Chapter 14

The cost of capital

Solutions to questions

1. The consistency principle requires that the definition of the cash flows in the numerator of
an NPV calculation must match the definition of the discount rate in the denominator of
the calculation. There are two main ways in which such consistency needs to be adhered
to in relation to inflation and taxation. With respect to inflation, if the cash flows reflect
the expected impact of changes in purchasing power (i.e. inflation) then the discount rate
should also reflect compensation for that effect such that real cash flows are discounted
using a real discount rate and nominal cash flows are discounted using a nominal rate.
Similarly, it is common practice to discount cash flows that are expressed on an after-
corporate tax basis using a discount rate that is also expressed on an after-corporate tax
basis.

2. The risk-independence assumption simplifies project appraisal because it allows managers

to evaluate projects on a project-by-project basis.

3. (a) The CAPM describes the riskreturn relationship for risky securities. Investors will
wish to commit funds only to those projects that promise a rate of return that is at
least equal to the return available from securities of equal risk. Therefore, the CAPM
can be used to estimate the cost of capital for a project. The conditions are that Rf, i
and E(RM + ) should be constant over time.
(b) The problems associated with estimating these variables are specified in Section
14.5.3.

4. In many cases, it is difficult to obtain an estimate of beta in which one can have a high
degree of confidence. It is also true that a beta value of 1 falls within the 95 per cent
confidence interval of the estimated beta value for the majority of companies. The
sentiments expressed in the quotation are therefore understandable, but relevant
information should not be ignored. If no information is available, then a companys beta
would be assumed to equal 1. However, if a regression-based estimate indicates a beta of,
say, 1.5, this would be used as the best estimate or as the basis on which a better estimate
could be determined. Confidence in the accuracy of this estimate would increase if it is
supported by other data. For example, other companies in the same industry may be found
to have similar betas.

5. (a) Given that the correlation decreases, the beta of aluminium production would also
decrease. Assuming that the risk of the rolling mill is the same as the risk of
producing aluminium, the projects cost of capital would be lower.
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 (b) Reducing financial leverage is purely a financing change, and should have no effect on
the risk of the project or on its cost of capital.
(c) The cost of capital would increase.
(d) This change would affect the expected cash flows from the project, but would not
necessarily change its cost of capital.

6. The statutory company tax rate represents the rate of tax collected by companies on
behalf of the government. Under the dividend imputation system present in Australia,
some of the taxes collected by companies are claimed by their shareholders as when the
company pays dividends it also distributes tax credits representing the proportion of tax
paid upon the distributed profit. The net result is that the effective corporate tax rate in
Australia for most companies is lower than the statutory rate. The relationship between
the effective and statutory rates is expressed as te = tc(1 ) where te is the effective tax
rate, tc the statutory rate and is the proportion of tax collected from a company that is
paid out to shareholders and recovered in the form of franked dividends. Obviously, as
increases the difference between te and tc also increases. Factors that will increase include
the proportion of after-tax earnings distributed by a company as well as the proportion of
investors that can claim back the tax credits that are distributed.

7. While it is true that a companys WACC is commonly calculated using its current ratios of
debt to equitywhich do reflect historical financing decisionsit does not follow that the
calculation should employ historical estimates of the cost of funds. Companies are
interested in WACC as a measure of their current cost of funds (for example, a company
might use WACC as a discount rate in the evaluation of new projects). The other point to
make is that, as detailed in section 14.5.4, where the acceptance of a new project may
result in a change in the companys optimal/targeted capital structure, the companys
historical levels of leverage (and estimates of E/V and D/V in the WACC formula) should
be replaced by its targeted leverage ratios.

8. Trade credit is not a free source of finance. It has a cost that depends on the difference
between the price paid for goods purchased on credit, compared to the cash price.
However, it is true that when estimating a companys cost of capital, the cost of trade
credit does not need to be explicitly incorporated into the estimates. The reason is that the
cost of using trade credit will flow through into a companys cost of goods sold and is
therefore deducted in calculating the companys profit and net operating cash flow. It
follows that the cost of trade credit does not have to be met from net operating cash flow
when this cash flow is defined in the usual way. Therefore, to include trade credit as a
source of finance would be inconsistent.

