10733_CH06.

QXD 26/10/07 14:18 Page 81

chapter 6

Cost of capital

contents
1 Effects of risk on the cost of capital 7 Assessment of risk in the debt versus
2 Cost of equity equity decision
3 Cost of preference shares 8 Cost of capital for unquoted companies
4 Cost of debt capital 9 Cost of capital for not-for-profit
5 Internally generated funds organisations
6 Weighted average cost of capital

learning outcomes
After reading and understanding the contents of this chapter and working through all the
worked examples and practice questions, you should be able to:

 Understand why companies need to know their cost of capital.

 Understand the significance of risk in relation to the cost of capital.
 Calculate the cost of equity (allowing for growth), preference shares and irredeemable debt.
 Understand in principle how to calculate the return on redeemable debt capital and
convertible loan stock.
 Allow for tax relief in calculating the cost of debt capital.
 Discuss the costs of using retained earnings as a source of capital.
 Be aware of the potential relevance of the capital asset pricing model.
 Calculate the weighted average cost of capital (WACC) and discuss its use.
 Calculate the effect of different forms of capital funding on earnings per share.
 Be aware of special problems faced by unquoted companies and not-for-profit organisations
in determining their cost of capital.
10733_CH06.QXD 26/10/07 14:18 Page 82

82 COST OF CAPITAL AND CAPITAL STRUCTURE

Introduction
A company’s cost of capital is the return that it gives to the providers of capital.The
form of the return depends on the nature of the capital. Shareholders receive divi-
dends and usually expect capital growth from increases in the share price.The mix of
dividend income and capital growth depends on the nature of the company. A high-
tech company that is growing fast, and investing in research and development to
support this growth, is holding out the prospect of capital growth but may pay little
or none of its available cash out as dividends.A company in a mature industry – such
as a water or electricity utility – may have few opportunities to invest for growth and
pays large dividends (in relation to the share price) which grow only slowly.
Some investors need a large income straight away from their investment and are
willing to forgo growth to get it. Others are willing and able to wait for their returns
and may prefer them to be in the form of capital gains realised later rather than
income that is subject to tax straight away.When investors buy shares, they have some
understanding of the company’s investment and dividend policies, and select the
companies in which they invest to match their own requirements.
Loan stock holders receive their return in the form of regular, usually fixed,
interest payments and redemption proceeds. Since the market price of loan stock
varies, there is scope for capital gain, though usually less than that expected by many
ordinary shareholders. The returns to holders of convertible loan stock and prefer-
ence shareholders are slightly different and are considered below.
The return that investors require, in whatever form they receive it, depends on
their cost of capital and the risk of the investment (discussed below). An investor’s
cost of capital may be his borrowing cost or his opportunity cost – the return that he
can get by investing elsewhere and which he forgos by investing in this company.
The nature of the risk associated with capital structure is discussed in chapter 9.
The relation between investment risk and return is discussed in chapter 7 on
Portfolio Theory and in chapter 8, which describes and explains the Capital Asset
Pricing Model.
Corporate financial managers need to know the cost of capital in order:
 To make well-informed choices about capital structure and what kinds of new
capital to raise, which means that they need to know the costs of the alternatives.
 To keep informed about the expectations of providers of capital so that they can act
to satisfy these expectations and encourage investors to keep their capital in the
company.
 In particular, in making capital investment decisions, to invest in projects that give
the return that shareholders require, and avoid those that do not.
We will consider initially the costs of the different individual types of capital, before
looking at the cost of the capital structure of the company as a whole.

test your knowledge 6.1

Why does a company need to know its cost of capital?

1 Effects of risk on the cost of capital

Investing in companies involves risk – investors may lose some or all of their money.
The risk comprises two elements:
 business risk associated with the company’s prospects and projects; and
 financial risk associated with the company’s capital structure – the higher the level
of gearing the higher the risk of insolvency and hence the financial risks.
10733_CH06.QXD 26/10/07 14:18 Page 83

6 COST OF CAPITAL 83

The return investors require depends on the level of risk – the higher the risk the
higher the expected return, because people expect to be compensated for bearing
additional risk.This ‘risk premium’ (made up of premiums for business and financial
risks) will be required in addition to the risk-free rate of return.The risk-free return
is the return that would be required if there were no risk and is typically taken to be
the return on government bonds. The returns required from investing in different
companies will vary with their different levels of business and financial risk.

