SKILL SET

Calculate the cost of long-term finance

TOPIC
Cost of bond finance

Course learning objective

After completing this course, you should be able to calculate the cost of bond finance.

Introduction
There are two main types of finance — debt and equity — and it is necessary to work out the cost of each type to find out the overall cost of
finance for the company.

Part of understanding the cost of debt is to consider the cost of any bonds that the company has in issue, including irredeemable,
redeemable, and convertible bonds. The cost of debt is the interest rate a company pays on its debt, adjusted for tax to show the true cost of
the bond debt.

The yield to maturity (YTM) of bonds takes the investors’ perspective, calculating the return they will get from bonds, based on the interest
received and the final redemption amount of the bonds (if the bonds aren’t irredeemable). A yield to maturity calculation allows investors to
compare bonds with different maturities and coupon payments.

From the company’s perspective, the yield to maturity is not the same as the cost to the company. The cost to the company is lower than the
investors’ yield to maturity because interest is an allowable expense for tax purposes. Hence the calculation to work out the cost of bond
debt is like the yield to maturity calculation, but it includes an adjustment for tax.

Once the cost of debt is calculated, it can be combined with the cost of equity to calculate the overall cost of capital for a company. The cost
of capital represents a hurdle rate that a company must overcome before it can generate value, and it is used extensively in the capital
budgeting process to determine whether a company should proceed with a project.

Irredeemable bonds

An irredeemable bond is a rare type of bond that has been issued by a company with no redemption date. The bond pays interest at a coupon
rate (for example, 5%) in perpetuity.

Instead of irredeemable bonds, companies normally issue redeemable bonds where the bonds will be redeemed for a fixed amount on a fixed
future date. One reason is that the financing needs of a company change over time. A key problem with irredeemable bonds is that because
the bonds are never going to be redeemed, it is possible that a company will, in the future, have a significant amount of debt finance that it
does not need.

To calculate the cost of the irredeemable bond to the company, tax must be considered. The finance cost is deductible for tax purposes, so
the post-tax interest figure is used. The formula is therefore:
The price of bonds is normally quoted per 100-unit nominal value — for example, per $100. Ex-interest refers to the market price of the bond
excluding any interest payment.

The cost to the company is lower than the yield to investors because of the impact of interest being an allowable tax expense.

Illustration 1

The coupon rate of an irredeemable bond is 5%, the ex-interest market price is $90, and the tax rate is 20%. The cost of the irredeemable
bond is 4.4%, which is calculated as follows:

Redeemable bonds
The cost of redeemable bond debt can be calculated using an internal rate of return (IRR) approach, which is the approximate rate that
discounts the net present value (NPV) of all cash flows relating to the bond to zero. The cost of the bond debt is the IRR of the after-tax cash
flows associated with the redeemable bonds.

The cost of redeemable bonds

The methodology to calculate the cost of redeemable bonds is as follows:

1. Identify the cash flows (typically the bond price at issuance, the interest payments, and the bond redemption amount).
2. Discount the cash flows at two different discount rates (one lower, one higher) so that two NPVs are calculated.

Note: The lower rate should be such that the calculated NPV of the cash flows relating to the bond is positive, meaning a higher rate is
required to achieve an NPV of zero. The higher rate should be such that the calculated NPV of the cash flows relating to the bond is
negative, meaning a lower rate is required to achieve an NPV of zero. The higher and lower discount rates are used to generate an
average (to approximate where NPV is zero). The discount rates that need to be used to generate one positive and one negative NPV
are not always the same. They vary depending on a number of things, including the term of the bond, prevailing rates of bond interest,
and the initial issue and redemption amounts of the bond.
3. Calculate the IRR

The IRR formula is:

The cash flows under consideration to work out the cost of redeemable bonds are:
The bond price at issuance
The interest payments, net of tax in each year
The redemption value of the bond

Bringing this information together allows calculation of the IRR and the cost of the debt.

Illustration 2

To illustrate the application of the formula, consider the following information provided about the required variables:

L is 6% and its NPV is $5

H is 9% and its NPV is −$2.60

Note:
1. The NPV at the higher discount rate (H) is negative, while the NPV at the lower discount rate (L) is positive. This is an indicator that the
cost of the bond debt lies between the two rates, as required for the formula to work properly.
2. The formula only provides an approximation of the internal rate of return. If the NPV had been calculated at rates other than 6% and 9%
— for example, 5% and 10% —and the results inserted into the formula, the IRR would be slightly different.

Illustration 3

Company X issues 10% bonds quoted at $95 ex-interest. The bonds are redeemable at par ($100) in 3 years. The tax rate is 35%.

The cost of this bond debt is calculated as follows:

First calculate the cash flows:

Year 0 (bond price at issuance) $95

Years 1–3 (interest payments) $10 × (1 − 0.35) = $6.50

 Year 3 (bond redemption) $100

Then discount the cash flows and perform the IRR calculation:
For the single cash flows associated with the issue of the debt ($95) and the redemption of the bond ($100), the present value table is used
to identify the appropriate discount rather for the chosen interest rates and the period of time.

For example – The $100 redemption is to be paid in 3 years, so the discount factors for 5% and 10% in three years’ time to be applied are
0.864 and 0.751, respectively.

For the interest payments of $6.50, which are fixed amounts annually for three years, the cumulative present value table for a series of cash
flows can be used for speed and ease.
The cumulative rate is the sum of the present value factors for each of a series of periods at a chosen discount rate. For interest rates of 5%
and 10% in three years’ time, the cumulative discount factors are 2.723 and 2.486, respectively.

The present values of the cash flows, at each rate, are then totalled. Note that although it may be counterintuitive to see a cash inflow as a
negative value (that is, the bond issuance), and a cash outflow as a positive value (that is, the interest payments and the bond redemption),
the presentation in the table that follows supports the underlying nature of the IRR formula.

