Académique Documents
Professionnel Documents
Culture Documents
chapter 6
Cost of capital
contents
1 Effects of risk on the cost of capital 7 Assessment of risk in the debt versus
2 Cost of equity equity decision
3 Cost of preference shares 8 Cost of capital for unquoted companies
4 Cost of debt capital 9 Cost of capital for not-for-profit
5 Internally generated funds organisations
6 Weighted average cost of capital
learning outcomes
After reading and understanding the contents of this chapter and working through all the
worked examples and practice questions, you should be able to:
Introduction
A company’s cost of capital is the return that it gives to the providers of capital.The
form of the return depends on the nature of the capital. Shareholders receive divi-
dends and usually expect capital growth from increases in the share price.The mix of
dividend income and capital growth depends on the nature of the company. A high-
tech company that is growing fast, and investing in research and development to
support this growth, is holding out the prospect of capital growth but may pay little
or none of its available cash out as dividends.A company in a mature industry – such
as a water or electricity utility – may have few opportunities to invest for growth and
pays large dividends (in relation to the share price) which grow only slowly.
Some investors need a large income straight away from their investment and are
willing to forgo growth to get it. Others are willing and able to wait for their returns
and may prefer them to be in the form of capital gains realised later rather than
income that is subject to tax straight away.When investors buy shares, they have some
understanding of the company’s investment and dividend policies, and select the
companies in which they invest to match their own requirements.
Loan stock holders receive their return in the form of regular, usually fixed,
interest payments and redemption proceeds. Since the market price of loan stock
varies, there is scope for capital gain, though usually less than that expected by many
ordinary shareholders. The returns to holders of convertible loan stock and prefer-
ence shareholders are slightly different and are considered below.
The return that investors require, in whatever form they receive it, depends on
their cost of capital and the risk of the investment (discussed below). An investor’s
cost of capital may be his borrowing cost or his opportunity cost – the return that he
can get by investing elsewhere and which he forgos by investing in this company.
The nature of the risk associated with capital structure is discussed in chapter 9.
The relation between investment risk and return is discussed in chapter 7 on
Portfolio Theory and in chapter 8, which describes and explains the Capital Asset
Pricing Model.
Corporate financial managers need to know the cost of capital in order:
To make well-informed choices about capital structure and what kinds of new
capital to raise, which means that they need to know the costs of the alternatives.
To keep informed about the expectations of providers of capital so that they can act
to satisfy these expectations and encourage investors to keep their capital in the
company.
In particular, in making capital investment decisions, to invest in projects that give
the return that shareholders require, and avoid those that do not.
We will consider initially the costs of the different individual types of capital, before
looking at the cost of the capital structure of the company as a whole.
6 COST OF CAPITAL 83
The return investors require depends on the level of risk – the higher the risk the
higher the expected return, because people expect to be compensated for bearing
additional risk.This ‘risk premium’ (made up of premiums for business and financial
risks) will be required in addition to the risk-free rate of return.The risk-free return
is the return that would be required if there were no risk and is typically taken to be
the return on government bonds. The returns required from investing in different
companies will vary with their different levels of business and financial risk.
2 Cost of equity
The value of equity is given in the balance sheet by shareholders’ funds and in the
market by the market value of issued ordinary shares.
The cost of equity can be found as the return received by shareholders from the divi-
dends paid, or the earnings after tax, in relation to the share price. (The rationale for
valuing a share on the basis of the expected future dividend stream may need justifica-
tion. Some sharholders expect to receive part of their return in the form of capital gain
when the share price increases, and not just in the form of dividends. If they do, it is
because the price rises since some other investor is keener than before to own the shares.
The justification for basing this increased desire to own the shares on the dividend stream
is that some investors – for example, insurance companies and pension funds – often
invest for the long term, with the express purpose of generating growing future cash
flows to meet their obligations to policy holders, annuitants, pensioners and others.)
Tosca plc’s current dividend is 25p and the market value of each share is £2. What is the cost of Tosca’s
equity?
Answer
d
Using the above formula Ke o
Po
25
Ke 0.125 12.5%
200
10733_CH06.QXD 29/10/07 12:07 Page 84
We can now find the average rate of growth by using the following formula:
n
Growth rate (g) Latest dividend
1
Earliest dividend
where n number of years’ growth.
3
g 0.32 1 0.0717 or approximately 7%.
0.26
Note: Here we are using the cube root because there are three years of growth. If we had been given five years’
data (from which we could project four years’ growth) the fourth root would have been used.
When the expected growth figure has been determined we can calculate the value of
Gordon’s Model of the company’s shares using the Dividend Growth Model or Gordon’s Model of
Dividend Growth Dividend Growth.
