Chapter‐5: Cost of Capital

Aspects of the cost of capital

There are two aspects:

 The Cost of Funds that a company raises and uses and the return that investors expect to be
paid for putting funds into the company.
 It is therefore the minimum return that a company should make on its own investments, to earn
the cash flows out of which investors can be paid their return.

Cost of Capital as an Opportunity cost of finance

The cost of capital is an opportunity cost of finance because it is the minimum return that investors
require. If they do not get it, they will transfer all or some of investment in somewhere else.
Examples:
 Bank gives loan at higher rate of interest.
 Shareholders invest money only from where they get higher return.

The cost of Ordinary share capital

New funds from equity shareholders are obtained either from new issues of shares or from retained
earnings. But both of these sources of funds have cost.
a. Shareholders will not be prepared to provide funds for a new issue of shares unless the return
on their investment is sufficiently attractive.
b. Retained Earnings also have a cost. This is an opportunity cost, the dividend forgone by
shareholders.

The Dividend Valuation Model:

If we ignore issue costs, cost of equity for both new issues and retained earnings could be estimated by
dividend valuation model on the assumption that market value of shares directly related to expect future
dividend on the shares.
If Dividend remain constant then Ke =D0/P0
If dividend grow at a constant rate, P0 = {D0(1+g)}/(Ke‐g) Or, Ke= {D0 (1+g)/p0} +g

There are two methods of estimating growth rate.

a) Historical Pattern: 1 X (1 + g)n = last year dividend
b) Gordon Growth model: g = r X b
g = growth in future dividends
r = the current account rate of return
b = the proportion of profits retains

Weaknesses of the dividend growth model:

 The model does not explicitly incorporate risk

 Dividends do not grow smoothly in reality so g is only an approximation.
 It fails to take capital gain in account
 Taxation is not considered.
 It assumes there is no issue costs for new shares.

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Cost of Retained Earnings (or part of equity):

The Capital Asset pricing model:

 It can be used to calculate a cost of equity and incorporates risk.
 It is based on a comparison of the systematic risk of individual investments with the risks of all
shares in the market.

Ke = Rf + β (Rm—Rf)
Where Ke is the rate of return on share,
Rf is the risk free rate of return,
β is the beta of security,
Rm is return on market portfolio.

Example:
What is the rate of return for a company if its β is 1.5, risk free rate of return is 8% and the market rate
or return is 20%.

Systematic and Unsystematic Risk:

 Risk occur due to variations in market activity called systematic risk where specific risk to the
company called unsystematic risk.
 Unsystematic risk can be diversified away, while another one can’t.

Earnings Price Ratio Approach

According to this approach, the cost of equity can be calculated as:
Ke = E1/P,
Where E1 is expected EPS one year hence and P is the current market price per share.
E1 is calculated by multiplying the present EPS with (1 + Growth rate).

Cost of Retained Earnings and Cost of External Equity

As we have just learnt that if retained earnings are reinvested in business for growth activities the
shareholders expect the same amount of returns and therefore Ke=Kr. But it should be borne in mind by
the policy makers that floating a new issue and people subscribing to it will involve huge amounts of
money towards floatation costs which need not be incurred if retained earnings are utilized towards
funding activities. Using the dividend capitalization model, the following model can be used for calculating
cost of external equity.

Ke = {D1/P0(1—f)} + g

Where Ke is the cost of external equity,

D1 is the dividend expected at the end of year 1,
P0 is the current market price per share,
g is the constant growth rate of dividends,
f is the floatation costs as a % of current market price.

The below formula can be used as an approximately

K’e = ke/(1—f)
Where, K’e is the cost of external equity,
ke is the rate of return required by equity holders,
f is the floatation cost.

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Example:
Alpha Ltd. requires Tk. 400 Cr to expand its activities. The company’s CFO is planning to get Tk. 250 Cr
through a fresh issue of equity shares to the general public and for the balance amount he proposes to
use ½ of the reserves which are currently to the tune of Tk. 300 Cr. The equity investors’ expectations of
returns are 16%. The cost of procuring external equity is 4%. What is the cost of external equity?

Solution:
We know that Ke=Kr, that is Kr is 16%
Cost of external equity is K’e=ke/(1—f)
0.16/ (1—0.04) = 0.1667 or 16.67%

Cost of Debt
The cost of debenture is the discount rate which equates the net proceeds from issue of debentures
to the expected cash outflows—interest and principal repayments.

The two computational problems

Solely from a computational point of view, there are two different aspects to the problem:
• Fixed charge finance Irredeemable (or redeemable at current market price)
• Redeemable at other than current market price

Irredeemable securities
If securities are irredeemable, the company does not intend to repay the principal but to pay interest for
ever. In this case the present value of a perpetuity equation may be used as introduced above:
P0 = Interest/ kd
Where, P0 = Present value
Interest = Annual interest (starting in one year's time)
kd = Cost of debt (with no tax)
Example
Irredeemable debt is quoted at CU40% and the coupon (nominal) interest rate is 5%. What is the return
on the security?