Year Cash flow Discount factor at 5% Present value Discount factor at 10% Present value

0 (95.00) 1 (95.00) 1 (95.00)

1 6.50 2.723 17.70 2.486 16.16

3 100.00 0.864 86.40 0.751 75.10

Total 9.10 (3.74)

At a discount factor of 5%, the present value of all cash flows relating to the bond are positive. At a discount factor of 10%, the present value
of all cash flows relating to the bond are negative. Therefore, to achieve a net present value of zero for all cash flows relating to the bond, we
know that the discount factor needs to be between 5% and 10%. The IRR formula is used to approximate the true discount factor, which is
the cost of the bond debt.

The total net present value for all cash flows associated with the bond, at each rate, are then taken into the IRR formula as follows:

Therefore, the cost of bond debt is 8.54%.

Knowledge check

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Question
Company Y issues 8% bonds quoted at $94 ex-interest. The bonds are redeemable at par in four years. The tax rate is 32%. Use
discount rates of 5% and 10% to work out your answer.
 Using the specified discount rates, the factors for both a single payment in the future (discount factor) and a series of payments over
time (cumulative discount factor) are as follows:

5% discount rate 10% discount rate

Discount factor Cumulative Discount factor Cumulative

(for year 4) discount factor (for year 4) discount factor
(years 1–4) (years 1–4)

0.823 3.546 0.683 3.169

What is the cost of this bond debt? Give your answer to 2 decimal places. Do not include symbols, commas, or letters in your
response.

Solution

Only numerical input allowed, if decimal number is needed please use '.' to separate numbers (e.g. '3.14', '1000' not '1,000').

SUBMIT

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The cash flows are as follows:

Year 0 (bond price at issuance) $94

Years 1–4 (interest payments) $8 × (1 − 0.32) = $5.44

Year 4 (bond redemption) $100

The discounted cash flows and IRR calculation are as follows:

Year Cash flow Discount factor at 5% Present value Discount factor at 10% Present value

0 (94.00) 1 (94.00) 1 (94.00)

1–4 5.44 3.546 19.29 3.169 17.24

4 100.00 0.823 82.30 0.683 68.30

Total 7.59 (8.46)

The total net present value for all cash flows associated with the bond, at each rate, are then taken into the IRR formula as follows:
Therefore, the cost of bond debt is 7.36%

Convertible bonds

Convertible bonds allow investors the opportunity to convert the bonds into a fixed number of ordinary shares on the redemption date as an
alternative to taking cash. The flexibility of convertible bonds makes them an attractive investment option.

The cost of convertible debt is calculated in a similar way to the cost of redeemable debt, but the value of the highest conversion option is
used as the cash flow at redemption.

To calculate the cost of convertible bonds, it will be assumed that all investors will make the same repayment decision.

Illustration 4

Company A issued a 7% convertible bond at par value ($100) today with a term of 5 years.

The bond gives the holder the right, in 5 years, to convert the bond into 20 ordinary shares or to redeem it for cash at par value.

If the value of the shares exceeds the redemption value of the bonds, then it is financially advantageous for the investor to convert into
ordinary shares, and it is expected that the investor would pursue this option.

Each ordinary share would need to be worth more than $5 in five years’ time for the investor to choose to convert into shares. If the shares
are worth $5 each, then the value of the shares per $100 nominal value is $100 (20 shares × $5), which is the same as the redemption value
of the bond.

At a $5 share value, the amounts that would be received are the same and the investor may therefore prefer the cash, as it is liquid.

Note: It is the investor and not the company that will have the option to convert the bonds into a certain number of ordinary shares. The
number of shares that the bonds can be converted into will be fixed at the time that the bond is issued.

The post-tax cost of convertible bonds

The post-tax cost of convertible bonds is worked out in a similar way to the cost of redeemable bonds, by calculating the internal rate of
return (IRR) of the bonds.

The key difference between calculating the cost of a redeemable bond and calculating the cost of a convertible bond is that it is necessary to
predict the value of the shares on conversion before the internal rate of return can be calculated. Therefore, a two-step process is useful:
1. Find out which option is most likely to be exercised at maturity – cash or shares
2. Calculate the cost of capital

Illustration 5

Company Z issued an 8% bond at par which is redeemable at par ($100) in 4 years’ time. Alternatively, the bond may be converted into 25
ordinary shares at maturity. The current share price is $3.50, and the share price is expected to grow at 6% each year.

The tax rate is 20%.

Step 1 – Cash or shares?

Work out whether shares or cash are likely to be more attractive at redemption.

On a compound basis, the share price in four years’ time (the date of conversion) is expected to be:
Each $100 bond is convertible into 25 ordinary shares. Per $100 nominal value of bonds, the value of the ordinary shares on conversion is
expected to be $110.50 (25 shares × $4.42).

Given that this is higher than the value of the cash on redemption ($100), it is likely that the investor will convert the bonds into ordinary
shares.

Step 2 – Calculate the cost of capital

The cost of the bonds can then be determined by calculating the IRR of the cash flows. In this example, the discount factors of 7% and 14%
have been used to calculate the two NPVs required for the IRR formula.

Interest payments are tax allowable, so the post-tax interest payment is $8 (1 − 0.2) = $6.40.

The market value of the bonds is currently $100.

The bonds are convertible into shares worth $110.50 in four years’ time.

Note that, in the table that follows, it may be counterintuitive to see a cash inflow as a negative value (that is, the bond issuance), and a cash
outflow as a positive value (that is, the interest payments and the bond redemption); the presentation supports the underlying nature of the
IRR formula.

