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F. #

COST#OF#CAPITAL #

1. Source#of#Finance#and#their#Relative#Costs #

2. Estimating#the#Cost#of#Equity #

3. Estimating#the#Cost#of#Debt#and#Other#Capital#Instruments #

4. Estimating#the#Overall#Cost#of#Capital #

5. Capital#Structure#Theories#and#Practical#Considerations #

6. Impact#of#C ost#of#Capital#on#Investments #

What!is!the!cost!of!capital? !

The#cost#of#capital#is: #

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#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 #

The#cost#of#capital#is#an#opportunity#cost#of#finance,#because#it#is#the#minimum#return#that# investors#require. #

What!are!the!elements!of!cost!of!cap ital? !

Cost#of#capital#=#Risk#free#rate#of#return#+#premium#for#business#risk#+#premium#for#financial# risk #

What!is ! the!Risk!free!rate!of!return? !

The#risk#free#rate#of#return#is#the#return,#which#would#be#required#from#an#investment#if#it# were#completely#fre e#from#risk.#(E.g.#yield#on#government#security) #

What!is!the!Premium!for!business!risk? !

The#premium#for#business#risk#is#an#increase#in#the#required#rate#of#return#due#to#the# existence#of#uncertainty#about#the#future#and#about#a#firm’s#business#prospects. #

What!is!the! Premium!for!financial!risk? !

This#relates#to#the#danger#of#high#debt#levels#(high#gearing).#The#higher#the#gearing#of#a# company’s#capital#structure,#the#greater#will#be#the#financial#risk#to#ordinary#shareholders,# and#this#should#be#reflected#in # a#higher#risk#premium#and#therefore#a#higher#cost#of#capital. #

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Source!of!Finance!and!their!Relative!Costs!

The#cost#of#debt#is#likely#to#be#lower#than#the#cost#of#equity,#because#debt#is#less#risky#from# the#debtholders’#viewpoint.#In#the#event#of#liquidati on,#the#creditor#hierarchy#dictates#the# priority#of#claims#and#debt#finance#is#paid#off#before#equity.#This#makes#debt#safer# investment#than#equity#and#hence#debt#investors#demand#a#lower#rate#of#return#than#equity# investors.#Debt#interest#is#also#corporat ion#tax#deductible#making#it#even#cheaper#to#a#tx# paying#company. #

Estimating!the!Cost!of!Equity !

What!is!the!dividend!growth!model? !

The#dividend#growth#model#can#be#used#to#estimate#a#cost#of#equity,#on#the#assumption#that# the#market#value#of#share#is#direc tly#related#to#the#expected#future#dividends#from#the# shares. #

How!can!the!cost!of!equity!on!new!issues!and!retain!earnings!be!calculated? !

The#cost#of#equity#for#new#issues#and#retained#earnings#can#be#estimated#using#the#dividend# valuation#model,#on#the#as sumption#that#the#market#value#of#shares#is#directly#related#to# expected#future#dividends#on#shares. #

Ke#=#D/P0 #

Where#Ke#=#Cost#of#Equity,#D#=#annual#dividend#per#share,#starting#at#year#1,#P0#=#ex X dividend#share#price #

Shareholders#will#normally#expect#divi dends#to#increase#year#by#year#and#not#to#remain# constant#in#perpetuity.#The#fundamental#theory#of#share#values#states#that#the#market#price# of#a#share#is#the#present#value#of#the#discounted#future#cash#flows#of#revenue#from#the#share,# so#the#market#value# given#an#expected#constant#annual#growth#in#dividends#would#be:#

Ke#=#D0(1+g)/P0#+#g #

How!can!you!estimate!the!growth!rate? !

There#are#two#methods#for#estimating#the#growth#rate: #

Dividend#in#the# 1 st # year#x#(1#+#g) # n =#Dividends#in#the#N th # year #

Gordon’s#growth#approximation: # #

G rowth # =#Portion#of#profits#retained#x#rate#of#return#on#new#investments #

What!are!the!weaknesses!of!the!divide nd!growth!model? !

