Chapter # 03

Cost of Finance
LO 01: RELATIVE COST OF EQUITY AND DEBT:
Cost of equity, cost of debt and the weighted average cost of capital (WACC)
The cost of capital for investors is the return that investors The cost of capital for a company is the return that it must make
require from their investment. Companies must be able to on its investments so that it can afford to pay its investors the
make a sufficient return from their own capital investments returns that they require. The cost of capital for investors and
to pay the returns required by their shareholders and the cost of capital for companies should theoretically be the
holders of debt capital. The cost of capital for investors same. However, they are different because of the differing tax
therefore establishes a cost of capital for companies. positions of investors and companies.

 For each company there is a cost of equity. This is  The cost of capital for investors is measured as a pre-
the return required by its tax cost of capital.
shareholders, in the form of dividends · The cost of capital for companies recognizes that interest
or share price growth (capital gain). costs are an allowable expense for tax purposes, and the
 There is a cost for each item of debt finance. This cost of debt capital to a company should allow for the tax
is the yield required by the lender or bond relief that companies receive on interest payments,
investor. reducing their tax payments.
· The cost of debt capital for companies is measured as an
 When there are preference shares, there is also a
after-tax cost.
cost of preference share capital.

The weighted average cost of capital (WACC) is the average cost of all the sources of capital that a company uses. This average
Comparing the cost of equity and the cost of debt:
Aspect Cost of Equity Cost of Debt
Riskiness Generally higher due to volatility in earnings Generally lower due to fixed interest payments.
per share.

Contractual Rights Shareholders do not have rights to dividend Debt capital providers have contractual rights to
payments. interest and principal payments.

Enforcement in Default Shareholders do not have security to enforce Providers of secured debt can enforce their
in default. security.

Priority in Insolvency Shareholders are paid last in the event of Debt capital providers are paid before
insolvency. shareholders.

Since equity has a higher investment risk for investors, the expected returns on equity are higher than the expected returns on
debt capital. In addition, from a company’s perspective, the cost of debt is also reduced by the tax relief on interest payments.
This makes debt finance even lower than the cost of equity.

The effect of more debt capital, and higher financial gearing, on the WACC is considered in more detail later.
LO 02: COST OF EQUITY:
Methods of calculating the cost of equity
The cost of equity is the annual return expected by ordinary shareholders, in the form of dividends and share price growth
(capital gain). However, share price growth is assumed to occur when shareholder expectations are raised about future
dividends. If future dividends are expected to increase, the share price will also increase over time. At any time, the share
price can be explained as a present value of all future dividend expectations.

Using this assumption, we can therefore say that the current value of a share is the present value of future dividends in
perpetuity, discounted at the cost of equity (i.e. the return required by the providers of equity capital).

METHODS FOR CALCULATION OF COST OF EQUITY

The Dividend Valuation Model The CAPM Model

 (a) The Dividend Valuation Model Method:
The dividend valuation model (DVM) is a quantitative method used for predicting the price of a company's equity instrument
based on the theory that its present-day price equals the sum of all of its future dividend payments when discounted with the
Cost of Equity (ke) to their present value. It attempts to calculate the fair value of a share irrespective of the prevailing market
conditions and takes into consideration the dividend payout factors and the market expected returns.

DIVIDEND VALUATION MODEL

Without Growth With Growth

(i) Without Growth:
If it is assumed that future annual dividends are expected to remain constant into the foreseeable future and the whole of the
profit will be distributed as dividend, the cost of equity can be calculated by following formula
ke =
Market value of equity can be calculated by arranging above formula:
MV =
Where:
MV = Market price of the share (Ex – Div)
D = Constant Dividend paid from year 1 to infinity
ke = Shareholder’s required rate of return (expressed in fraction, not percentage)

Some Important Terms:

Cum-dividend market value of share:
Market price of the share prevailing in market, after announcement of dividends but before its payment.

Ex-dividend market value of share:

Market price of the share prevailing in market, immediately after the payment of dividend.
MV (Ex-div) = MV (Cum-div) – Proposed dividend
Illustration # 01:
A company might declare on 1 March that it will pay a dividend of Rs.0.60 per share to all holders of equity shares on 30 April,
and the dividend will be paid on 31 May. Until 30 April the share price allows for the fact that a dividend of Rs.0.60 will be
paid in the near future and the shares are said to be traded ‘cum dividend’ or ‘with dividend’.

After 30 April, if shares are sold they are traded without the entitlement to dividend, or ‘ex dividend’. This is the share price to
use in the cost of equity formula whenever a dividend is payable in the near future and shares are being traded cum dividend.

Illustration # 02:
A company’s shares are currently valued at Rs.8.20 and the company is expected to pay an annual dividend of Rs.0.70 per
share for the foreseeable future. The cost of equity in the company can therefore be estimated as:

ke =

ke = = 8.5%
Example # 01:
A company has paid a dividend of Rs. 6 per share for many years. The company expects to continue paying dividends at this
level in the future (means no growth). The company’s current share price is Rs. 30 ex div.
Required:
Calculate the cost of equity.

