7 The Cost of Capital The cost of capital is the cost of finance raised and used by a company.

It is also the return expected by investors in the company. The companys investments must therefore have returns at least equal to the cost of capital. Thus the discount rate used for NPV calculations equals the companys overall cost of capital. The cost of capital has three components: Risk free rate of return current yield on government securities Business risk premium varies between companies and even between projects within the same company Financial risk premium relating to the danger of high debt levels & consequent risk of financial failure

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Cost of equity Ke Two methods available: Dividend Growth model assumes ordinary shares are valued on basis of the NPV of expected future dividends

MVxd =

d1 Ke g

Ke

d1 + MVxd

MVxd is current (ex-div) market value of share d1 is dividend in one years time Ke is the cost of equity g is the rate of growth

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Example Current ex-div MV is 2, most recent dividend was 10p and the rate of growth in dividends is forecast at 6% Ke = 10 (1.06) + 200 = = 0.053 0.113 + 0.06 0.06

or 11.3%

Alternatively the Capital Asset Pricing Model (CAPM) may be used:

Ke =

Rf + (Rm Rf)

Where Rf is the risk free rate of return, Rm is the market rate of return and is the companys beta factor
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Example Risk free rate is 6%, the market rate is 10% and the is 1.1

Ke = = =

0.06 + 1.1 (0.10 0.06) 0.06 + 0.044 0.104 or 10.4%

Comparison of methods: Dividend growth advantages: Simplicity Recognises importance of dividends & dividend growth prospects Includes unsystematic risk factors Disadvantage: Difficult to predict dividend growth prospects
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CAPM advantages: may be determined fairly accurately based on past performance Independent of share price anomalies (e.g. bid rumours) Disadvantage: Ignores unsystematic risk

Cost of Preference Shares Kp = d0 MVxd Where d0 is the most recent dividend

Cost of Debt Capital

The method of calculation depends upon whether the stock is redeemable or not
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As interest on debt capital is an allowable deduction for corporation tax purposes then the tax saving should be included in the calculation of the cost of debt

Irredeemable loan stock Kd = after tax cost of debt Market value of debt

Example Company has 20m 10% unsecured loan stock, current rate of interest is 8% and corporation tax rate is 31% To find current market value of 100 loan stock: 10 MV
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8% or 0.08

MV

10 0.08

125

The stock must be currently trading at 125 Kd = 10 x (100 31)% 125 = 6.9 125 = 5.52%

Redeemable loan stock

Where loan stock is redeemable (usually at nominal value) the movement in the current market value to the redemption value is part of the cost of the stock in addition to the interest paid consequently it is determined by calculating its IRR
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Refer to the example in the student notes

Weighted Average Cost of Capital (WACC)

This is the average cost of all of the companys long term capital sources, weighted in accordance with their current market values

Source

market value m

cost % 18 16 6.9

weighting calculation m 4.5000 0.0800 0.3312 4.9112

Ordinary 8% Prefs 12% Debt Total

25 0.5 4.8 30.3

WACC =

4.9112 30.3

16.21%

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WACC may be used for investment appraisal provided no major changes to the companys capital structure are envisaged.

However the company must consider that: New projects may be more or less risky than current operations Finance raised for the new investment may affect the capital structure and therefore the financial risk to investors

Ensure you attempt the seminar questions

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