Equation relating the ex- This model states:
dividend ordinary share (1 g)
price to the dividend, the Po do
(Ke g)
expected annual growth in
dividends and the cost of where: Po the current ex dividend market price
equity capital. do = the current dividend
g the expected annual growth in dividends
Ke the shareholder’s expected return on the shares
The equation above can be rearranged as:
do(1 g)
Ke Po g
Using the example of Puccini above and assuming its share price is £2.50, then:
0.32(1.072)
Ke 0.072 0.137 0.072 20.9%.
2.50
10733_CH06.QXD 29/10/07 12:09 Page 85
6 COST OF CAPITAL 85
The dividend valuation and dividend growth model are based on the following
assumptions:
taxation rates are assumed to be the same for all investors and in particular higher
rates of tax are ignored. the dividends used are the gross dividends paid out from
the company’s point of view;
the costs incurred in issuing shares are ignored;
all investors receive the same, perfect level of information;
the cost of capital to the company remains unaltered by any new issue of shares;
all projects undertaken as a result of new share issues have the same level of risk as
the company’s existing activities;
the dividends paid must be from after-tax profits – there must be sufficient funds
to pay the shareholders from profits after tax.
In the case of Puccini in Worked Example 6.3 above, if issue costs amount to (say) 10 per cent of the capital
raised, the issue cost per share is 10 per cent of £2.50 £0.25. The cost of new equity, allowing for issue
costs, is:
0.32(1.072)
Ke 0.072 0.224 22.4%
2.50 0.25
The cost of exisiting equity capital in Puccini calculated in Worked Example 6.3 was
20.9 per cent. The cost of a new issue of equity capital for Puccini is 22.4 per cent.
Both figures are based on the market price of one share, which is assumed to be the
same in both cases, and the expected future dividends, which are also the same, since
new and existing shares have identical rights and are therefore treated in exactly the
same way for the payment of dividends. The difference is that the cost of existing
retained earnings
capital is based on the market value of one share, while the cost of new capital is based
Profits reinvested in the
on what the company receives when it issues the new share: the market value less the
business instead of being
paid out as dividends. They issue cost.
belong to the shareholders
and form part of 2.3 Retained earnings
shareholders’ funds,
together with equity capital Retained earnings are profits reinvested in the business instead of being paid out as
subscribed by shareholders dividends. They belong to the shareholders and form part of shareholders’ funds,
and reserves. The cost of together with equity capital subscribed by shareholders and reserves. As such, the
retained earnings is the
cost of retained earnings is essentially the same as the cost of other equity capital
same as the cost of other
forms of equity capital calculated above. (In other words, shareholders will only be happy with their
included in shareholders’ company retaining profits if the company can make the same return on those
funds. retained profits as they get on the money that they have invested in shares.)
10733_CH06.QXD 26/10/07 14:18 Page 86
Many companies use retained earnings as their main source of new capital.
Reasons for preferring this form of equity capital are discussed in section 5 of this
chapter. One reason for preferring retained earnings over new issues of ordinary
shares is the cost of new issues, which (as shown above) means that the cost of new
ordinary share capital is higher than the cost of other shareholders’ funds, including
retained funds.
Anorak plc has 8% preference shares which have a nominal value of £1 and a market price of 80p. What is the
cost of preference shares?
Answer
The dividend is 8 per cent of the nominal value (8 per cent of £1 8 pence).
Using the above formula:
dp 8
Kp 10%.
Sp 80
6 COST OF CAPITAL 87
higher the rate of corporation tax payable by the company, the lower will be the after-
tax cost of debt capital.Thus the cost of debt capital is lower than the cost of prefer-
ence shares with the same coupon rate and market value as the debentures because
there is no tax relief on preference dividends. The effect of tax relief on the interest
cost only applies if the business has taxable profits from which to deduct its interest
payments. If there is a taxable loss for the year, there is no immediate tax relief for
loan stock interest, but the interest increases taxable losses, which can be carried
forward and may be set against profits in future years.
Clown plc has £10,000 of 8% irredeemable debentures in issue which have a current market price of £92 per
£100 of nominal value.
Required
If the corporation tax rate is 30 per cent what is the cost of the debt capital?
Answer
The annual interest payment will be based on the nominal value, i.e. 8 per cent of £10,000 or £800, so using
the above formula:
I(1 t)
Kd
Sd
800(1 0.30)
0.0609 6.09%.
92/100 10,000
Pierrot plc has redeemable 10 per cent loan stock, redeemable on 31 December year 4, with a current market
price on 31 December year 1 of £95.57 per £100 nominal. The corporation tax rate is 30 per cent.