Time Cash flow Discount Net present Discount Net present

(in years) factor at 7% value at 7% factor at 14% value at 14%

T0 (100) 1.000 (100) 1.000 (100)

T1-T4 6.4 3.387 21.68 2.914 18.65

T4 *110.50 0.763 84.31 .592 65.42

Total 5.99 (15.93)

*This is the higher of the conversion value and the value of the cash on redemption.

At a discount factor of 7%, the present value of all cash flows relating to the bond are positive. At a discount factor of 14%, the present value
of all cash flows relating to the bond are negative. Therefore, to achieve a net present value of zero for all cash flows relating to the bond, we
know that the discount factor needs to be between 7% and 14%. The IRR formula is used to approximate the true discount factor, which is
the cost of the bond debt.

The total net present value for all cash flows associated with the bond, at each rate, are then taken into the IRR formula as follows:

Therefore, the cost of the convertible bond is 8.91% — rounded to 9%.

Yield to maturity (YTM)

Thus far, this topic has focused on the cost of debt from the point of view of the issuing entity. The yield to maturity is the term given for the
return that an investor in that debt will require. Irredeemable bonds, like all bonds, can be traded on the bond market. The market price of a
bond will reflect the yield that the investor in the bond requires.

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Yield to maturity

The method used to calculate the yield to maturity depends on whether the bonds are irredeemable or redeemable. However, a consistent
factor for both calculations of yield to maturity is the use of pre-tax values as investors do not benefit from tax relief on the interest they
receive on corporate bonds, unlike the issuer who does qualify for tax relief on the interest paid when the cost of debt is calculated.

The formula used to calculate the yield on an irredeemable bond is i divided by P0, where i is the pre-tax annual interest and P0 is the ex-
interest market price of the bond, which is usually quoted per $100 of nominal value.

This reflects the effective annual percentage return to the investor in relation to the current market value of the bond.

Let’s use an illustration to demonstrate the calculation.

A company has $10m of irredeemable bonds in issue with a coupon rate of 5%.

The ex-interest market price of each bond is $90 per $100 of nominal value.

The annual interest is calculated by multiplying the coupon rate of 5% by the nominal value of $100, which is $5 per year. The ex-interest
market price per $100 nominal value of bond is $90. By dividing $5 by $90, the yield to maturity is 5.5%.

To calculate the yield to maturity of a redeemable bond to an investor, the IRR calculation is used. This involves the same steps as the
calculation of the cost of debt for an issuer, except the cash flows used are pre-tax.

The IRR calculation involves calculating the net present value of the relevant cash flows using both a lower and higher discount rate, the
results of which are entered into the IRR formula which is then used to establish the yield to maturity.

Let’s use an illustration to demonstrate the calculation.

A company invests in 10% bonds at a par value of $100. The bonds are redeemable at par in three years’ time.

To calculate the yield to maturity, the IRR formula is used which means the net present value at two different discount rates is needed. In this
illustration, 5% and 10% are used.

The first step involved in the IRR calculation is to establish the relevant cash flows to be discounted. At year 0, the bond price at issuance of
$100 is a cash outflow. For each of the 3 years the debt is held, the investor receives $10 in interest and at the end of year 3, the investor
redeems the debt and receives $100 both of which are cash inflows.

At a discount rate of 5%, the present value of all cash flows relating to the bond are positive with a total of 13.63. At a discount factor of 10%,
the present value of all cash flows relating to the bond are negative at -0.04. Therefore, to achieve a net present value of zero for all cash
flows relating to the bond, the discount factor needs to be between 5% and 10%, and it is likely to be closer to 10% as the negative amount of
-0.04 is closer to zero than the positive amount of 13.63.

Year Cash flow Discount factor at 5% Present value Discount factor at 10% Present value

0 (100) 1 (100.00) 1 (100.00)

 Year Cash flow Discount factor at 5% Present value Discount factor at 10% Present value

1–3 10 2.723 27.23 2.486 24.86

3 100 0.864 86.40 0.751 75.10

Total 13.63 (0.04)

The total net present value for all cash flows associated with the bond, at each rate, are then taken into the IRR formula.

Firstly, the NPV of the lower rate of 13.63 is divided by the NPV of the lower rate minus the NPV of the higher rate. When a negative value is
subtracted from a positive amount the two values are added together to give the denominator of 13.67. The resulting amount is then
multiplied by the difference between the rates used, which is 5, to give 4.98. Finally, this is added to the lower rate of 5 to give a yield to
maturity of 9.98%.

Knowledge check

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Question
Company B invested in 7% $100 bonds. The bonds are currently quoted at $93. The bonds are redeemable at par in four years. Use
discount rates of 5% and 10% to work out your answer.

Using the specified discount rates, the factors for both a single payment (discount factor) and a series of payments (cumulative
discount factor) are as follows:

5% discount rate 10% discount rate

Discount factor Cumulative discount factor Discount factor Cumulative discount factor
(for year 4) (years 1–4) (for year 4) (years 1–4)

0.823 3.546 0.683 3.169

What is the yield to maturity of these bonds? Give your answer to 2 decimal places. Do not include symbols, commas, or letters in
your response.

Solution

Only numerical input allowed, if decimal number is needed please use '.' to separate numbers (e.g. '3.14', '1000' not '1,000').

SUBMIT
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First identify the cash flows:

Year 0 (bond price at issuance) $93

Years 1–4 (interest payments) $7

Year 4 (bond redemption) $100

Then discount the cash flows and perform the IRR calculation:

Year Cash flow Discount factor at 5% Present value Discount factor at 10% Present value

0 (93.00) 1 (93.00) 1 (93.00)

1–4 7.00 3.546 24.82 3.169 22.18

4 100.00 0.823 82.30 0.683 68.30

Total 14.12 (2.52)

The total net present value for all cash flows associated with the bond, at each rate, are then taken into the IRR formula as follows:

Therefore, the yield to maturity of the bond is 9.24%.