9. As discussed in section 14.5.5, a companys WACC should reflect the risk of the project
being assessedas opposed to the specific source of funds for this specific project. If a
company is to maintain its optimal capital structure over time then it will need to raise
both debt and equity over time, and hence it is the forecast average level of ongoing issue
costs that a firm faces that is important to include in project evaluation as opposed to the

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 issue costs associated with raising capital for a single project. Example 14.2 demonstrates
this point.

10. (a) The opportunity cost to investors of financing a project is equal to the rate of return
that could be obtained on an investment of equivalent risk. If the project fails to
achieve this return, the project will be valued at less than the funds invested in it. In
this case, the market value of the company undertaking the project will decrease.
Accepting such a project is, therefore, inconsistent with the objective of maximising
shareholders wealth. Therefore, the cost of capital for a project should be the rate
required by investors to finance the project (and this rate will reflect the perceived
risk of the project).
(b) The cost of capital is project-specific for the following reasons:
(i) it will reflect the risk of the project (see (a) above); and
(ii) it will depend on the life of the project (see the discussion of the term structure
of interest rates in Section 4.6).

11. The marginal cost of capital is the cost of capital for a specific investment and depends on
the features of that investment. The relevant features are the risk of the investment and the
period during which capital will be committed to the investment. A companys weighted
average cost of capital (WACC) will reflect the risk and duration of its average
investments. Therefore, a companys WACC is a measure of the marginal cost of capital
for new investments, provided that their risk and duration are the same as the risk and
duration of the companys average investments. In other words, while the WACC does
have important limitations, it is a valid approach that is appropriate for estimating the
marginal cost of capital.

12. In a company with separate divisions, it is likely that the cost of capital for the various
divisions will differ from that of the company as a whole. If the company uses a single cut-
off ratethat is, the companys cost of capitalfor all of its investments, this will result
in:
(a) the high-risk divisions finding it much easier than the low-risk divisions to have their
projects accepted
(b) the company rejecting some projects that it should accept, and vice versa.

13. The relative merits of each method and the problems associated with using each method
are discussed in Section 14.6.1.

14. It would be appropriate to use this estimate where the new investment has the same risk
as the proxy company, and the new investment is to be financed in the same debtequity
ratio as the proxy company.

15. The suggestion that WACC can be minimised by sourcing more capital from debt as it has
a lower required rate of return (kd) than equity (ke) fails to take into account that, as
leverage increases, equity (and often debt) becomes riskier to hold and hence the required
return on these sources of capital will increase. This may in turn result in an increase in the
companys WACC.
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16. The two factors that need to be accounted for when discounting a cash flow to its present
value are (i) the time until the cash flow occurs and (ii) the riskiness associated with the
cash flow. The standard approach to discounting relies upon using a single risk-adjusted
discount rate to account for both of these effects at the same time whereas the certainty-
equivalent approach separates out the two effects. This is particularly useful when the risk
associated with future cash flows does not increase at a constant rate per unit of time (as
is assumed via the risk-adjusted discount rate approach).

Solutions to problems

1. Note that the cost of equity capital Re under the CAPM is:

R f e E ( RM ) R f
and the cost of capital is then:

E D
k = k e k d 1 t e
V V

Note that the market premium (including the franking premium) is E ( R M ) R f

If the market premium (including the franking premium) is 1 per cent, then ke = 0.05 + 1.2 (1)
= 6.2 per cent.

Then k = 0.062 (0.6) + 0.06 (1 0.12) (0.4) = 5.832 per cent

If the market premium (including the franking premium) is 5 per cent, then ke = 0.05 + 1.2 (5)
= 11 per cent.

Then k = 0.11 (0.6) + 0.06 (1 0.12) (0.4) = 8.712 per cent.

Clearly, differences in the estimation of the market risk premium have a substantial impact on
estimates of the cost of capital.

2. ki = Rf + i [E(RM + ) Rf)]
= 0.11 + 0.75(0.15 0.11)
= 0.14
1 1
1 (1.14) 5 1 (1.14) 5
NPV = $100 000 $130 000 (1.14) 5 $600 000
0.14 0.14

= $24 897

The company should not undertake the expansion.

