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CHAPTER 7

COST
OF
CAPITAL
Learning Objectives
After working through this chapter, you should be able to:
Understand the concept of the weighted average cost of
capital (WACC) (3rd year)
Determine the cost of debt (3rd year)
Determine the cost of preference share capital (3rd year)
(NB: convertible and redeemable preference shares 4th year).
Calculate the cost of equity using the dividend growth
model and the CAPM approach (3rd year)
Understand the practical issues of estimating the CAPM
parameters (3rd year)
Understand how a firms capital structure affects a firms
WACC (3rd year)
Calculate firms weighted average cost of capital (WACC)
(3rd and 4th year)
Understand the use of the WACC in determining a firms
EVA (4th year)
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Why is the Weighted Average Cost of
Capital (WACC) so important?
Evaluation of capital projects
Valuation of companies
Determination of a companys EVA (economic
profit)
Determination of fair value for corporate
reporting purposes
WACC is employed to set pricing decisions for
entities subject to regulatory review
Determination of fair value for financial reporting
purposes 3
WACC Some Principles

Use a weighted average of the costs of the


different sources of finance.
Use marginal costs.
Include the effects of corporate tax.
Use nominal rates.
Use market values or a target capital
structure.

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WACC Formula

What is the formula for the WACC?

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Component Costs of Capital:
Cost of Debt
Cost of Debt = Interest rate (1 - tax rate) [Formula 7.1]
Flotation Costs?
Net receipt = Vd (1 - F)
Coupon rate of debenture = 10%
Market rate on date of issue = 11%
Assumption: The debenture is a perpetuity
Vd = (10%/11%) x R100 = R90.91
If flotation (issue) costs are involved, say at 2%
= $90.91(1 - 0.02)
= $89.09
Cash received per debenture = $89.09
Interest at 10% on $100= $10
Cash interest cost (10/89.09) = 11.22%
Effective rate
Kd = 11.22% (1 -0.28) = 8.08%

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Yield to Maturity for
Redeemable Debentures / Bonds
What is the cost of redeemable debentures? The
cost is the yield to maturity.
Assume that the price of a debenture is currently
trading at $93.80. The coupon rate is 10% and the
redemption date is in 5 years time.

Year 0

If tax is based on YTM, then the after-tax cost of


debt is 0.117 x (1-0.28) = 8.43%
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Component Costs of Capital
Cost of Preference Shares
Hypothec Ltd wishes to issue 12% preference shares with a par value of R1.
Assume the current market rate has risen to 14%. Find the component
cost. Floatation costs are 5c

SAME PRINCIPLE AS DEBENTURES IF THERE


ARE FLOTATION COSTS

NO TAX SHIELD - DIVIDENDS ARE NOT TAX DEDUCTIBLE


Component Costs of Capital
Cost of Equity
Example 7.4
Current market price: $7.68
Expected EPS for the next year $1.28
Dividend payout ratio 30%
Expected growth rate 11% p.a.
Beta 1.2
METHOD 1: DIVIDEND GROWTH
MODEL
KEQUITY = (D1 / P0) + g
= [(1.28 x 0.30)/7.68] +0.11
= 16%

SAME PRINCIPLE IF FLOTATION COSTS ARE


INVOLVED P = P(1 - F)
Component Costs of Capital
Cost of Equity Dividend Growth
Estimating growth there are a variety of
method that we can use to estimate growth
Use historical growth rate in dividends
Use analyst forecast of future growth
Use sustainable growth

Advantages and Disadvantages of Dividend


Growth Model

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Component Costs of Capital
Cost of Equity
Example 7.4

Risk free rate 8%


Expected return on the market 14%
Beta 1.2

METHOD 2: CAPITAL ASSET PRICING


MODEL
KEQUITY = Rf + Beta(Rm - Rf)
= 0.08 + 1.2(0.14 - 0.08)
= 15.2%

Advantages and disadvantages of CAPM??


Component Costs of Capital
Cost of Equity
METHOD 3:
Bond Yield Plus a Risk Premium
Do not use risk-free rate
Use the companys (or a comparable companys) bond
yield or the companys borrowing cost.
Add a risk premium
Risk premium is selected by management/analyst
Assume bond yield = 9% and risk premium = 5%

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THE WEIGHTED AVERAGE COST
OF CAPITAL
Calculating the WACC

The weightings are determined by analysis of the Statement of


Financial Position (if this reflects the target capital structure)

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Breaks in the WACC

Investment opportunities.

If WACC = 13%, then projects 1, 2 and 4 should be accepted.


Limitations of borrowing:
Debentures: $60m
Preference shares: $25m
Retained earnings: $90m
The company cannot afford to engage in all projects with the
current level of borrowing. 14
Break Points in the WACC

Breaking point for debt, preference shares and ordinary shares are
the limits before the WACC % changes (breaks).
The change occurs from increases in costs of further borrowing
from each of the three components.

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Estimating the Cost Capital of
Divisions
A company may not be operating in just one sector
or industry, but multiple sectors
Each sector may be associated with varying levels
of risk
Due to this, the overall companys cost of capital
should not be used to evaluate projects
A divisional cost of capital is required
Systematic risk of the sector should be used to
determine the cost of capital
Covered in more detail in Chapter 10
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Unlevering and relevering betas

If a comparable company has a different level of


financial leverage, then we need to unlever and
relever the beta to reflect the firms financial
leverage.