The#model#does#not#incorporate#risk !

Dividend#do#not#grow#smoothly#in#reality#so#g#is#only#an#approximation !

No#all owance#is#made#for#the#effects#of#taxation !

It#assumes#there#are#no#issue#costs#for#new#shares!

What!is!unsystematic!or!business!risk? !

Unsystematic#or#business#risk#can#be#diversified#away#it#is#the#risk#specific#to#the#company. #

What!is!systematic!or!market! risk? !

Systematic#or#market#risk#cannot#be#diversified#away. #

What!is!the!beta!factor? !

The#beta#factor#measures#a#share’s#volatility#in#terms#of#market#risk. #

!

!

What!is!the!capital!asset!pricing!model? !

The#capital#asset#pricing#model#can#be#used#to#calculate#a# cost#of#equity#and#incorporates# risk.#The#CAPM#is#based#on#a#comparison#of#the#systematic#risk#of#individual#investments# with#the#risk#of#all#shares#in#the#market.#The#capital#asset#pricing#model#is#mainly#concerned# with#how#systematic#risk#is#measured,#an d#how#systematic#risk#affects#required#returns#and# share#prices.#Systematic#risk#is#measured#using#beta#factors. #

The!CAPM!theory!includes!the!following!propositions: !

Investors#in#shares#require#a#return#in#excess#of#the#riskX free#rate#to#compensate# them#fo r#the#systematic#risk !

Investors#should#not#require#a#premium#for#unsystematic#risk,#because#this#can#be# diversified#away#by#holding#a#wide#portfolio#of#investments !

Investor#will#require#a#higher#return#from#shares#in#those#companies#where#the# systematic#ri sk#is#bigger !

The!expected!return!on!a!company’s!share ! (Ri) : !

Ri#=#Capital#gain#(or#loss)#+#dividend#/#Price#at#start#of#period #

The!expected!return!on!the!market!portfolio ! (Rm) : !

Rm # =#Capital#gain#(or#loss)#+#dividend#/#Price#at#start#of#period #

What!is!the!eq uity!risk!premium? !

The#market#risk#or#equity#risk#premium#is#the#difference#between#the#expected#rate#of#return# on#a#market#portfolio#and#the#risk X free#rate#of#return#over#the#same#period.#It#is#the#excess#of# market#returns#over#those#associated#with#inves ting#i n#risk X free#assets.# (Rm# – # Rf) #

CAPM !

Statistical#analysis#of#historic#returns#from#a#security#and#from#the#average#market#may# suggest#that#a#linear#relationship#can#be#assumed#to#exist#between#the#market#return#of# investment#and#an#individual#security. #

The#return#from#a#security#and#the#return#from#the#market#as#a#whole#will#tend#to#rise#or#fall# together #

What!is!the!CAPM!formula? !

Ri#=#Rf#+#B(Rm# – # Rf) #

What!are!the!problems!with!applying!the!CAPM? !

Historical# returns#rather#than#expected#returns#are#used !

D etermining#the#risk X free#rate#can#be#difficult#depending#on#the#terms#the#interest# will#change !

Errors#in#the#statistical#analysis#used#to#calculate#beta#value !

Beta#may#also#change#over#time !

The#CAPM#is#unable#to#forecast#accurately#returns#for#companies#wi th#low# price/earnings#ratios !

CAPM#does#not#take#into#account#seasonal#effects#that#influence#returns#on#shares !

Estimating!the!Cost!of!Debt!and!Other!Capital!Instruments !

What!is!the!cost!of!debt? !

The#cost#of#debt#is#the#return#an#enterprise#must#pay#to#its # lenders.# It#is#the#cost#of# continuing#to#use#the#finance#rather#than#redeem#the#securities#at#their#current#market#price.# For#redeemable#debt,#the#cost#is#the#internal#rate#of#return#of#cash#flows.#For#irredeemable# debt,#this#is#the#(post X tax)#interest#as # a#percentage#of#the#ex#interest#market#value#of#the# bonds#or#preferred#shares. # Also,#it#is#the#cost#of#raising#additional#fixed#interest#capital# assuming#the#cost#of#the#additional#capital#would#be#equal#to#the#cost#of#that#already#issued.# #

Calculate!the! cost!of!an!irredeemable!debt: !

