Kp = 2.40 = 0.15 = 15%
18 – 2

Marginal cost of debenture Kd

Kd = Int (1-t)
Vd-f

f = 0
Vd = Sh.80
Int = 18% x Sh.100 par = Sh.18
T = 30%

Kd = 18(1-0.3) = 0.1575 = 15.75%

80

Marginal cost of loan Kd

Kd = Int (1-t)
Vd-f

T = 30%
Vd = Sh.5 million
f = Sh.0.2 million
Int = 18% x Sh.5M = Sh.0.9M

Kd = 0.9 (1-0.3) = 0.13125 = 13.13%

5 – 0.2

Source Amount to % marginal Maturity

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 raise before cost cost
f. costs
Sh.’000’ Sh.’000’
Ordinary shares 3,200 23.4% 748.8
Preference 1,350 15.0% 203.5
shares 3,000 15.75% 472.5
Debenture 5,000 13.13% 656.5
Loan 12,550 2,080.3

Weighted marginal cost = 2,080.3 x 100 = 16.58%

12,550

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