Answer:
ke =
ke = = 20%

Example # 02:
ABC Company has paid a dividend of Rs. 3.50 for many years. The company expects to continue paying dividends at this level
in the future. The company's current share price is Rs. 20.
Required:
Calculate the cost of equity.

Answer:
ke =
ke = = 17.50%
Example # 03:
Description A B C D
Profits 460,000 3,000,000 250,000 1,800,000
Shares 25,000 75,000 12,500 60,000
MV per share ? 250 88.89 ?
Cost of Equity 12.50% ? ? 8.00%
Total MV of equity ? 18,750,000 1,111,111 ?
Required:
Complete the above table.
Answer:
Company A: Company B:
MV = MV =
MV = = 3,680,000 18,750,000 = = 16%
MV per share = = Rs. 147.2/Share
Company C: Company D:
MV = MV =
1,111,111 = = 22.5% MV = = 22,500,000
MV per share = = Rs. 375/Share
Important Exam Focus Point:
 If both book value and market value of equity are given we will use market value.

 If price to book ratio is given the first we will convert book value into market value

Illustrative Example # 01:

Arsal Limited distributes all its earnings as dividend, The book Value of the equity is Rs. 200,000. Price to book ratio is 1.45.
Annual dividend (which is constant since a long period) is 40,000.

Required:
Calculate the cost of equity.

Answer:
200,000 x 1.45 = 290,000

ke = = 13.79%
 (ii) With Growth:

If it is assumed that the annual dividend will grow at a constant percentage rate into the foreseeable future, the cost of equity
can be calculated by following formula.
ke = + g
Market value of equity can be calculated by arranging above formula:
MV =

Where:
Do = Most recent dividend paid or just to be paid
g = Constant Annual growth in dividend (Expressed as fraction)
Do (1 + g) = Dividend expressed after one year
Example # 04:
A company’s share price is Rs.8.20. The company has just paid an annual dividend of Rs.0.70 per share, and the dividend is
expected to grow by 3.5% into the foreseeable future. The next annual dividend will be paid in one year’s time.

Required:
Calculate the cost of equity in the company.

Answer:
ke = + g
ke = + 0.035 = 12.3%
Example # 05:
A company has recently paid a dividend Rs. 3 per share and the dividend is expected to grow by 5% into the foreseeable
future. The next annual dividend will be paid in one year’s time. The shareholders require an annual return of 12%.

Required:
Calculate the market value of each equity share.

Answer:
MV =

MV = = Rs. 45/Share
Example # 06:
Ahmed and Co. is about to pay a dividend of Rs. 3.60. Shareholders expect dividends to grow at 12% Pa. Ahmed and Co.’s
current share price is Rs. 16.50.

Required:
Calculate the cost of equity of Ahmed and Co.

Answer:
ke = + g

ke = + 0.12= 36.44%
Methods for Estimation of Growth:
The growth rate used in the expression is the growth rate that investors expect to occur in the future. This can be estimated in
following ways:

Extrapolation of historical growth

Gordon’s Growth Model

Extension of Gordon’s Growth Model

Growth in Profit

Growth in Net Assets

(i) Extrapolation of Historical Growth:

This is based on the idea that the shareholders’ expectations will be based on what has been experienced in the past. An
average rate of growth is estimated by taking the geometric mean of growth rates in recent years.

Geometric Mean Growth Rate = – 1

Formula can also be stated as:

Value at start (1 + g)n = Value at end of period of n years

Where:

n = Number of terms in the series (e.g years of growth)

Example # 07:
A company has paid out the following dividends in recent years:
Year Dividend
20X1 100
20X2 110
20X3 120
20X4 134
20X5 148
Required:
Calculate Growth Rate.

Answer:
Geometric Mean Growth Rate = – 1

Geometric Mean Growth Rate = – 1 = 10.3%

Example # 08:
Dividend history of Shehroz Limited:
Year Dividend Per Share (Rs.)
2016 20
2017 21.5
2018 23.2
2019 24.8
2020 26.2
Cost of equity of SL is 25%.
Required:
Find Market Value Share on 31.12.2020.
Answer:

MV =

MV = = Rs. 156/Share

(W-1) 20 (1 + g)4 = 26.2  g = 7%

Example # 09:
Stop Limited has the following dividend history

Year Dividend Per Share (Rs.)

1 50
2 53

Price per share now is Rs. 432.154.

Required:
Find cost of equity.