Comparable company beta = 1.30 and D/E = 150%


If firms D/E = 100%, then relevered beta = 1.075 17
Capital structure and leases

Capitalisation of all leases, including


operating leases may increase the D/E of a
company
If not already factored into the determination
of a firms beta, then we may need to reflect
the higher D/E by using a higher beta and we
can do this be unlevering and relevering the
firms beta.
Lower cost of debt financing is mainly offset by
increase in the cost of equity 18
WACC Capital structure
Steps
What is the capital structure based on current
market values of debt and equity?
What are the capital structures of firms in the
same industry? (Useful if company is unlisted)
What is managements target capital structure?
If no specific target, what is implied by their
financing activities? What is implied by potential
financial restructuring (note what private equity
firms are planning to do)?
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WACC Some Practical Issues
Capital Structure
Book Values or Market Values? generally use
market values
Note that financing activities can be lumpy
What about a target capital structure?
What do market values mean?
Focus on target capital structure otherwise use
market values as a guide.
Only use book values if this reflects the target
capital structure

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Cost of Debt & Preference Shares
Use current market rates
Ignore historical and coupon rates
Variable rate financing use long-term rate
Use interest rate spreads for different credit ratings
Probabilities of default implied by rating spreads
What is the current real interest rate? Is it sustainable?
Foreign loans due to interest rate parity, use the
market rate in the local market. (Yet higher liquidity of
bond issues in Europe and NY)
Preference shares non-redeemable = Dividend/Market
Price. If redeemable, use market yield.

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CAPM Some Practical Issues
KEQUITY = Rf + Beta(Rm - Rf)
The Risk-free rate
Treasury Bills or Long-term Bonds?
Matching of rate to the life of the company
Practitioners use the long-term RSA
government bond rate.
Consistent with objective of setting a long-
term cost of equity
Short-term interest rates are volatile, and this
would make the cost of equity very volatile

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More on the Risk-free rate
Long-term bond yields reflect the holding
period returns that match the term of the
underlying investments
Any country risk premium is included in the
risk free rate
PWC Survey = Risk-free rate used is the
long-term government bond rate

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The Market (Equity) Risk Premium
The Market Risk Premium
The difference between the expected rate of
return and the risk-free rate.
How do we measure market premiums?
Historical
Surveys
Dividend growth model for the economy
Market premium
Average market (equity) premium

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Historical Premiums
Most common method for determining risk premium
Extrapolate past premiums into the future
How far back do we go?

PWC Survey 2005

PWC Survey 2010 average market premium from


5.6% to 6.0%
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Use of Dividend Growth Model to
Estimate Market Risk Premium
This is a big picture view.
Dividend Yield is close to 3% for the JSE.
Real growth rate is about 4.0% and assume inflation
is 4.5%, so that approximate nominal future growth
rate is 8.5%.
K = D/P + g = 3% + 8.5% = 11.5%
Bond yield = approx. 8.7%
Therefore the market premium is almost 4.0%
(11.5%-8.7%)
This is on the low side but practitioners are using a
risk premium of 4-7%.
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Beta
How do we determine a forward looking
beta?
Use of historical returns of company versus
the market
How far back? What time interval? Which
index?
Beta services such as UCT / Cadiz (Financial Risk
Service), McGregor, Bloomberg
Individual company betas vs sector betas

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Estimating Betas
Which Index should we use as a Proxy for the
market portfolio?
Levered betas are converted to unlevered betas and
relevered by the firms capital structure
In 2010, the following were some sector betas;
Resources 1.31
Food producers 0.50
Financials 0.71
IT 0.80
Food & Drug retailers 0.42

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More on divisional WACC and beta
Cost of Equity using the
CAPM formula

If a firm as a beta of 1.1 and the risk-free rate is


9%, and (Rm - Rf) is 5%, then the required return
is 14.5%.
If a firm is investing in another industry sector,
then the beta for that industry sector should be
used.
Firms with higher debt-equity ratios will have
higher equity betas. We need to adjust for
differences in financial leverage. How?
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Unlevering Equity Betas
Co. A is investing in a different industry sector and the
equity beta for that sector is 0.89. The Debt/Equity ratio for
that sector is 0.92. The tax rate is 28%.

How do we use this equity beta when the financial leverage


of the sector differs from the financial leverage of Co.A?
We need to unlever and then relever using Co.As level
of gearing.
Using the Hamada formula;

Unlevered Beta = 0.89/[1+(1-0.28)(0.92)] = 0.535

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Relevering Equity Betas
To determine the equity beta of Co. A, we need to relever
this to reflect Co. As gearing. We can restate Hamadas
formula as;

If Co. A has a debt-equity ratio of 0.50, then the


relevered beta that Co. A needs to use to determine the
required return for the project is;
0.54[1+(1-0.28)(0.50)] = 0.734
Although Co. A may have a current equity beta of 1.1,
which reflects the risk of its current operations, the cost
of capital used to evaluate the project in the new sector
would be based on an Equity Beta of 0.734.

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Why use a Risk-adjusted Discount Rate?
Why not simply use the firms cost of capital to determine a projects
NPV? What is wrong with using the cost of capital?

High risk projects will be accepted and low risk projects will be
rejected.
Project A should be accepted due its return relative to its risk, yet it is
rejected. Project B should be rejected due to its high risk relative to
its return, yet it is accepted.
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CAPM-parameters.....continued

Specific risk premium


PWC - most companies add a specific risk
premium to the cost of equity [range = 2% to 7%
in 2009]
Small stock risk premium
PWC survey found that most firms add a small
stock premium [4.9%]

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