Conclusion
When calculating the overall cost of capital for an organisation, it is necessary to calculate the cost of equity and the cost of debt. The cost of
debt includes the cost of bond finance if a company has issued bonds.

The calculations to work out the cost of bonds differ depending on whether the bonds are irredeemable, redeemable, or convertible.

For irredeemable bonds, there is a straightforward formula, taking the interest paid each year divided by the market price of the debt.
For redeemable bonds, the exact cost is difficult to calculate and therefore an approximation is calculated using the internal rate of
return (IRR) formula.
For convertible bonds, an additional calculation to work out the expected value of the shares on conversion is required.

It is worth noting that the difference between the yield to maturity (YTM) received by the investor and the cost of bond debt incurred by the
company is due to an adjustment for taxation.

Once calculated, the cost of debt is combined with the cost of equity in a weighted average cost of capital (WACC) calculation to work out
the overall cost of capital for a company. WACC is further explained in another topic in this same skillset.
 TOPIC
Cost of equity finance

Course learning objective

After completing this course, you should be able to calculate the cost of equity considering different expectations of dividend growth.

Introduction

One of the major ways that a company is financed is through the issue of equity (that is, share capital). Shareholders obtain voting rights; if
the company performs well and its value increases, shareholders benefit from an increase in the share price. They may also receive
investment income in the form of dividends.

Shareholders of common equity shares are the investors that are most at risk of losing their investment if a company goes into liquidation.
Debt holders are normally ahead of common equity holders with regards to which investors get paid first upon the bankruptcy or liquidation
of a company. Hence there is more risk for shareholders than for debtholders. Shareholders demand a higher return on their investment due
to the extra risk. From the company’s point of view, the shareholders’ required return is a cost to the business, and so called the cost of
equity.

Suppose an investor buys equity shares. The investor may require a return of 20% each year on that investment. This required rate of return
becomes the cost of equity to the company issuing the equity shares. To calculate the cost of equity, the dividend valuation model (DVM)
may be used.

When calculating the cost of equity, it is important to understand the following:

The dividend valuation model
Whether the share price given is ex- or cum-dividend
How to calculate the growth in dividends

Calculating the cost of equity helps organisations properly evaluate investment opportunities. If the cost of equity is less than the expected
return on an investment, an organisation is more likely to make the investment (subject to other financial and nonfinancial considerations
related to the potential investment). Knowing the cost of equity is therefore important when making investment and financing decisions.

Dividend valuation model

The dividend valuation model (DVM) is a quantitative method of valuing a company’s shares that assumes that the value of a share is equal
to the present value of future dividends, discounted at the shareholders’ required rate of return. There are two variations of the model, one
that assumes future dividends are constant, and one that assumes future dividends grow at a constant rate. The methods of calculating the
two models are as follows:
Future constant dividends

A company pays a constant dividend of 9 cents per share starting in one years’ time and continuing for the foreseeable future. The ex-div
share price is currently 80 cents per share. The cost of equity is therefore 0.1125 or 11.25%:

Recall the formula for DVM, assuming a constant dividend:

Applying the formula, the cost of equity is as follows:

Most issuing companies expect earnings and dividends to grow in the future rather than being constant. A variation of the model exists
which assumes that dividends will grow at a constant rate from the payment of the dividend in one year and for the foreseeable future.

Future constant rate dividend growth

A company has just paid a dividend of 10 cents per share. Dividends are expected to grow in the future at 5% each year. The ex-div share
price is currently 105 cents per share. The cost of equity is therefore 0.15 or 15%:

Recall the formula for DVM, assuming future dividends grow at a constant rate:

Applying the formula, the cost of equity is as follows:

Ex-dividend and cum-dividend

Generally, once a company announces a dividend payment, the share price rises by the amount of the dividend declared per share because
investors are entitled to receive the upcoming dividend payment. The share price during this period is referred to as the cum-dividend (“cum-
div”) price. The first day that a share trades without its dividend included in the share price is considered the ex-dividend (“ex-div”) date.
Investors buying the shares on or after the ex-div date are not entitled to the dividend and therefore can purchase shares at the ex-div price,
which is lower than the cum div price because it no longer includes the built-in value of the dividend. The ex div date occurs shortly before the
date of record, which is the date on which a company determines its current roster of shareholders for purposes of identifying those
shareholders eligible to receive the dividend.

The DVM formula previously described uses the ex-dividend (“ex-div”) share price where it is assumed that a dividend has just been paid. To
use the cum-div share price in the DVM formula, the share price first needs to be converted to the equivalent ex-div share price. This is done
by taking away the value of the upcoming dividend from the cum-div share price, as illustrated below.

Ex-div share price = Cum-div share price − upcoming dividend to be paid

For example, a company is about to pay a dividend of 50 cents per share. The cum-div share price is currently $3.50 per share. The equivalent
ex-div share price that could be used in the DVM formula is $3.00 per share, calculated as follows:

(Ex-div share price = Cum-div share price $3.50 − upcoming dividend to be paid 50 cents).

Ex-div share price = $3.50 − $.50

Ex-div share price = $3.00

Scenario

Ingmar Iverson, the CFO of Travel Cruises, is considering expanding his company’s fleet of cruise ships by ordering two new
ships. This will enable Travel Cruises to meet the growing future demand for Asian cruises. The ships will cost a total of $2.5m
and take two years to build. He wishes to finance the purchase by issuing new equity; however, before the final decision is
made, he needs to know the company’s cost of equity. Travel Cruises recently announced a dividend payment, which should be
considered in the calculation.

Knowledge check

Select one choice that best answers the question below.