Answer:

ke = + g
ke = + 6% = 19%
(W-1) 50 (1 + g)1 = 53
g = 6%
(ii) Gordon’s Growth Model: (The earnings retention valuation model)

Dividend growth can be achieved by retaining some profits (retained earnings) for reinvestment in the business. Reinvested
earnings should provide extra profits in the future, so that higher dividends can be paid. When a company retains a proportion
of its earnings each year, the expected annual future growth rate in dividends can be estimated using the formula:

g=bxr

Where:

g = annual growth rate in dividends in perpetuity

b = Proportion of earnings retained or Retention Ratio (for reinvestment in the business)

r = Rate of return that the company will make on its investments

Example # 10:
A company has just achieved annual earnings per share of Rs.50 of which 40% has been paid in dividends and 60% has been
reinvested as retained earnings. The company is expected to retain 60% of its earnings every year and pay out the rest as
dividends. Rate of return required on investment is 8%.

Required:
Find MV of Equity.

Answer:
The current annual dividend is 40%  Rs.50 = Rs.20

The anticipated annual growth in dividends = b x r = 60% × 8% = 4.8% or 0.048

Using the dividend growth model, the expected value per share is:

MV =

MV = = Rs. 655/Share
(iii) Extension of Gordon’s Growth Model:

This method is just a further extension of Gordon’s formula.

g=

Where:

b = Proportion of earnings retained or Retention Ratio (for reinvestment in the business)

r = Rate of return that the company will make on its investments

g= x

g=
Example # 11:
Description Year–1 Year–2 Year–3 Year–4 Year–5
Op. Capital 1,000 1,080 1,166 1,259 1,360
Add: Return On Capital Employed 200 216 233 252 272
Less: Dividend (120) (130) (140) (151) (163)
Closing Net Assets 1,080 1,166 1,259 1,360 1,469

Required:
Calculate growth rate using extension of Gordon’s Growth for each of above 5 years.
(iv) Growth in Profit:

This formula can also be used to calculate growth rate.

Oldest Profit x (1 + g) n = Latest Profit

Example # 12:
Description Year–1 Year–2 Year–3 Year–4 Year–5
Op. Capital 1,000 1,080 1,166 1,259 1,360
Add: Return On Capital Employed 200 216 233 252 272
Less: Dividend (120) (130) (140) (151) (163)
Closing Net Assets 1,080 1,166 1,259 1,360 1,469

Required:
Find growth rate.

Answer:

Oldest Profit x (1 + g) n = Latest Profit

200 (1 + g) 4 = 272

g=
 (v) Growth in Net Assets:

This formula can also be used to calculate growth rate.

Oldest Net Assets x (1 + g) n = Latest Net Assets

Example # 13:
Description Year–1 Year–2 Year–3 Year–4 Year–5
Op. Capital 1,000 1,080 1,166 1,259 1,360
Add: Return On Capital Employed 200 216 233 252 272
Less: Dividend (120) (130) (140) (151) (163)
Closing Net Assets 1,080 1,166 1,259 1,360 1,469

Required:
Find growth rate.

Answer:

Oldest Net Assets x (1 + g) n = Latest Net Assets

1,000 (1 + g) 5 = 1,469

g = 8%
Example # 14:
Net assets of Alpha Limited on 31.12.2017 were 200 Million. Now assets of Alpha Limited are 280 Million.
Today Date is 31.12.2018.

Required:
Find Growth Rate.

Answer:

200 x (1 + g) 1 = 280

g = 4%
 Multi Stage Dividend Growth Model:

This method normally used for companies with higher growth rate over an initial few number of periods followed by a
constant growth rate of dividends forever.

Illustrative Example # 01:

ABC Ltd is launching a new product. Dividends expected in future would be:
Year – 1 Rs. 40/Share
Growth Expected up to year 5 20%
Growth Expected after year 5 5%

Cost of equity of ABC Ltd. Is 15%.

Required:
Find Market value per share.
Illustrative Example # 02:

XYZ Ltd is launching a new product. Dividends expected in future would be:

Year – 1 Rs. 50/Share

Growth Expected up to Year 4 25%
Growth from Year 5 to Year 8 20%
Growth Expected after Year 8 5%

Cost of equity of XYZ Ltd. Is 15%.

Required:
Find Market value per share.
 (a) The CAPM (Capital Asset Pricing) Method:

Another approach to calculating the cost of equity in a company is to use the capital asset pricing model (CAPM).

The formula for the model is as follows:

ke = rf +(rm – rf) β

Where:

ke = The cost of equity for a company’s shares

rf = The risk-free rate of return (This is the return that investors receive on risk-free investments)

rm = The average return on market investments as a whole, excluding risk-free investments

β = the beta factor for the company’s equity shares.

Example # 15:
The rate of return available for investors on government bonds is 4%. The average return on market investments is 7%. The
company’s equity beta is 0.92.

Required:
Using the CAPM, Find the company’s cost of equity.

Answer:
ke = rf +(rm – rf) β

4% + (7% – 4%) 0.92

ke = 6.76%
Example # 16:
The ABC Company's current share price is Rs. 11.60 and they have beta of 1.10. The current dividend of Rs. 1 is due to be paid
in two weeks’ time and dividends are expected to grow at 6% per year in future. The market return is 15% and the risk free
rate of return is 5%.