Redeemable

I (1—T) + {(F—P)/n}
Kd =
(F+P)/2

Where Kd = is post tax cost of debenture capital,

I = is the annual interest payment per unit of debenture,
T = is the corporate tax rate,
F = is the redemption price per debenture,
P = is the net amount realized per debenture,
n =is maturity period.

Example:
James Ltd. wants to have an issue of non‐convertible debentures for Tk. 10 Cr. Each debenture is of a par
value of Tk. 100 having an interest rate of 15%. Interest is payable annually and they are redeemable after
8 years at a premium of 5%. The company is planning to issue the NCD at a discount of 3% to help in quick
subscription. If the corporate tax rate is 35%, what is the cost of debenture to the company?

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 Cost of Preference Capital

The cost of preference share Kp is the discount rate which equates the proceeds from preference capital
issue to the dividend and principal repayments which is expressed as:

Kp = D + {(F—P)/n}/(F+P)/2

Where Kp is the cost of preference capital,

D is the preference dividend per share payable,
F is the redemption price,
P is the net proceeds per share,
n is the maturity period.
Example:

C2C Ltd. has recently come out with a preference share issue to the tune of Tk. 100 lakhs. Each preference
share has a face value 100 and a dividend of 12% payable. The share is redeemable after 10 years at a
premium of Tk. 4 per share. The company hopes to realize Tk. 98 per share now. Calculate the cost of
preference capital.

Weighted Average Cost of Capital

In the previous section we have calculated the cost of each component in the overall capital of the
company. The term cost of capital refers to the overall composite cost of capital or the weighted average
cost of each specific type of fund. The purpose of using weighted average is to consider each component
in proportion of their contribution to the total fund available. Use of weighted average is preferable to
simple average method for the reason that firms do not procure funds equally from various sources and
therefore simple average method is not used. The following steps are involved to calculate the WACC:

Step I: Calculate the cost of each specific source of fund, that of debt, equity, preference capital and term
loans.
Step II: Determine the weights associated with each source.
Step III Multiply the cost of each source by the appropriate weights.
Step IV: WACC = WeKe + WrKr + WpKp + WdKd

Practice Math:

1. The shares of CT plc have a current market price of 74 pence each, ex‐div. it is expected that the
dividend in one year's time will be 8 pence per share. The required rate of return from net dividend
on these shares is 16% per annum.
If the expected dividend growth in future dividends is a constant annual percentage, what is the
expected annual dividend growth?
2. A firm has a divided cover of 2, a P/E ratio of 9.3 (both based on its ex‐dividend price). the most recent
financial statements indicated a growth in shareholder's fund of 10%, resulting from retained
earnings. Which of the following is the best estimate of the firm's cost of equity?
3. An all equity financed company distributes 30% of its earnings each year and reinvests the balance.
The return on its projects is a constant 15% pa. Assume that the company's current market
capitalization is Tk. 1.5 m and its earnings are Tk. 125,000. What is the required rate of return for the
ordinary shareholder?
4. Hyden plc's irredeemable of preference shares have a coupon rate of 8% and pay a dividend of Tk. 4
per Tk. 100 nominal stock on 1 January and 1 July each year. If the ex‐dividend price on 1 January is
Tk. 82, what is the annual cost of the preference share capital to the company?
5. The following data relates to an all equity financed company:

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 Dividend just paid Tk. 50m
Earnings retained and reinvested 70%
Return on investments 15%
Cost of equity 23%

What is the market value of the company?

6. A firm has achieved an average growth in dividends over the last five years of 14% pa. it is now widely
believed that the long‐run average dividend growth rate will be 15.6% pa. the firm's current net
dividend yield is 5.2%.
What is the cost of equity capital?

7. Shown below are recent statistic relating to the ordinary shares of Lamdin plc, a quoted company.
Last year's net dividend 8p
Average annual growth rate of dividends 16%
Dividend cover 3.84
Price/earnings ratio 12.8
The company calculates its cost of equity capital using net dividend growth valuation model. What is the
cost of Lamdin's cost of capital?

8. Ingham plc's capital structure is as follows:

50p ordinary shares Tk. 12m

8% Tk. 1 preference shares Tk. 6m
12.5% loan stock 2012 Tk. 8m
The loan stock is redeemable at par in 2012. The current market prices of the company's securities are
as follows:
50p ordinary shares Tk. 12m
8% Tk. 1 preference shares Tk. 6m
12.5% loan stock 2012 Tk. 8m

The company is paying corporation tax at the rate of 30%. The cost of the company's ordinary equity
capital has been estimated at 15% pa. What is the company's weighted average cost of capital investment
appraisal purposes?

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