Financial Management I BBPW3103

Chapter 8 Cost of Capital

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Definition For Cost of Capital

Is the minimum rate of return that must be obtained by the company from its investment Cost of capital holds the role as the main liaison between the decision of long-term investment with maximizing shareholders wealth There are 2 factors that differentiate between the rate of return and cost of capital that is

Taxation

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Financing Policy and Cost of Capital

Refer to the policy that has been specified by the management in financing of investment either via debt or equity The cost of capital, generally provides effect on the combination cost all the companys financing resources (debt and equity) that is known as the weighted average cost of capital (WACC) Weighted refer to the percentage of usage for each resources from the total overall financing mardi_umar83@yahoo.com 3

Determining The Cost of Capital For Each Component of Capital Resources

To determine the total cost of capital, a company must determine the 3 capital resources which is debts, preference shares and ordinary share The cost of capital for each financing resources is obtained by getting the required rate of return by taking into account the floating cost and taxation impact
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Cost of Debt

Obtained by getting rate of return for debt There are 3 important step to calculate the cost of debt that is

Calculate the net value of debt (NPb) that shown bellow NPb = Market Value (P0) Floating Cost Calculate the rate of return for debt that is required by investor using YTM formula or using trial and error mardi_umar83@yahoo.com 5 Calculate the cost of capital by taking into

Cost of Debt (Cont.)

Example 8.1 : Indah Company has sold bond that have a maturity period of 20 years with a coupon rate of 9%. The par value is RM1,000. The bond is sold at the price of RM980 and there exist a floating cost of 2% from the par value (2% x RM1,000). What is the cost of debt for Indah Company?
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Cost of Debt (Cont.)

Step 1 : Calculate the Net Value of Bond

NPb = Market Value (P0) Floating Cost = RM980 (2% x RM1,000) = RM980 RM20 = RM960

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Cost of Debt (Cont.)

Step 2 : Calculate the Rate of Return for the Bond Using Trial and Error The selling price lower than the par value (RM980<RM1,000). So, the required rate of return higher than the coupon rate (k > I). Use the rate of 10% to begin the calculation NPb = I(PVIFAk,n) + M(PVIFk,n) = 90(PVIFA10%,20) + 1,000(PVIF10%,20) = 90(8.514) + 1,000(0.149) = RM915.26 If the rate of return 10%, the value is RM915.26. So, the cost of capital for RM960 is between 9% and 10% as shown below.
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Cost of Debt (Cont.)

Rate (%) 9 NPb 10 Difference Value (RM) 1,000 960 RM40 Value (RM) 1,000 915.26 RM84.74

So, the cost of capital is kb= 9% + (RM40 RM84.74) x (10% - 9%) = 9.47%
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Cost of Debt (Cont.)

Step 2 : Calculate the Rate of Return for the Bond (Cont.)

Using YTM formula

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Cost of Debt (Cont.)

Step 3 : Calculate the cost of debt (assume the corporate tax is 34% per year)
Trial and Error method Cost of debt = 9.47% (1 0.34%) = 6.25% YTM method Cost of debt = 9.4% (1 0.34) = 6.2%

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Cost of Preference Share

The preference shareholders have the rights to receive fixed dividends before earnings are distributed to the ordinary shareholders The cost of preference share (kps) is the rate of return for preference share, which is the ratio of dividends (Dps) with the net earning from sales of preference share (Nps) The formula is mardi_umar83@yahoo.com 12 kps = Dps Nps

Cost of Preference Share (Cont.)

Example 8.2 : Calculate the cost of preference share for Indah Company based on the information below: Selling Price : RM8.70 value per share Cost of issuance and sale of share : RM0.50 per share Annual dividend : RM0.87 So, the cost of capital is Net Price (NPps) = Selling Price Cost = RM8.70 RM0.50 = RM8.20 kps = Dividend NPps = RM0.87 RM8.20 mardi_umar83@yahoo.com 13

Cost of Ordinary Share

Is the rate of return that is required by investor for ordinary share Characteristics for determination of Cost of Ordinary Share that is
Difficult to estimate as the returns to ordinary shareholders are a surplus after the payment of interest for bond and dividend for preference share There are 2 resources of financing for ordinary share, which are the retained earning and the issuance of new mardi_umar83@yahoo.com 14 ordinary share

Cost of Ordinary Share (Cont.)