Required:
Estimate the company's cost of equity capital using both the DVM and the CАРМ.

Answer:

DVM Method: CAPM Method:

ke = + g ke = rf +(rm – rf) β

ke = + 0.06 5% + (15% – 5%) 1.10

ke = 16% ke = 16%
 Right Issue:

Deciding the issue price for a rights issue:

The offer price in a rights issue will be lower than the current market price of existing shares. The size of the discount will
vary, and will be larger for difficult issues. The offer price must however be at or above the nominal value of the shares, so as
not to contravene company law.

A company making a rights issue must set a price which is low enough to secure the acceptance of shareholders, who are
being asked to provide extra funds, but not too low, so as to avoid excessive dilution of the earnings per share.

A question could ask for discussion on the effect of a rights issue, as well as calculations, e.g of the effect on EPS.
Illustrative Example # 01:

Seagull can achieve a profit after tax of 20% on the capital employed. At present its capital structure is as follows.
Rs.
200,000 ordinary shares of Rs. 1 each 200,000
Retained Earnings 100,000
300,000

The directors propose to raise an additional Rs. 126,000 from a rights issue. The current market price is Rs. 1.80.

Required
(a) Calculate the number of shares that must be issued if the rights price is: Rs. 1.60; Rs. 1.50; Rs. 1.40; Rs. 1.20.

(b) Calculate the dilution in earnings per share in each case.

 Right Issue:

The market price of shares after a rights issue: (Theoretical ex rights price)

When a rights issue is announced, all existing shareholders have the right to subscribe for new shares, and so there are rights

attached to the existing shares. The shares are therefore described as being 'cum rights' (with rights attached) and are traded

cum rights. On the first day of dealings in the newly issued shares, the rights no longer exist and the old shares are now 'ex

rights' (without rights attached).

After the announcement of a rights issue, share prices normally fall. The extent and duration of the fall may depend on the

number of shareholders and the size of their holdings. This temporary fall is due to uncertainty in the market about the

consequences of the issue, with respect to future profits, earnings and dividends.

After the issue has actually been made, the market price per share will normally fall, because there are more shares in issue

and the new shares were issued at a discount price. In theory, the new market price will be the consequence of an

adjustment to allow for the discount price of the new issue, and a theoretical ex rights price can be calculated.
Illustrative Example # 02:

Fundraiser has 1,000,000 ordinary shares of Rs. 1 in issue, which have a market price on 1 September of Rs. 2.10 per share.

The company decides to make a rights issue, and offers its shareholders the right to subscribe for one new share at Rs. 1.50

each for every four shares already held. After the announcement of the issue, the share price fell to Rs. 1.95, but by the time

just prior to the issue being made, it had recovered to Rs. 2 per share. This market value just before the issue is known as the

cum rights price.

Required:

What is the theoretical ex rights price?

 Right Issue:

The theoretical gain or loss to shareholders:

The possible courses of action open to shareholders are:
(a) To 'take up' or 'exercise' the rights, that is, to buy the new shares at the rights price. Shareholders who do this will
maintain their percentage holdings in the company by subscribing for new shares.
(b) To 'renounce' the rights and sell them on the market. Shareholders who do this will have lower percentage
holdings of the company's equity after the issue than before the issue, and total value of their shares will be less.
(c) To renounce part of the rights and take up the remainder. For example, a shareholder may sell enough of his
rights to enable him to buy the remaining rights shares he is entitled to with the sale proceeds, and so keep the
total market value of his shareholding in the company unchanged.
(d) To do nothing. Shareholders may be protected from consequences of their inaction because rights not taken up
are sold on a shareholder's behalf by the company. The Stock Exchange rules state that if new securities are not
taken up, they should be sold by the company to new subscribers for the benefit of the shareholders who were
entitled to the rights.
Illustrative Example # 03:

Gopher has issued 3,000,000 ordinary shares of Rs. 1 each, which are at present selling for Rs. 4 per share. The company plans
to issue rights to purchase one new equity share at a price of Rs. 3.20 per share for every three shares held. A shareholder
who owns 900 shares thinks that he will suffer a loss in his personal wealth because the new shares are being offered at a
price lower than market value. On the assumption that the actual market value of shares will be equal to the theoretical ex
rights price.

Required:

What would be the effect on the shareholder's wealth if:

(a) He sells all the rights.

(b) He exercises half of the rights and sells the other half.

(c) He does nothing at all?

 Right Issue:

The actual market price after a rights issue:

The actual market price of a share after a rights issue may differ from the theoretical ex rights price. This will occur when:

Expected yield from new funds raised ≠ Earnings yield from existing funds:

The market will take a view of how profitably the new funds will be invested, and will value the shares accordingly. An

example will illustrate this point.

Illustrative Example # 04:

Musk currently has 4,000,000 ordinary shares in issue, valued at Rs. 2 each, and the company has annual earnings equal to
20% of the market value of the shares. A one for four rights issue is proposed, at an issue price of Rs. 1.50. If the market
continues to value the shares on a price/earnings ratio of 5.