Required
Find the cost of the loan stock capital.
Answer
Pierrot plc will make the following cash payments to a holder of £100 nominal of 10 per cent redeemable loan
stock: £10 in interest on 31 December in each of the years 2, 3 and 4 and repayment of £100 capital on 31
December year 4. Pierrot will receive tax relief on interest paid (for this example, we assume that tax relief is
given one year after each interest payment is made: £3.00 on 31 December in each of the years 3, 4 and 5).
The cash payments for each £100 nominal of 10 per cent loan stock are set out in Table 6.1.
10733_CH06.QXD 26/10/07 14:18 Page 88
table 6.1 Cash payments for each £100 nominal of loan stock
Why is the calculation of the cost of redeemable debt capital or convertible loan
stock more complicated than the calculation of the cost of irredeemable debt
capital or preference shares?
10733_CH06.QXD 26/10/07 14:18 Page 89
6 COST OF CAPITAL 89
Quality plc has 10 per cent convertible debentures due for conversion in two years’ time. They have a current
market value of £165.32 per cent. The conversion terms are five shares per £10 of debentures. All the debenture-
holders are expected to convert and the shares are expected to have a price of £4 at the conversion date.
Required
What is the cost of capital? Assume the rate of corporation tax is 30 per cent and is payable in the same year as
profits are made.
Answer
The ‘market value of 165.32 per cent’ means that the market price of £100 nominal of 10 per cent.
10733_CH06.QXD 26/10/07 14:18 Page 90
convertible debentures is £165.32. Interest on convertible stock can be offset against tax and is shown as a
saving in the following calculation:
Year 0 1 2
£ £ £
Current market value of debenture (165.32)
Interest 10 10
Tax relief (3) (3)
Value of shares on conversion
((5 100/10) £4) 200
Total yearly cash flow (165.32) 7 207
This shows that with a discount rate (cost of capital) of 14 per cent, the present value of the future cash flows
is equal to the market value of the debenture. This means that the cost of capital is 14 per cent.
Remember that discounted cash flow calculations will be covered in greater detail in
chapter 12.
6 COST OF CAPITAL 91
decisions on investments and funding and can rely on shareholder support for
larger decisions that need to be approved by general meetings of the company.
(d) No change is involved in the balance of equity control. New equity issues can
lead to dilution of the control exercised by existing shareholders.
(e) Bank borrowing, including overdrafts, brings with it third party scrutiny that
may be salutary but is often not welcomed by managers.
(f ) Fixed interest borrowing raises gearing and with it the possibility that operating
cash flows may not cover interest payments if profits come under pressure.
There are some factors limiting the use of internally generated funds:
(a) There may not be enough internally generated funds. Particular cases are new
companies that may need a lot of cash for investment but may not yet be making
profits – or even generating revenue! Examples of the latter could be fledgling
biotechnology or e-commerce companies.
(b) The flow of funds may not match the timing of investment requirements.
(c) Interest on debt attracts corporation tax relief. Dividends do not.
(d) It may be possible to determine an ideal mix of equity and debt in the capital
structure.This is discussed in chapter 9.
(e) Although the immediate cash cost of new equity may be low and of retained
funds nil, the total cost of equity includes capital growth as well as income
(growth in the share price as well as dividends). Investments should be limited
to those that give a rate of return that justifies this cost, plus a margin for risk.
This is discussed in chapter 12. If no suitable investments are available, share-
holders are incurring an opportunity cost by having their money kept in the
company and may be able to use it more profitably elsewhere. The money
should be paid out to them. In recent years several large companies (including
privatised utilities and de-mutualised building societies) have made special
dividend payments for this reason.
Why may companies choose to provide capital from internally generated funds?
The formula above assumes that debt is irredeemable, which means that the cost of
debt capital is purely interest, all of which qualifies for tax relief. If debt is
redeemable, the cost of debt is calculated as described in section 4.2 and used to
replace Kd (1 t) in the formula above.
The weighted average cost of capital is the average of costs of the different types of
finance in a company’s structure weighted by the proportion of the different forms of
capital employed within the business.The financial manager needs to ensure that any
project under consideration will produce a return that is positive in terms of the busi-
ness as a whole and not just in terms of an issue of capital made to finance it.
Investments which offer a return in excess of the WACC will increase the market value
of the company’s equity, reflecting the increase in expected future earnings and divi-
dends arising as a result of the project.
There is no one accepted method of calculating the weighting factors for different
forms of capital. Some companies use book values from the company’s balance sheet
and some use market values. Unquoted companies may have to use book values
because of the problems that we have discussed earlier in estimating market values.