Question
Travel Cruises plans to pay a dividend of 20 cents per share. The cum-div share price is currently quoted at $2.30 per share. Dividends
are expected to grow at approximately 3% each year.

What is the cost of equity?

Solution
 A. 8.70%.

B. 9.52%.

C. 11.96%.

D. 12.81%.

SUBMIT

Knowledge check feedback

The cum-div share price needs to be adjusted for the future dividend (cum-div share price $2.30 − dividend to be paid 20 cents) = Ex-div
share price (Po) $2.10. This converted share price is then used in the cost of equity formula as follows:

Do = 20 cents
g = 3%
Po = $2.10

The cost of equity for Travel Cruises using the DVM formula is 12.81%.

Estimating growth

There are two useful methods that can be utilised to calculate the dividend growth rate (when required to factor in a dividend growth rate to
calculate DVM):
The averaging method
The profit retention rate method

The averaging method would be appropriate for circumstances in which the dividend growth rate was fairly stable, so that the past growth
rate in dividends is likely to represent how dividends will grow in the future. The profit retention rate method is appropriate when a company
regularly reinvests a set percentage of its profit, and when that reinvestment generates a fairly constant rate of return. Both models are based
on a set of assumptions about the future that may not materialise and hence estimations of future growth rate can be inaccurate from both
approaches. In practice, many companies make adjustments to whichever model is being used to reflect anticipated future events.

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The averaging method

Also known as the past average method, this method assumes that future growth in dividends will be similar to the average growth rate
experienced in the recent past.

The following formula can be used to determine the past average growth:
For this example, a company has just paid a dividend of 15 cents per share. The dividend paid five years ago was 10 cents per share.

The average growth in dividends can be determined by using the formula as follows:

Knowledge check

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Question
At 31 December 20X4, a company has just paid a dividend of 20 cents per share. The following past dividends were also paid:
31 December 20X3 – 19.1 cents per share
31 December 20X2 – 17.7 cents per share
31 December 20X1 – 17.9 cents per share

Using the averaging method, what is the average growth in dividends between 31 December 20X1 and 31 December 20X4?

Enter your response as a percentage, rounded to two decimal places. Do not include symbols, commas, or letters in your response.

Solution

Only numerical input allowed, if decimal number is needed please use '.' to separate numbers (e.g. '3.14', '1000' not '1,000').

SUBMIT

Knowledge check feedback

The correct answer is 3.77%. There are three years of growth between the dividend payable on 31 December 20X1 and the dividend payable
on 31 December 20X4 (20X2, 20X3 & 20X4). Therefore n = 3, do = 20 cents, dn = 17.9 cents. Growth can therefore be determined as follows.
The average growth in dividends over the three-year period is 3.77%.

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The profit retention rate method

This profit or earnings retention rate method assumes that growth in future dividends arises when profits (or earnings) are retained within the
company and reinvested, resulting in a constant rate of return. This method further assumes that the company has only equity finance, that
retained profits are the only source of additional investment available, that a constant amount of retained profits are reinvested, and projects
financed from retained profits earn a constant rate of return.

The greater the proportion of profits that are retained within the company rather than paid out as a dividend to shareholders, the greater the
future growth in dividends.

Future growth can be estimated by using the following formula:

Knowledge check

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Question
Company “A” has just paid a dividend of 20 cents per share. The dividend paid is consistently 30% of profits after tax. The share price
of the company is $2.10 per share. When profits are reinvested, it is expected that they will generate a return of 8% each year.

Using the profit retention rate method, what is the estimated future dividend growth of the company?

Enter your response as a percentage, rounded to one decimal place. Do not include symbols, commas, or letters in your response.

Solution

Only numerical input allowed, if decimal number is needed please use '.' to separate numbers (e.g. '3.14', '1000' not '1,000').
 SUBMIT

Knowledge check feedback

If the dividend paid is consistently 30% of profit after tax, then the proportion of profits that are retained must be 70% (100% − 30%).

b = 70%, or 0.70
r = 8%, or 0.08
g = r × b = 0.08 × 0.70 = 0.056, or 5.6%

The dividend growth rate is 5.6% using the profit retention rate method.

Conclusion
It is important for a company to know the return that the shareholders require to determine whether its potential investments are likely to
generate enough return to satisfy shareholders. The return that shareholders require is also called the cost of equity.

The dividend valuation model (DVM) is one way to calculate the cost of equity. When calculating the cost of equity, two aspects should be
considered:
Whether the share price given is ex- or cum-dividend – (that is, does it include an upcoming dividend to be paid (cum-dividend) or has
the dividend been paid (ex-dividend)
How to calculate the growth in dividends – whether more appropriate to use the past average method or the profit retention rate
method

When calculating dividend growth, another consideration is how much the past performance of a company is likely to reflect the future
performance. Using historic figures to estimate future performance can work, though if there is something new or different likely to happen in
the future (for example, an expected rise or decline in company growth), then the growth rate may need to be adjusted to reflect this change.

The cost of equity is an important part of the overall cost of capital for a company. When a company is also financed by debt, the cost of
debt is factored in to calculate the overall cost of capital.

TOPIC
Cost of bank finance

Course learning objective

After completing this course, you should be able to calculate the cost of bank finance.

Introduction

Organisations are often financed by a mixture of equity and debt. So, to calculate the overall cost of capital, both the cost of equity and the
cost of debt must be considered. Bank finance is often a key part of an organisation’s debt finance structure and, therefore, is a key
component when working out the cost of debt.

The cost of debt to the debtor organisation is usually lower than the cost of equity to the organisation seeking equity investors. The lower
cost associated with debt finance is due to the fact that lenders (such as banks or bondholders) assume less risk, generally speaking, than
equity investors. Therefore, the required rate of return by lenders is normally lower than the required rate of return by equity investors.