Required:

What would be the value per share if the new funds are expected to earn, as a percentage of the money raised:

(a) 15%? (b) 20%? (c) 25%?

How do these values in (a), (b) and (c) compare with the theoretical ex rights price? Ignore issue costs.
LO 03: COST OF DEBT:
Each item of debt finance for a company has a different cost. This is because different types of debt capital have differing risk,
according to whether the debt is secured, whether it is senior or subordinated debt, and the amount of time remaining to
maturity.
The market value of debt is the present value of all future cash flows in servicing the debt. A difference between debt and
equity is that interest payments are tax deductible whereas dividend payments are not.

This means that debt might be valued from two different viewpoints:
The lenders’ viewpoint:
Discount the pre-tax cash flows (i.e. ignoring the tax relief on the interest) at the lenders’ required rate of return (the
pre-tax cost of debt.
The company’s viewpoint:
Discount the post-tax cash flows (i.e. including the tax relief on the interest) at the cost to the company (the post-tax
cost of debt). This is the rate that is input into WACC calculations.
Pre and post-tax cost of debt:
Illustration # 03:
A company takes out a bank loan. The bank charges interest at 10%. The company pays interest at 10% but obtains tax relief
on this at 30%.

The pre-tax cost of the debt is 10% and the post-tax cost is 10 (1 – 0.3) = 7%. This would be a component of the WACC
calculation.

The required rate of return can be found by calculating the IRR of the cash flows associated with the debt using the market
value as the amount of cash flow at time 0.
Nominal rate of interest:
This is another rate that appears in cost of debt calculations. The nominal interest rate is used to identify the cash flow paid on
a nominal amount of debt.

Illustration # 04:
A company borrows Rs. 1,000,000 by issuing Rs. 1,000, 10% bonds.

This means that it has issued 1,000 bonds and each of these is for Rs. 1,000.

The company has to pay interest of 10% which totals to be Rs. 100,000 per annum (or Rs.100 per annum for each individual
bond).

Suppose the market value of the bonds changed to Rs. 2,000 (perhaps because the company’s debt was looked on very
favorably by the market).

This would have no effect on the nominal interest rate which is still 10% of the nominal value of the bonds.

However, the bondholders (the lenders) are now receiving Rs. 100,000 on an investment worth Rs. 2,000,000. This is a return
of 5%. This is the pre-tax return and is also known as the yield on the bond.
Some Important Terms:
The following terms are important in understanding the explanation of the market value and cost of debt.

 Face value/nominal value:

This is the reference value used for the determination of coupon interest. The price determined by the issuer when the
bond is first issued. This is usually payable at the time of bond maturity and used as reference to calculate the bond’s coupon
interest.

 Nominal or coupon (interest) rate:

This is the rate at which interest is actually paid by the borrowers to holder of the debt securities (the lenders). The coupon
interest rate is applied to the nominal value to determine the amount of cash paid as interest (coupon interest amount).

 Redemption value:
The amount for which a security will be redeemed on its maturity i.e. it is the amount of principal to be paid back by the
borrower at end of the loan term.
Redemption may be at:

 A Premium: This where the redemption amount is greater than the face value of the bond.

 A Par: This where the redemption amount is equal to the face value of the bond.

 A Discount: This where the redemption amount is less than the face value of the bond.
 METHODS FOR CALCULATION OF COST OF DEBT

Irredeemable Debt Redeemable Debt Bank Loan Convertible Debt

 (i) Irredeemable Fixed Rate Debt (Perpetual Bonds):

The expressions for the market of irredeemable fixed rate bonds (perpetual bonds) and the rearrangement to provide an
expression for the cost of debt are as follows:
Pre Tax Cost of Debt
Post Tax Cost of Debt
(Lender’s required rate of return)
kd = Post Tax kd =
Market Value Of debt can be find by arranging above Market Value Of debt can be find by arranging above
MV = MV =

Where:

Post Tax kd = Pre Tax kd x (1 – t)

kd = the cost of the debt capital

i = the annual interest payable

t = rate of tax on company profits

MV = Ex interest market value of the debt

(Note that calculations are usually performed on a nominal amount of 100 or 1,000.)
Example # 17:
Right Limited is performing a due diligence exercise for Left Limited. RL is asked to perform a valuation exercise for the
following companies for their traded debt.
A B C D
Face value of issued debt 7,898,000 6,752,535 9,658,750 18,000,000
Coupon Rate 12.50% 18.00% 8.00% 15.00%
Nature Irredeemable Irredeemable Irredeemable Irredeemable
Tax Rate 32% N/A 30% N/A
MV of Debt 105.60 ? ? 96.80
Pre Tax Cost of Debt ? 15% 10.5% ?