The choice between market values and book values is discussed further in chapter 9.
(a) Using book values in the proportions in which they appear in the company’s accounts:
Weighting Cost Weighted cost
Ordinary shares 60 per cent 12 per cent 7.2 per cent
Debentures 40 per cent 8 per cent 3.2 per cent
WACC 10.4 per cent
(b) Using market values:
Number Price Market Cost Market
value per cent value
Cost
£ £ £ £
Ordinary shares 6,000 2.50 15,000 12 per cent 1,800
Debentures 4,000 1.50 6,000 8 per cent 1,480
21,000 2,280
The WACC is then calculated as:
£2,280
10.86%
£21,000
Both methods produce the historic WACC (based on the relative weights of equity and debt capital in the past).
You should remember that raising fresh capital may alter the weighting and therefore the cost of capital. A
change in the company’s level of risk will also affect the company’s cost of capital.
Which companies are relatively more likely to calculate WACC using book
values?
6 COST OF CAPITAL 93
new investments must be financed from new sources of funds, including new
share issues, new debentures or loans;
the weighted average cost of capital must reflect the long-term future capital struc-
ture of the company.
A company has a current profit before interest and tax (PBIT) of £5m pa and current interest payable of
£1.7m. The company’s issued share capital comprises 10m £1 ordinary shares and the earnings per share
(EPS) are 5p.
The firm wishes to invest £7.5m of new capital and it expects to increase its PBIT by £1.25m pa as a result.
The alternatives under consideration by the directors are as follows:
(a) To issue 3.75 million shares at 200p, representing a discount on the current market price of 240p.
(b) To issue £7.5 million of 10-year debentures with a 12 per cent interest coupon.
Assume a corporation tax rate of 30 per cent.
Answer
One approach to decide on the better route would be to attempt to predict the effect on the market value of the
ordinary shares. The company would then elect for the opportunity which gives the best return to shareholders
(remember the dominant objective of financial management). Table 6.2 below shows the effect on the earnings
per share.
EPS will be improved if capital is raised in the form of debt rather than equity, provided PBIT really does
increase by £1.25m.
However, the use of debt has a higher level of risk than equity, because:
interest payments and debt capital repayments cannot be deferred if projected returns fail to materialise,
whereas dividends can be reduced or passed (not paid at all);
use of debt capital could result in a lower price/earnings ratio for the shares (reflecting this increased risk).
In our example the debt option would increase the gearing ratio and the interest cover (PBIT/interest) would
fall from the present 2.94 to 2.4. (We shall consider gearing in detail in chapter 9.)
10733_CH06.QXD 26/10/07 14:18 Page 94
A higher interest cover means a smaller risk that, in the event of a fall in PBIT, there
will not be enough profits to pay the interest.
6 COST OF CAPITAL 95
difference in financial and business risk, or it could add estimated premiums for its
financial and business risk to the risk-free rate given by government bonds.
(a) What does this approach to identifying the cost of capital miss out?
(b) How does your organisation determine its cost of capital? What is the result?
chapter summary
In this chapter we considered the costs of the different types companies and other organisations. It is important when you
of capital individually, before looking at the cost of capital are revising this area to consider also the capital asset pricing
structure on the company as a whole. We also saw the model, which we shall discuss in chapter 8.
problems in determining the cost of capital for unquoted
practice questions
Section A (4 marks each)
6.1 ‘Companies should use retained earnings to finance new projects because they are free.’
Discuss this point.
6.2 Describe the difficulties in obtaining a cost of capital for a private limited company
6.4
(a) Why should the weighted average cost of capital (WACC) be used to evaluate the required return on a project?
(b) Calculate the WACC from the following, using two different approaches to calculate the weighting factors:
10733_CH06.QXD 26/10/07 14:18 Page 96
6.5 Zeta plc is planning to raise £2.5 million (before expenses) through an issue of ordinary shares. The issue price is £1.25.
The expenses of the issue are expected to be £300,000. The company has just paid a dividend of 4 pence per share for
2002. Three years ago it paid a dividend of 3 pence for 1999. Investors expect future dividend growth at the same rate as in
recent years.
Required
(a) Calculate the cost of equity capital using the Gordon dividend growth model.
(b) Calculate the dividend yield, and explain the difference between this and the cost of capital in (a).
(c) Calculate the cost of Zeta’s irredeemable 8 per cent debenture capital, the market price of which is £110 per £100
nominal (Zeta pays corporation tax at 30 per cent). State any assumptions you make, and justify any choices you make
in doing your calculations.
(d) Explain (without doing any calculations) how you would calculate the cost of redeemable debt capital.