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3. Using the procedure outlined in Section 14.6.1:
D
e = a 1
E
1.2 = a [1 + 1]
a = 0.6

Substituting for a we obtain:

a = 0.6(1 + 2/3)
= 1.0

Then:
ke = Rf + e (E(RM + ) Rf)
= 0.12 + 1.0 (0.17 0.12)
= 0.17

Finally:
E D
k = k e k d 1 te
V V
= 0.17 (3/5) + 0.14 (1 0.12)(2/5)
= 0.1513 or (15.13 per cent)

The assumptions underlying the above calculations include the following:

(i) the proxy company is suitable for calculating the systematic risk of the companys
equity;
(ii) the values for a, Rf and E(RM + ) are assumed to remain constant over the life of the
investment; and
(iii) the debt of both companies is risk-free.

D1
4. ke = +g
Po
0.10
= + 0.5
1.00
= 15 per cent
kp = 9 per cent
kd = 0.08 (1 0.12)
= 7.04 per cent

Market Weight Cost Weighted

value(a) cost

Ordinary shares $500 000 0.5 0.15 0.07500

Preference shares 200 000 0.2 0.09 0.01800
Debentures 300 000 0.3 0.0704 0.02112

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 1 000 000 1.0 0.11412
(a)
Book values are used where market values are not available.
k = 0.1141, or 11.41 per cent

5. Cost of debt:

Accounts payable: these are ignored for the reason outlined in Section 14.5.1.

Bank overdraft (kb):

(1 + r) = (1 + i)m
r = (1 + i)m 1
= (1.05)2 1
= 1.1025 1
= 10.25 per cent p.a.
kb after tax = r(1 te)
= 10.25(1 0.12)
= 9.02 per cent p.a.

Debentures (kd):
1
1 (1 k ) 5
$97 = $12 d
+ $112(1 + kd)6
kd


kd = 12.75 per cent p.a.
kd after tax = kd(1 te)
= 12.75(1 0.12)
= 11.22 per cent p.a.

Cost of preference shares (kp)

Dp
kp =
P0
1.40
=
9.50
= 14.74 per cent p.a.

Cost of equity (ke)

D0 (1 g ) g
*
ke =
P0

As discussed in Section 4.3.2, g = br where b is the proportion of earnings retained each

year and reinvested at a constant rate, r.

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 net profit after tax, preference dividend and ordinary dividend
b=
net profit after tax and preference dividend
52 000
=
172 000
= 0.302
net profit after tax and preference dividend
r=
book value of (shareholders' funds preference shares)
172 000
=
1 202 000
= 0.143
g= 0.302 0.143
0.30
*
D0 = 0.12 + 0.12
0.70
= 0.1714
0.1714 1.0432
ke = + 0.0432
1.1
= 20.6%

Calculation of WACC (k)

Market Weight Cost Weighted cost
value ($) (%) (%) (%)

Bank overdraft 200 000 9.65 9.02 0.87

Debentures 582 000 28.09 11.22 3.15
Preference shares 190 000 9.17 14.74 1.35
Equity 1 100 000 53.09 20.60 10.94
Total 2 072 000 100.00 16.31

k = 16.31 per cent p.a.

6. Excluding the effects of broken interest periods, the statement is true if the effective
annual coupon rate is less than the effective annual cost of debt capital.

The effective annual coupon rate

2
0.1
= 1+ 1
2
= 10.25%

This is less than 13 per cent.

1 (1.13) 10
p $10
0.13
$100

(1.13)10
$83.72
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 This is less than $100.

7. ke = Rf + e (E(RM + ) Rf)
= 0.12 + 0.5(0.18 0.12)
= 0.15, or 15 per cent
Dp
kp =
P0
$0.14
=
$1.00
= 14 per cent
kd = 0.13, or 13 per cent

Note: as all the shares are held by Australian residents, it is assumed that te = 0.

Calculation of WACC (k)

Market value Weight Cost (%) Weighted

($000s) cost (%)

Ordinary shares 9 000 0.7500 15.00 11.25

Preference shares 500 0.0417 14.00 0.59
Debentures 2 500(a) 0.2083 13.00 2.71
Total 12 000 1.0000 14.55
(a)
Market value is equal to book value because interest rates have not changed since the
debentures were issued.
k = 14.55 per cent

8. Based on the figures given, the observer might argue that with 40 per cent debt, Dorsets
cost of capital k ' could be as follows:

E D
k' = ke k d 1 t e
V V
= 0.16 (0.6) + 0.10 (1 0.12) (0.4)
= 0.1312, or 13.12 per cent

which is considerably lower than its current cost of capital.