Required:
Complete the above table.
 (ii) Redeemable Fixed Rate Debt:

(a) Market Value of Redeemable Debt:

This is calculated as the present value of the future cash flows:

 To be received by the lender discounted at the pre-tax cost of debt (the lender’s required rate of return)

 To be paid by the company (net of tax relief on the interest flows) discounted at the post-tax cost of debt (the cost to the
company).
Example # 18:
A company has issued 7% loan stock. Annual interest has just been paid. The bonds will be redeemed at par after four years.
The lenders’ required rate of return is 8.14%.

Required:
Calculate the market value of the loan stock.

Example # 19:
A company has issued 12% bonds that are due to be redeemed at a premium of 5% in four years’ time. The tax rate is 20% and
the post-tax cost of debt is 8%.

Required:
Calculate the total market value of bonds.
(b) Cost of redeemable debt:

The cost of redeemable bonds is their redemption yield. This is the return, expressed as an average annual interest rate or
yield, that investors in the bonds will receive between ’now’ and the maturity and redemption of the bond, taking the current
market value of the bonds as the investment. It is the investment yield at which the bonds are currently trading in the bond
market.

This is calculated as the rate of return that equates the present value of the future cash flows payable on the bond (to
maturity) with the current market value of the bond. In other words, it is the IRR of the cash flows on the bond to maturity,
assuming that the current market price is a cash outflow.

The redemption of the principal at maturity is not an allowable expense for tax purposes. This means that post tax cost of
redeemable debt cannot be calculated by multiplying the pre-tax cost by (1  t). A full IRR calculation must be carried out.

The approach is to calculate the post-tax cost of debt as the IRR of the future cash flows, allowing for tax relief on the interest
payments and the absence of tax relief on the principal repayment using the market value as the cash flow at time 0.
The cash flows for calculating the cost of redeemable debt:

The cash flows used to calculate an IRR (redemption yield) are:

 The current market value of the bond, excluding any interest payable in the near future (shown as a cash outflow).

 The annual interest payments on the bond (shown as a cash inflow).

 Tax relief on these annual interest payments: these are cash outflows (the opposite of the interest payments) and
occur either in the same year as the interest payments or one year in arrears, depending on the assumption used
about the timing of tax payments (shown as a cash outflow)

 The redemption value of the bonds, which is often par (shown as a cash inflow).
EXAM FOCUS POINTS ABOUT PRE-TAX AND POST-TAX COST OF DEBT (KD):
Lender’s required rate of return = Company’s pre-tax kd
Company’s post-tax kd = Company’s pre-tax cost kd x (1 – t)
Exam Approach:
As mentioned above, WACC calculations involve post-tax kd.
Irredeemable debt:
The post-tax kd can be calculated as [pre-tax kd x (1 – t)].
Redeemable debt:
The approach is different since gain/loss on redemption is not taxable.
If the scenario only has lenders’ required rate of return (pre-tax Kd):
 MV of debt: Plot all pre-tax cash flows and discount with the lenders’ required rate of return.
 Post-tax kd: Plot MV of debt, all post-tax cash flows and calculate IRR.
If the scenario provides MV of debt:
 Plot the MV of debt and post-tax cash flows, calculate the IRR.
 This is the post-tax kd.
If the scenario provides post-tax kd and requires MV of debt, plot post-tax cash flows, and discount the present values with the
post-tax kd. This is the MV of debt.
(Note: Pre-tax cash flows will be discounted with pre-tax kd and post-tax cash flows will be discounted with a post-tax kd.)
Example # 20:
The current market value of a company’s 7% loan stock is 96.25. Annual interest has just been paid. The bonds will be
redeemed at par after four years. The rate of taxation on company profits is 30%.

Required:

Calculate the after-tax cost of the bonds for the company.

Redeemable Debt (Summary):
Case # 01 Case # 02
Cash Flows Given Cash Flows Given
Market Rate Given Market Rate ?
Market Value ? Market Value Given
To Find Market Value: To Find Market Rate:
Calculate Present Value of All Cash Flows at Market Rate Calculate IRR.
(iii) Convertible Debt:

Convertible debt is debt that gives the holder (the lender) the option of converting it into equity at an agreed rate and at an
agreed time (or during an agreed period) in the future.

The cost of a convertible bond is the higher of:

 The cost of the bond as a straight bond that will be redeemed at maturity.

 The IRR of the relevant cash flows assuming that the conversion of the bonds into equity will take place in future.

The cost of capital of the bond as a straight bond is only the actual cost of the bond if the bonds are not converted into shares
at the conversion date. The IRR of the relevant cash flows is the cost of the convertible bond assuming that conversion will
take place.

The relevant cash flows for calculating this yield (IRR) are:

 The current market value of the bonds (Year 0 outflow).

 Annual interest on the bonds up to the time of conversion into equity (annual inflows).

 Tax relief on the interest (annual outflows).