2 Cost of equity
The value of equity is given in the balance sheet by shareholders’ funds and in the
market by the market value of issued ordinary shares.
The cost of equity can be found as the return received by shareholders from the divi-
dends paid, or the earnings after tax, in relation to the share price. (The rationale for
valuing a share on the basis of the expected future dividend stream may need justifica-
tion. Some sharholders expect to receive part of their return in the form of capital gain
when the share price increases, and not just in the form of dividends. If they do, it is
because the price rises since some other investor is keener than before to own the shares.
The justification for basing this increased desire to own the shares on the dividend stream
is that some investors – for example, insurance companies and pension funds – often
invest for the long term, with the express purpose of generating growing future cash
flows to meet their obligations to policy holders, annuitants, pensioners and others.)

2.1 Dividend yield (or dividend valuation) method

One method of calculating the cost of equity is the dividend valuation or dividend
yield model.The precise form of model used depends on the assumptions made.The
simplest model to use assumes that dividends will remain at a constant level in the
future.The value of a company’s shares can be calculated using the formula shown in
the Appendix to chapter 4:
Market value  Current dividend payable in pence/Expected return (or yield) on
the shares.
For use in calculating the cost of equity the formula is rearranged as follows:
Expected return (or yield) on the shares  Current dividend payable in
pence/Market value.
The expected return (or yield) on the shares is the cost of equity and the market
value of the shares is the current ex div share price (i.e. the share price after the divi-
dend has been paid).
This is often written as:
do
Ke   Po
Where: Ke  cost of equity
do  current dividend payable
Po  current ex dividend share price

worked example 6.1

Tosca plc’s current dividend is 25p and the market value of each share is £2. What is the cost of Tosca’s
equity?

Answer
d
Using the above formula Ke  o
Po
25
Ke    0.125  12.5%
200
10733_CH06.QXD 29/10/07 12:07 Page 84

84 COST OF CAPITAL AND CAPITAL STRUCTURE

2.2 Gordon’s dividend growth model

However, as we saw in chapter 4, shareholders prefer a constant growth in their divi-
dends. To reflect this in the dividend valuation method we have to predict future
growth in dividends. Growth generally reflects predicted changes in a company’s
earnings, although it is difficult to decide the level of growth that will be sustained in
future years.The most usual approach is to take several years’ historical data and then
extrapolate forward.

worked example 6.2

Assume Puccini’s past dividends have been:

Dividend per share

Year 1 0.26
Year 2 0.27
Year 3 0.28
Year 4 0.32

We can now find the average rate of growth by using the following formula:


 
n
Growth rate (g)  Latest dividend
1
Earliest dividend
where n  number of years’ growth.


3
g 0.32 1  0.0717 or approximately 7%.

0.26
Note: Here we are using the cube root because there are three years of growth. If we had been given five years’
data (from which we could project four years’ growth) the fourth root would have been used.

When the expected growth figure has been determined we can calculate the value of
Gordon’s Model of the company’s shares using the Dividend Growth Model or Gordon’s Model of
Dividend Growth Dividend Growth.
Equation relating the ex- This model states:
dividend ordinary share (1  g)
price to the dividend, the Po  do 
(Ke  g)
expected annual growth in
dividends and the cost of where: Po  the current ex dividend market price
equity capital. do = the current dividend
g  the expected annual growth in dividends
Ke  the shareholder’s expected return on the shares
The equation above can be rearranged as:
do(1  g)
Ke   Po g