Kd#=#i /P0 #

or #

Kdnet#=#i#(1 X T)/P0 #

Calculation#for#half#year#interest#payments:#(1#+#i/P0#)#^2# – # 1 #

Calculate!the!cost!of!redeemable!debt!capital: !

Kd#=#IRR #

L%#+#NPVL/(NPVL X NPVH)#x#(H% X L%) #

The#cost#of#short X term#funds#such#as#bank# loans#and#overdrafts#is#the#current#interest#being# charged#on#such#funds. #

Calculate!the!cost!of!convertible!debt: !

The#cost#of#convertible#debt#depends#on#whether#or#not#conversion#is#likely#to#happen: #

If#the#conversion#is#not#expected#the#bond#is#treated#as#redeemable#debt#using#the# IRR#method #

If#conversion#is#expected#the#IRR#method#is#used#but#the#number#of#years#to# redemption#is#replaced#by#the#number#of#years#to#conversion#and#the#redemption# value#is#replaced#by#the#conversion#value #

Conversion#value#=#P 0#(1+g) ^ n # x###of#shares#received #

What!is!the!cost!of!preference!shares? !

Kp#=#D/P0 #

Estimating!the!Overall!Cost!of!Capital !

What!is!the!Weighted!Average!Cost!of! Capital!( WACC)? !

The#weighted#average#cost#of#capital#is#the#average#cost#of#the#company’s#finance # (equity,# bonds,#bank#loans)#weighted#according#to#the#proportion#each#element#bears#to#the#total# pool#of#capital. #

Calculate!the!WACC: !

WACC#=#(Ve/Ve+Vd)Ke#+#(Vd/Ve+Vd)Kd(1 X T) #

Capital!Structure!Theories!and!Practical!Considerations !

The!two!capital!structure ! theories!are: !

The#traditional#view# – # that#their#exist#an#optimal#mix#of#finance#at#which#WACC#is# minimised #

The#alternative#view#of#Modigliani#and#Miller# – # that#the#overall#WACC#is#not# influenced#by#changes#in#its#capital#structure #

Traditional!view: !

Under# the#traditional#theory#of#cost#of#capital,#the#cost#declines#initially#and#then#rises#as# gearing#increases.#The#optimal#capital#structure#will#be#the#point#at#which#WACC#is#lowest.#

The!traditional!view!holds!that: !

As#the#level#of#gearing#increases,#the#cos t#of#debt#remains#unchanged#up#to#a#certain# level#of#gearing.#Beyond#this#level,#the#cost#of#debt#will#increase !

The#cost#of#equity#rises#as#the#level#of#gearing#increases#and#financial#risk#increases !

The#WACC#does#not#remain#constant,#but#rather#falls#init ially#as#the#proportion#of# debt#capital#increases,#and#then#begins#to#increase#as#the#rising#cost#of#equity#(and# debt)#becomes#more#significant !

The#optimum#level#of#gearing#is#where#the#company’s#weighted#average#cost#of# capital#is#minimised !

Assumptions!un der!the!traditional!view: !

The#company#pays#out#all#its#earnings#as#dividends #

The#gearing#of#the#company#can#be#changed#immediately#by#issuing#debt#to# repurchase#shares#or#by#issuing#share#to#repurchase#debt #

There#are#no#transaction#costs#for#issues #

The#ear nings#of#the#company#are#expected#to#remain#constant#in#perpetuity #

Business#risk#is#constant#regardless#of#how#the#company#invests#its#funds #

Taxation#is#ignored #

Alternative!view!(Modigliani M Miller): !