 The expected market value of the shares, at conversion date, into which the bonds can be converted.
Market Value of Convertible Bond:

Example # 21:
Face Value 100
Coupon Rate 10%
Market Rate (Post Tax) 13.5%
Term 3 years
Share Price Now Rs. 13 Per Share
Growth Rate 12%
Tax Rate 30%
Redemption Option Rs. 120 Cash or 8 Shares
Required: Find Market Value of Convertible Bond.
Market Rate of Convertible Bond:

Example # 22:
Face Value 100
Coupon Rate 12%
Market Value of bond Rs. 121
Term 4 years
Share Price Now Rs. 20.40 Per Share
Growth Rate 5%
Tax Rate 30%
Redemption Option Rs. 115 Cash or 5 Shares
Required: Find Market Rate of Convertible Bond.
 Zero Coupon Debentures:
Post tax cost of debt = {(Redemption value ÷ Issue value*) 1/n – 1} x (1 – tax)
Where:
n = years to redemption.
*Market value shall be used in case of previously issued debentures.

Illustrative Example # 01:

Z Limited has just issued zero coupon bond at 40% discount which are redeemable at par (Rs. 100) in 8 years’ time. Income tax rate is 30%.
Required:
Calculate cost of debt for use in calculation of WACC.
Answer:
Post tax cost of debt = {(Redemption value ÷ Issue value) 1/n – 1} x (1 – tax)
Post tax cost of debt = {(Rs. 100 ÷ Rs. 60) 1/8 – 1} x (1 – 0.30) = 4.62%

Illustrative Example # 02:

Five years ago C Limited issued zero coupon bond at 50% discount on par value (Rs. 100) which are currently trading at Rs. 65. Bonds are
redeemable at 5% premium after 6 years. Income tax rate is 30%.
Required:
Calculate post tax cost of debt.
Answer:
Post tax cost of debt = {(Redemption value ÷ Issue value) 1/n – 1} x (1 – tax)
Post tax cost of debt = {(Rs. 105 ÷ Rs. 64) 1/6 – 1} x (1 – 0.30) = 6.02%
 (iv) Bank Loan:

Market Rate Market Value

The market value of bank loan is equal to book value as not

kd = Interest rate x (1 – tax rate)
tradable

Example # 23:
(a) Interest rate of 13%, tax rate of 0%.

(b) Interest rate of 13%, tax rate of 20%.

(c) Interest rate of 13%, tax rate of 35%.

Required:
Calculate the after-tax cost of debt of each.
 PREFRENCE SHARES

Redeemable Preference Shares Irredeemable Preference Shares

(i) Irredeemable Preference shares:

For irredeemable preference shares, the cost of capital is calculated in the same way as the cost of equity assuming a constant
annual dividend, and using the dividend valuation model.

Cost of Irredeemable Preference Shares can be find be the following formula

Kp =

Market value can be find by arranging above formula

MV =

(ii) Redeemable Preference shares:

For redeemable preference shares, the cost of the shares is calculated in the same way as the pre-tax cost of irredeemable
debt. (Dividend payments are not subject to tax relief, therefore the cost of preference shares is calculated ignoring tax, just as
the cost of equity ignores tax.)
Example # 24:
Adnan Limited has in issue the following securities:
Securities Book Value
8% Redeemable Preference Share 140,000
9.2% Redeemable Preference Share 245,000

The 8% redeemable preference shares is redeemable in five years and required rate of return for investor is observed to 9%.
The 9.2% redeemable preference shares is currently traded at 98.2%. Shares will be redeemed in four year time.
Applicable tax rate to the company is 30%.

Required:
Calculate market value and cost of capital for both sources of finance.
LO 04: WEIGHTED AVERAGE COST OF CAPITAL (WACC):
The weighted average cost of capital (WACC) is a weighted average of the (after-tax) cost of all the
sources of capital for the company. The different costs are weighted according to their market values.
This can be done using following formula:

WACC =
Example # 25:
A company has 10 million shares each with a value of Rs.4.20, whose cost is 7.5%. It has Rs.30 million of 5% bonds with a
market value of 101.00 and an after-tax cost of 3.5%.
It has a bank loan of Rs.5 million whose after-tax cost is 3.2%. It also has 2 million 8% preference shares of Rs.1 whose market
price is Rs.1.33 per share and whose cost is 6%.

Required:
Calculate the WACC.
WACC and market values

For a company with constant annual ‘cash profits’, there is an important connection between WACC and market value. (Note:
‘Cash profits’ are cash flows generated from operations, before deducting interest costs.)

If we assume that annual earnings are a constant amount in perpetuity, the total value of a company (equity plus debt capital)
is calculated as follows:

Total Market Value =

From this formula, the following conclusions can be made:

 The lower the WACC, the higher the total value of the company will be (equity + debt capital), for any
given amount of annual profits.

 Similarly, the higher the WACC, the lower the total value of the company.
Illustration # 05:
For example, ignoring taxation, if annual cash profits are, say, Rs.12 million, the total market value of the company would be:

 Rs.100 million if the WACC is 12% (Rs.12 million/0.12)

 Rs.120 million if the WACC is 10% (Rs.12 million/0.10)

 Rs.200 million if the WACC is 6% (Rs.12 million/0.06).