The observers argument is not correct. Problems inherent in his argument include the
following:
(a) If the company borrows, shareholders will face financial risk, and the cost of
equity will become greater than 16 per cent. Therefore, the companys cost of
capital will not decline to 13 per cent as suggested by the calculation.
(b) Changing Dorsets capital structure by borrowing should not affect the NPV of
proposed new projects. Any borrowing will be supported by the companys
existing assets, whether or not they are explicitly used as security for the debt.

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 Therefore, any advantage associated with adding debt to the capital structure
should logically be attributed to the companys existing assets rather than to
proposed new projects.

9. (a) ke = Rf + e(E(RM + ) Rf)

= 0.10 + 0.8(0.15 0.10)
= 0.14
The before-tax cost of debt is calculated as follows:

1
1 (1 k ) 8
$111 = $11 d
$100 (1 k d ) 8
kd


kd = 0.09
E D
k = k e k d 1 te
V V
3 1
= 0.14 + 0.09 (1 0.12)
4 4
= 0.1248, or 12.48 per cent

(b) The assumptions include:

(i) The risk of the new project will be identical to the average risk of the existing
company.
(ii) The new project will not cause the companys optimal capital structure to
change.
(iii) See assumption (ii) in the answer to Problem 2.

10. (a) Using Equation 14.12 and the method illustrated in Example 14.4:
Company X 0.14 = 0.5 k1' + 0.5 k 2' (1)
' '
Company Y 0.128 = 0.7 k1 + 0.3 k 2 (2)
' '
Company Z 0.146 = 0.4 k1 + 0.6 k 2 (3)
' '
where k1 and k 2 are the weighted average costs of capital for industries 1 and 2,
respectively. Any two of the equations (1), (2) and (3) can be solved simultaneously
to find k1' and k 2' . For example, from (2):

k '
=
0.128 0.7k 1
'

2
0.3
Substituting for k 2' in (1) gives:

0.14 = 0.5 k + '

0.5 0.128 k1'
1
0.3
k1' = 0.11, or 11 per cent

Substituting this result in any of the equations gives:

k 2' = 0.17, or 17 per cent

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 (b) The main assumptions that underlie the model are:
(i) The cost of capital is uniform within each industry.
(ii) The data on the proportion of assets in each industry accurately reflect the
market values of the companies divisions.
(c) The advantages of this method compared to the pure-play approach include the
following:
(i) It is not necessary to find companies that operate in only one industry.
(ii) There is no need to employ any model to adjust equity betas or the cost of equity
capital for differences in leverage.
One disadvantage of the method is that it may be difficult to estimate the market
value of each division of a diversified company.

11. In terms of (a) the reduction in net cash flow from cotton is incremental and hence should
be included in the analysis. However, it is unlikely that 10 per cent is the best estimate to
use. There are two reasons for this:

(i) There are likely to be fixed costs, suggesting that the reduction in net cash flows could
be more than 10 per cent

(ii) The same amount of water can now be used over a 10 per cent smaller area, which is
likely to increase crop yields, suggesting that the reduction may be less than 10 per cent
per annum.

In short, a more careful estimate is required.

Turning our attention to (b), the WACC reflects VCL's current activities (cotton growing)
and its current debtequity ratio. Both aspects will change if the camping ground project
is adopted. The risk of running a camping ground is unlikely to be the same as that of
growing cotton. Also, VCL's debtequity ratio will be higher. Hank's argument is wrong
as all of the liabilities finance all of the assets. For example, if the debt cannot be repaid
out of proceeds from the camping ground, the shareholders will have to fund it. In
addition, a higher debtequity ratio increases their financial risk. So their interests are
involved in this decision. The right way to approach this is to decide what the risk of the
project is, and what required rate of return is commensurate with that risk. A good place
to start would be trying to find out the required rates of returns on existing camping
grounds (and like ventures) owned by other investors.

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