For example, debt interest must be paid each year regardless of the profits the company is making, whereas dividends are discretionary and
may not be paid if profits are low or the directors wish to invest the money elsewhere. The interest charged on bank finance may be fixed or
variable.

Additionally, interest on debt is a tax-deductible expense that lowers the net cost of borrowing. It is useful, as a management accountant, to
be able to work out the post-tax cost of debt.
Assessing the cost of debt is important when making decisions about whether to borrow or not. It is also a key part of the assessment of
investment decisions, the aim of which is to produce a larger return than the company’s overall cost of capital.

The cost of debt

The cost of debt is the effective interest rate levied by lenders on company debt, and includes the finance cost of bank borrowings, bonds,
and other lending taken out by an organisation.

The cost of debt for bank borrowings is:

Tax effect of borrowing

Interest incurred on bank borrowings is normally tax deductible. This tax savings means that the post-tax cost of bank borrowings is lower
than the pre-tax cost.

For example, if a business pays $15,000 in interest annually on a bank loan of $200,000, and its income tax rate is 20%, the reduction in tax
resulting from the deductibility of interest is $3,000 ($15,000 × 20%). Therefore, when considering the tax benefits of paying interest, the
interest cost is effectively $12,000 ($15,000 − $3,000) rather than $15,000. Paying $15,000 in interest saved the business $3,000 in taxes. The
$3,000 savings is the tax benefit realised from the tax deductibility of the interest paid. This tax benefit has the effect of lowering the net cost
of the interest paid on the bank loan.

So, in the preceding example, the pre-tax cost of the bank loan in terms of the interest rate paid is 7.5% ($15,000 / $200,000). The post-tax
cost of the loan in terms of the interest paid is 6% ([$15,000 − $3,000] / $200,000). When evaluating the cost of bank finance, the tax benefit
from bank borrowings must be considered.

Scenario

You are a trainee accountant at DG Fireworks. The company manufactures fireworks that are sold to retail outlets throughout the country. DG
Fireworks also sells directly to event organisers. You report to Emma Gabbadini, who is the CFO.

You have just received a message from Emma indicating that the board of directors has decided to proceed with a proposal to raise $10m of
new bank finance to invest in automated manufacturing machinery and to develop a new range of fireworks. The bank is willing to loan the
$10m at an annual interest rate of 5.2% for a term of 10 years. DG Fireworks’ corporate tax rate is 20%.

Emma has asked you to calculate DG Fireworks’ post-tax cost of borrowing the $10m at an annual interest rate of 5.2% for a period of 10
years.

Your first step is to review the difference between the pre-tax and post-tax cost of borrowing and the terms of the proposed bank borrowing.
Pre-tax versus post-tax cost of borrowing

The bank charges an annual interest rate of 5.2% for providing the finance. You calculate DG’s annual pre-tax cost of a bank loan for $10m of
new bank finance, which you determine to be $520,000 ($10m × 5.2%).

The $520,000 interest incurred is, however, an allowable tax deduction. So, next you calculate the tax benefit of this deduction, which you
determine to be $104,000 ($520,000 × 20%). This tax benefit is the actual reduction in tax compared to what would have been paid in tax if
the interest weren’t tax deductible.

Next, you determine the post-tax interest cost by taking the pre-tax interest cost of $520,000 and subtracting the tax benefit of $104,000,
resulting in a post-tax interest cost of $416,000.

Knowledge check

Select one choice that best answers the question below.

Question
Using the scenario information for DG Fireworks, calculate DG’s post-tax cost of borrowing. The post-tax cost of bank borrowing is
represented by the following formula:

Solution

A. 4.16%

B. 1.04%

C. 6.50%

D. 5.20%

SUBMIT

Feedback
A. Correct.

B. Incorrect. This answer is the tax savings and not the post-tax cost.

C. Incorrect. This answer is a gross-up of the 5.20% and would represent the annual interest rate if the 5.20% were the post-tax cost.

D. Incorrect. This answer is the stated annual interest rate before allowing for the tax deduction and not the post-tax cost.

Knowledge check feedback

The post-tax cost of bank borrowings is determined as follows:

Knowledge check

Group items by dragging them into their corresponding boxes.

Question
Categorise the following statements as either true or false in relation to post-tax bank borrowings.

Sort each statement to the appropriate category.

Solution

The annual interest payable to the bank is the pre-tax cost of bank borrowings.

If a company pays corporate tax, the post-tax cost of bank borrowings is lower than the pre-tax cost of bank borrowings.

If the corporate tax rate increases, then the pre-tax cost of bank borrowings will decrease.

The post-tax cost of bank borrowings reflects the annual interest payment and the corporate tax rate.

If the corporate tax rate decreases, then the post-tax cost of bank borrowings will decrease.

True False

SUBMIT

Knowledge check feedback

The actual interest paid to the bank is not affected by the borrower’s tax rate. The borrower pays the interest on the outstanding borrowings
at the stated rate of interest. However, if the borrower is subject to income tax and interest expense is deductible according to the tax regime
applicable to the borrower, the post-tax cost of bank borrowings is lower than the pre-tax cost of bank borrowings. The post-tax cost of bank
borrowings is calculated as the interest rate on the outstanding borrowings multiplied by one minus the tax rate.

If the corporate tax rate increases, the tax benefit realized from the interest deduction increases, and therefore the post-tax cost of borrowing
decreases. If the corporate tax rate decreases, the tax benefit from the interest deduction decreases, and therefore the post-tax cost of
borrowing increases.

The relative cost of different types of bank finance

Banks offer several different types of finance product, including term loans, overdrafts, revolving credit facilities, and asset finance.