The aim should therefore be to achieve a level of financial gearing that minimizes the WACC, in order to maximize the value of
the company.

Important questions in financial management are:

 For each company, is there an ‘ideal’ level of gearing that minimizes the WACC?

 If there is, what is it?

LO 05: YIELD CURVES:
Each item of debt finance for a company has a different cost. This is because debt capital has differing risk, according to
whether the debt is secured, whether it is senior or subordinated debt, and the amount of time remaining to maturity.

Furthermore, the cost of debt differs for different periods of borrowing. This is because lenders might require compensation
for the risk of having their cash tied up for longer and/or there might be an expectation of future changes in interest rates. The
relationship between length of borrowing and interest rates is described by the yield curve. This session looks at the
derivation and use of yield curves.

Background:

An earlier section covered the relationship that exists between the market value of a bond, the cash flows that must be paid
to service that bond and the cost of debt inherent in that bond. The market value of a bond is the present value of the future
cash flows that must be paid to service the debt, discounted at the lender’s required rate of return (pre-tax cost of debt). The
lender’s required rate of return (the pre-tax cost of debt) is the IRR of the cash flows (pre-tax) that must be paid to service the
debt.
Example # 26:
Market value of bond A company has issued a bond that will be redeemed in 4 years. The bond has a nominal interest rate of
6%.
Required:

Calculate what the market value of the bond would be if the required rate of return was 5% or 6% or 7%.
Shape of the yield curve (Term structure of interest rates):

The cost of fixed-rate debt is commonly referred to as the ‘interest yield’. The interest yield on debt capital varies with the
remaining term to maturity of the debt.

 As a general rule, the interest yield on debt increases with the remaining term to maturity. For example, it should
normally be expected that the interest yield on a fixed-rate bond with one year to maturity/redemption will be
lower than the yield on a similar bond with ten years remaining to redemption. Interest rates are normally higher
for longer maturities to compensate the lender for tying up his funds for a longer time.

 When interest rates are expected to fall in the future, interest yields might vary inversely with the remaining time
to maturity. For example, the yield on a one-year bond might be higher than the yield on a ten-year bond when
rates are expected to fall in the next few months.

 When interest rates are expected to rise in the future, the opposite might happen, and yields on longer dated
bonds might be much higher than on shorter-dated bonds.

Interest yields on similar debt instruments can be plotted on a graph, with the x-axis representing the remaining term to
maturity, and the y-axis showing the interest yield. A graph which shows the ‘term structure of interest rates’, is called a yield
curve.
Normal Yield Curve:

Time to Maturity

As indicated above, a normal yield curve slopes upwards, because interest yields are normally higher for longer dated debt
instruments. Sometimes it might slope upwards, but with an unusually steep slope (steeply positive yield curve). However, on
occasions, the yield curve might slope downwards, when it is said to be ‘negative’ or ‘inverse’.
Inverse Yield Curve:

Time to Maturity
When the yield curve is inverse, this is usually an indication that the markets expect short-term interest rates to fall at some time in future.
When the yield curve has a steep upward slope, this indicates that the markets expect short-term interest rates to rise at some time in future.
Yield curves are widely used in the financial services industry. Two points should be noted about yield curve are:
 Yields are gross yields, ignoring taxation (pre-tax yields).
 A yield curve is constructed for ‘risk-free’ debt securities, such as government bonds. A yield curve therefore shows ‘risk-free
yields’.
As the name implies, risk-free debt is debt where the investor has no credit risk whatsoever, because it is certain that the borrower will repay
the debt at maturity. Debt securities issued by governments with AAA credit ratings (see later) in their domestic currency by the government
Bond valuation using the yield curve:
Annual spot (valid on the day they are published) yield curves are published in the financial press. The cost of new debt can
be estimated by reference to a yield curve.

Example # 27:
A company wants to issue a bond that is redeemable at par in four years and pays interest at 6% of nominal value. The annual
spot yield curve for a bond of this class of risk is as follows:
Maturity Yield
One year 3.0%
Two years 3.5%
Three years 4.2%
Four years 5.0%

Required:
Calculate the price that the bond could be sold for (this is the amount that the company could raise) and then use this to
calculate the gross redemption yield (yield to maturity, cost of debt).
Estimating the yield curve:
A yield curve was provided in the previous section. The next issue to consider is how these are constructed. This technique is
called “bootstrapping”.

Example # 28:
Estimating the yield curve There are three bonds in issue for a given risk class. All three bonds pay interest annually in arrears
and are to be redeemed for par at maturity. Relevant information about the three bonds is as follows:
Bond Maturity Coupon rate Market value
A 1 year 6.0% 102
B 2 years 5.0% 101
C 3 years 4.0% 97

Required:
Construct the yield curve that is implied by this data.