There are 2 methods that can be use to determine the cost of retained earnings or the rate of return which are:

Constant Growth Valuation Model @ Gordom Model The cost of ordinary share is the return required by the existing share investors on their investment. the formula is P0= D1 (Kcs g) Kcs = (D1 P0) + g
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Cost of Ordinary Share (Cont.)

Constant Growth Valuation Model @ Gordom Model Example 8.3 : The following is the financial information on Tuah Company Price of ordinary share (P0) : RM5.00 Expected dividend (D1) : RM0.40 Rate of growth (g) : 5% So, the cost of capital is Kcs = (D1 P0) + g = (RM0.40 RM5.00) + 5% = 8% + 5% = 13%
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Cost of Ordinary Share (Cont.)

Usage of Capital Asset Pricing Model (CAPM) Show the relationship between the return required or cost of ordinary share (Kcs) and the systematic risk that is measured by beta () The CAPM formula is Kcs = krf + (km krf) Example 8.4 : Assume that the risk free rate of Indah Company is 7%, the required rate of return by investor is 11% and the ordinary share for the company have a beta 1.5. What is the cost of retained earning? Kcs = krf + (km krf) = 7% + (11% - 7%)(1.5) = 7%mardi_umar83@yahoo.com + 6% 17

Cost of Ordinary Share (Cont.)

Cost of Issuing New Ordinary Shares (Kcs) Is obtained by taking into account the effect of floating cost or sales cost. Normally, new ordinary share are sold at a price that is lower than the current market price. The formula is kcs = (Dividend NPcs) + g Example 8.5 : Based on the financial information of Indah Company below, calculate the cost of issuing new ordinary share Cost of ordinary share (kcs) : 13% Expected dividend (D1) : RM0.40 Current market price (P0) : RM5.00 Floating cost : RM0.25 per share Rate of dividend growth : 5% Sale of new ordinary share : RM4.70 So, the cost of capital is kcs = (Dividend NPcs) + g = [RM0.40 (RM4.70 RM0.25)] + 5% = 14% mardi_umar83@yahoo.com 18

Weighted Average Cost of Capital

Refer to the overall cost of capital takes into account all individual costs of financing resources used There are 3 main step in determining WACC

Calculate the cost for each capital resources that is cost of debt, cost of preference share and cost of ordinary share Calculate the combined financing or capital structure that is the weight of each resources Calculate the WACC

The formula of WACC is = (wb x kb)mardi_umar83@yahoo.com + (wps x kps) + (wcs x19 kcs)

Weighted Average Cost of Capital (Cont.)

Example 8.6 : Based on the financial information of Indah Company, calculate the WACC Cost of debt (kb) : 6.25% Cost of preference share (kps) : 10.6% Cost of retained earning (kcs) : 13% Cost of ordinary share (kcs) : 14% Capital Resources Long term loans Preference share Ordinary share Ratio 40% 10% 50%
20

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Weighted Average Cost of Capital (Cont.)

The WACC is

If the company use retained earning WACC = (wb x kb) + (wps x kps) + (wcs x kcs) = (0.4 x 6.25%) + (0.1 x 10.6%) + (0.5 x 13%) = 2.5% + 1.06% + 6.5% = 10.6% If the company issuing new ordinary share WACC = (wb x kb) + (wps x kps) + (wcs x kcs) = (0.4 x 6.25%) + (0.1 x 10.6%) + (0.5 x 14%) = 2.5% + 1.06% + 7% mardi_umar83@yahoo.com 21 = 10.56%