The cost of each different type of finance varies according to the risk of the product to the bank. Hence, a bank normally charges a lower rate
of interest, for example, for a loan secured on the assets of the business than for an unsecured loan, all else being equal. The more
reassurance a bank can obtain that the borrower can pay back the loan and interest, the lower the rate of interest on the borrowing and
therefore a lower cost of borrowing to the borrower.

In addition to the type of product being offered, the circumstances of the borrowing company are also relevant to the bank. A well-established
company with a long trading history wishing to invest in a reliably high return project is likely to obtain a better offer from the bank in terms of
interest rate than a start-up company wanting to invest in something that has uncertain returns – for example, development of a new hi-tech
product.

Conclusion

Bank borrowings are a readily available way of obtaining finance for most companies. Bank borrowings are subject to interest cost based on
the interest rate required by the bank.

The pre-tax cost of bank borrowings is the annual interest payable on the bank loan. This amount of interest can be based on a fixed or
variable interest rate.

The post-tax cost of borrowings is the cost of the borrowings after taking into consideration the amount of interest payable that is tax
deductible.

This means that the post-tax cost of borrowings is lower than the pre-tax cost of borrowings. Companies should use the post-tax cost of
borrowings to determine how the debt will affect the overall budget.

The cost of this debt is considered along with the cost of equity when calculating the overall return required on new projects. This overall
return is a benchmark when projects are being appraised to decide whether to undertake them or not.

TOPIC
Weighted average cost of capital (WACC)

Course learning objective

After completing this course, you should be able to calculate the weighted average cost of capital (WACC).

Introduction

Companies are usually financed by a mixture of debt and equity. These forms of finance have differing costs, based upon the risks the
investors take and the circumstances of the company and investors when the finance is taken out.

The WACC is the average cost of a company’s finance, taking the cost of each type of finance (ordinary shares, bank borrowing, preference
shares, bonds) and weighing them according to the proportion of the overall finance pool they represent. Hence, the company can see the
overall cost of the finance it uses.

One advantage of doing this is that the WACC can be used to evaluate investment opportunities, such as a new project to expand the
business. The company uses the WACC to calculate the net present value (NPV) of the cash flows relevant to the investment. Hence, the
company can decide if the investment opportunity is worthwhile, if the NPV is positive.

The WACC can also be used when new sources of finance are considered, to help decide whether the cost of the new sources of finance are
in line with the existing cost of finance.

When using the WACC for project and investment appraisal, it is necessary to also understand the assumptions made and the limitations of
the technique.
Understanding WACC

The WACC is the overall cost of a company’s finance. When a company is financed in several different ways (for example, with a mixture of
equity, bank borrowings, and bonds), each source of finance has a different cost. The weighted average cost is determined by weighting the
costs of the individual types of finance according to the proportion of each type of finance.

The proportions are based on the market values of the different types of finance rather than the book values. Market values better reflect the
current amount invested by each of the providers of finance. If the shares or debt are unquoted, an estimate of market value or the carrying
amounts may be used, but this would reduce the reliability of the WACC figure.

WACC is important to a business because it can be used by the directors of a business in several different ways. These include the following:

● Making decisions about new investments — If the return expected from a new investment exceeds the WACC, then the new
investment would appear to be worthwhile. In this context, the WACC is the hurdle rate (that is, the minimum required rate of
return or target rate against which the expected return on an investment is measured against).
● Making decisions about financing the business — It may be possible for the directors of a business to reduce the WACC by
changing the proportions of equity and debt capital. A reduction in the WACC would be beneficial to the business because it
lowers the overall cost of an entity’s finance.

The following steps can be followed to calculate the WACC:

1. Estimate the cost of each type of finance.

2. Calculate the total market value of each type of finance.
3. Calculate what proportion of total finance each different finance type represents.
4. Multiply the proportion of total finance (step 3) by the cost of each finance type (step 1).
5. Sum the individual weightings (step 4) to give the WACC.

The formula can be expressed as follows:

Click the video to begin viewing or click Transcript below.

A WACC illustration
The data that follows demonstrates the type of data needed to calculate the WACC. It indicates the costs of the different types of finance
for Company X.

Cost of equity 20%

Cost of preference share capital 14%

Post-tax cost of bank borrowings1 6%

Post-tax cost of redeemable bonds1 8%

 1Note that, because interest payments on

debt instruments are generally tax

deductible, the financing cost is
determined on a post-tax basis.

Company X has 20 million ordinary shares in issue. Each ordinary share is currently trading at $8.50. The company also has 5 million
preference shares in issue. Each preference share is trading at $2.40.

The total nominal value of the bank borrowings is $30m, and the total nominal value of the redeemable bonds is $50m. The redeemable
bonds are trading at $95 per $100 nominal (or ‘face’) value.

STEP 1:
The cost of each type of finance has been provided in the table.

STEP 2:
The market value of each type of finance can be calculated as follows:

Equity
20 million shares × $8.50 = $170m

Preference shares
5 million shares × $2.40 = $12m

Bank borrowings
The market value is always the same as the book value, therefore $30m.

Redeemable bonds
The bonds are trading at $95 per $100 nominal value. Therefore, the total market value of all the bonds is $50m × $95 ÷ $100 = $47.5m

STEP 3:
Calculate what proportion of total finance each different type of finance represents.

Type of finance Market value Proportion of total finance

Equity $170m 170/259.5 = 65%

Preference shares $12m 12/259.5 = 5%

Bank borrowings $30m 30/259.5 = 12%

Redeemable bonds $47.5m 47.5/259.5 = 18%

Total $259.5m 100%

STEP 4 and 5:
Multiply the proportion of total finance calculated in step 3 by the cost of capital calculated in step 1(in this case given in the information).
The individual weighted costs are then summed to give the overall WACC of the total finance:

Type of finance Market value Proportion of total finance Cost of capital Weighted cost

Equity $170m 65% × 20% 13.0%

Preference shares $12m 5% × 14% 0.7%

Bank borrowings $30m 12% × 6% 0.7%

Redeemable bonds $47.5m 18% × 8% 1.4%

Total $259.5m 15.8%

 WACC = 15.8%

This means that, on average, the cost to the company is $0.158 for every $1 of capital that is invested by investors.