Modigliani#and#Miller#stated#that,#in#the#absence#of#tax, # a#company’s#capital#structure#would# have#no#impact#upon#its#WACC.# They # propose d # that#the#total#market#value#of#a#company # is# determine # by# its # total#earnings#and#the#level#of#operating#risk#attached#to#those#earnings. #

Assumptions!under!the!alternative!view: !

A#perfect#market#exists: #

o

Investors#have#the#same#information #

o

Investors#act#rationally #

There#is#no#tax #

There#is#no#transaction#costs #

Debt#is#risk X free #

Market#value#of#a#company: # Earnings#/#WACC #

Market#value#of#equity: # #

Ke: #

#

#

#

Market#value#per#share: ##

Market#value#of#a#company#less#market # value#of#debt #

Earnings#less#interest#/#Market#value#of#equity #

(Earnings#less#interest#/###shares)#x#(1/Ke) #

The#conclusion#of#the#net#operating#income#approach#is#that#the#level#of#gearing#is#a#matter# of#indifference#to#an#i nvestor,#because#it#does#not#affect#the#market#value#of#the#company,# nor#of#an#individual#share.#This#is#because#as#the#level#of#gearing#rises,#so#does#the#cost#of# equity#in#such#a#way#as#to#keep#both#the#WACC#and#the#market#value#of#the#shares#constant. #

M odigliani#and#Miller#modified#their#theory#to#admit#that#tax#relief#on#interest#payments#

does#lower#the#WACC.#The#saving#arising#from#tax#relief#on#debt#interest#is#a#tax#shield.#They# claimed#that#the#WACC# would # continue#to#fall,#up#to#gearing#of#100%. # Thi s#suggests#that# companies#should#have#a#capital#structure#made#up#entirely#of#debt#but#this#does#not# happen#in#practice#due#to#the#existence#of#other#market#imperfections.#

What!is!the!Pecking!order!theory? !

The#pecking#order#theory#is#an#alternative#to#the# traditional#view#and#it#states#that#firms#will# prefer#retained#earnings#to#any#other#source#of#finance,#and#then#will#choose#debt,#and#last# of#all#equity.#The#order#of#preference#being : # 1)#Retained#earnings,#2)#Straight#debt,#3)# Convertible#debt,#4)#Prefer ence#shares,#5)#Equity#shares. #

What!are!the!reasons!for!Pecking!order? !

It#is#easier#to#use#retained#earnings#than#go#to#the#trouble#of#obtaining#external# finance # and#have#to#live#up#to#the#demands#of#external#finance#providers #

There#are#no#issue#costs#if#r etained#earnings#are#used #

What!are!the!effects!of!gearing!on!the!Beta!values!of!a!company? !

If#a#company#is#geared# then # its#financial#risk#is#therefore#higher#than#the#risk#of#an#all X equity# company,# therefore,# the#Beta#value#of#the#geared#company’s#equity#w ill#be#higher#than#the# Beta#value#of#a#similar#ungeared#company’s#equity. #

What!is!the!formula!for!“un M gearing”!a!beta? !

Ba#=#Be#x#Ve#/#Ve#+#Vd#(1 X T) #

What!is!the!formula!for!“ gearing”!a!beta? !

Be#=#Ba#x#Ve#+#Vd#(1 X T)#/#Ve #

How!could!one!estimate!the!beta!factor!for!a!company’s!equity? !

Another#way#of#estimating#a#beta#factor#for#a # company’s#equity#is#to#use#the#beta#values#of# another#quoted#company#that#have#similar#operating#characteristics#to#estimate#a#beta#value# for#the#company#under#consideration. #

Instructions: #

Obtain#published#beta#values#for# companies#in#the#industry #

Convert#the#beta#values#of#other#companies#in#the#industry#to#ungeared#betas# i.e. # using#the#formula#above #

Conve rt#the#ungeared#beta# value # back#to#a#geared#beta#using#the#other#company ’ s# gearing#ratio #

Then#use#the#CAPM#to#estimate#the#cost#of#equity #

!

THE!END. !