The same figure could be calculated by putting the figures into the WACC formula:

Note that the preceding WACC formula is the traditional version that uses just one type of debt capital and one type of equity capital.

However, Company X has two types of debt capital - redeemable bonds and bank borrowings, and two types of equity capital - ordinary
shares and preference shares. Therefore, the formula has to be expanded into a 4-part formula as shown in the calculation that follows.

There may be slight differences in the final figure from both versions due to rounding.

Scenario

You are a finance manager at RTS Airlines. The company is a large international airline. Its shares are listed on the stock market. It is
financed by a mixture of equity, bank borrowings, redeemable bonds, and preference share capital. Note that preference share capital means
preferred stock for the benefit of anyone more familiar with U.S. accounting standards than international accounting standards.

The CFO of RTS Airlines is Doug Pearson. He has advised you that the board of directors is interested in knowing the WACC for RTS Airlines.
They anticipate several investment opportunities will become available in the near term, so they want to be positioned to evaluate them
appropriately.

RTS Airlines has 10 million ordinary shares in issue. The market value of each ordinary share is $2.50. The cost of equity is estimated to be
18%.

The company has $6m of bank borrowings. The post-tax cost of bank borrowings is estimated to be 5%.

The company also has $10m nominal value of redeemable bonds in issue. The market value of the bonds is $110 per $100 nominal value.
The post-tax cost of the redeemable bonds is estimated to be 8%.
RTS Airlines is growing and, to meet future demand, the board wishes to invest in 10 new aircrafts. The new investment will be financed by
either raising new equity or, alternatively, raising new debt finance. To decide about how to raise the new finance, Doug would like to know the
current WACC. He will then be able to estimate how the WACC will change if new equity or, alternatively, new debt finance is raised.

Knowledge check

Enter a number in the field below.

Question
What is the current WACC of RTS Airlines?

Round your answer to the nearest whole percent. Do not include symbols, commas, or letters in your response.

Solution

Only numerical input allowed, if decimal number is needed please use '.' to separate numbers (e.g. '3.14', '1000' not '1,000').

SUBMIT

Knowledge check feedback

The cost of capital of each source of finance has been provided, but the total market values can be determined as follows:

Equity
10 millions shares x $2.50 = $25m

Bank borrowings
The market value is always the same as the book value. It is $6m.

Redeemable bonds
The bonds are trading at $110 per $100 nominal value. Therefore, the total market value of all the bonds is $10m × $110 ÷ $100 = $11m

The costs can then be weighted according to proportions as follows:

Type of finance Market value Proportion of total finance Cost of capital Weighted cost

Equity $25m 25/42 = 60% × 18% 10.8%

Bank borrowings $6m 6/42 = 14% × 5% 0.7%

Redeemable bonds $11m 11/42 = 26% × 8% 2.1%

Total $42m 100% 13.6%

The WACC for RTS Airlines can be determined to be 14% (to the nearest whole cent).
Limitations of using the WACC
There are some limitations and drawbacks associated with WACC calculations, including the following:

● The assumptions underlying the calculation of the costs of the individual forms of finance may not be correct. The cost of
equity, for example, is calculated by using either the dividend valuation model or the capital asset pricing model. Both models
are based on assumptions that may not be realistic. To calculate the cost of equity using the dividend valuation model, for
example, it is often assumed that dividends will grow at a constant rate to infinity. This is unlikely to be the case in a real-life
situation.
● Calculating the cost of capital for an unquoted company can be more difficult. To calculate the cost of capital accurately,
market data such as share prices may be required. This data is not available for unquoted companies.
● Decide which sources of finance to use. The WACC is normally calculated using long-term finance. If a company uses short-
term finance for long-term purposes (for example, a rolling bank overdraft or trade credit), then perhaps the WACC calculation
should also include the costs of these types of finance.

There are also limitations arising from the assumptions used when using the WACC as the discount rate for determining the NPV or the
internal rate of return of potential investments or projects. Note that the WACC represents the minimum return that is required from the new
investment or project to make it worthwhile.

These assumptions, which may not be realistic, include:

● The long-term capital structure of the company will not change; there is no change to financial risk. The calculation of the
WACC is based on the proportions of debt and equity in the company. If these proportions change, then the WACC will also
change.
● There is no change to business risk. The potential investment under consideration has the same business risk as the existing
investments of the company.
● The new potential investment is marginal and relatively small compared to the whole of the business and hence will not
significantly change Ke, Kd, or WACC.

Conclusion
The WACC combines the costs of capital of a company’s debt and equity in proportion to the market value of each type of finance. The
resulting figure calculated is useful for the following:

● Project appraisal to discount the cash flows of a project at the WACC for the company to decide if the project is worthwhile.
● Assessing new financing for the company to give a comparison to the existing overall cost of capital.

The types of finance used in calculating the WACC are usually the long-term debt and equity finance of the company, though it is worth
considering whether there are any significant shorter-term forms of finance that should be included.

There are issues that should be considered to decide if the WACC is appropriate:

● The assumptions made behind the calculations for each cost of capital
● Whether the long-term capital structure of the company is going to change
● For unquoted companies, how to estimate ‘market values’ for inclusion in the calculation of the WACC
● For a project appraisal, whether the risks of a new project are different and whether a higher or lower discount rate should be
used to reflect this

The WACC is a valuable figure to use to help appraise projects and decide on new sources of finance, but must be assessed to make sure it
is the right figure to use.