worked example 6.3

Using the example of Puccini above and assuming its share price is £2.50, then:
0.32(1.072)
Ke    0.072  0.137  0.072  20.9%.
2.50
10733_CH06.QXD 29/10/07 12:09 Page 85
worked example 6.4
In the case of Puccini in Worked Example 6.3 above, if issue costs amount to (say) 10 per cent of the capital
raised, the issue cost per share is 10 per cent of £2.50  £0.25. The cost of new equity, allowing for issue
costs, is:
0.32(1.072)
Ke   0.072  0.224  22.4%
2.50  0.25
retained earnings
Profits reinvested in the
business instead of being
paid out as dividends. They
belong to the shareholders
and form part of
shareholders’ funds,
together with equity capital
subscribed by shareholders
and reserves. The cost of
retained earnings is the
same as the cost of other
forms of equity capital
included in shareholders’
funds.
6 COST OF CAPITAL 85
The dividend valuation and dividend growth model are based on the following
assumptions:
 taxation rates are assumed to be the same for all investors and in particular higher
rates of tax are ignored. the dividends used are the gross dividends paid out from
the company’s point of view;
 the costs incurred in issuing shares are ignored;
 all investors receive the same, perfect level of information;
 the cost of capital to the company remains unaltered by any new issue of shares;
 all projects undertaken as a result of new share issues have the same level of risk as
the company’s existing activities;
 the dividends paid must be from after-tax profits – there must be sufficient funds
to pay the shareholders from profits after tax.
Share issue costs
A new share issue involves costs, including the cost of preparing issue documents
and the fees paid to advisors. This means that the capital raised by issuing one new
share is reduced from Po, the issue price, to Po  I, the issue price less the issue cost
per share. If the expression above for the cost of equity capital is adjusted to take
account of this, it becomes:
do(1  g)
Ke    g
(Po  I)
where: Ke  cost of equity raised by the new issue
do  current dividend
g  expected annual growth in dividends
Po  issue price
I  issue cost per share
The cost of exisiting equity capital in Puccini calculated in Worked Example 6.3 was
20.9 per cent. The cost of a new issue of equity capital for Puccini is 22.4 per cent.
Both figures are based on the market price of one share, which is assumed to be the
same in both cases, and the expected future dividends, which are also the same, since
new and existing shares have identical rights and are therefore treated in exactly the
same way for the payment of dividends. The difference is that the cost of existing
capital is based on the market value of one share, while the cost of new capital is based
on what the company receives when it issues the new share: the market value less the
issue cost.
2.3 Retained earnings
Retained earnings are profits reinvested in the business instead of being paid out as
dividends. They belong to the shareholders and form part of shareholders’ funds,
together with equity capital subscribed by shareholders and reserves. As such, the
cost of retained earnings is essentially the same as the cost of other equity capital
calculated above. (In other words, shareholders will only be happy with their
company retaining profits if the company can make the same return on those
retained profits as they get on the money that they have invested in shares.)
10733_CH06.QXD 26/10/07 14:18 Page 86

86 COST OF CAPITAL AND CAPITAL STRUCTURE

Many companies use retained earnings as their main source of new capital.
Reasons for preferring this form of equity capital are discussed in section 5 of this
chapter. One reason for preferring retained earnings over new issues of ordinary
shares is the cost of new issues, which (as shown above) means that the cost of new
ordinary share capital is higher than the cost of other shareholders’ funds, including
retained funds.

2.4 Capital asset pricing model

The capital asset pricing model (CAPM), which we shall look at in detail in chapter 8,
can also be used to find the cost of equity, making explicit allowance for risk. You
should review this topic again when you have worked through chapter 8.

3 Cost of preference shares

The formula for calculating the cost of preference shares is:
dp
Kp  
Sp
where: Kp  cost of preference shares
dp  fixed dividend based on the nominal value of the shares
Sp  market price of preference shares

worked example 6.5

Anorak plc has 8% preference shares which have a nominal value of £1 and a market price of 80p. What is the
cost of preference shares?

Answer
The dividend is 8 per cent of the nominal value (8 per cent of £1  8 pence).
Using the above formula:
dp 8
Kp      10%.
Sp 80

4 Cost of debt capital

We saw in chapter 5 that debentures can be either redeemable or irredeemable. It is
important that you know the type of debenture a firm has in issue when calculating
its cost of capital because, as you will see, the approach used varies with the form of
debentures being considered.

4.1 Irredeemable debt

The formula for calculating the cost of irredeemable debt is:
I(1  t)
Kd  
Sd
where: Kd  cost of debt capital
I  annual interest payment
Sd  current market price of debt capital
t  the rate of corporation tax applicable.
The rate of corporation tax comes into the formula because interest can be offset
against taxation, which lowers the net rate and thus the cost of debt capital. The
10733_CH06.QXD 26/10/07 14:18 Page 87

6 COST OF CAPITAL 87

higher the rate of corporation tax payable by the company, the lower will be the after-
tax cost of debt capital.Thus the cost of debt capital is lower than the cost of prefer-
ence shares with the same coupon rate and market value as the debentures because
there is no tax relief on preference dividends. The effect of tax relief on the interest
cost only applies if the business has taxable profits from which to deduct its interest
payments. If there is a taxable loss for the year, there is no immediate tax relief for
loan stock interest, but the interest increases taxable losses, which can be carried
forward and may be set against profits in future years.

worked example 6.6

Clown plc has £10,000 of 8% irredeemable debentures in issue which have a current market price of £92 per
£100 of nominal value.

Required
If the corporation tax rate is 30 per cent what is the cost of the debt capital?

Answer
The annual interest payment will be based on the nominal value, i.e. 8 per cent of £10,000 or £800, so using
the above formula:
I(1  t)
Kd  
Sd
800(1  0.30)
   0.0609  6.09%.
92/100  10,000

4.2 Redeemable debt

Internal Rate of Return
The discount rate that
makes the Net Present Value
of a project zero – equals the
rate of return on capital
invested in the project (see
Discounted cash flow
analysis).
Redeemable debt is repayable at a fixed future date. The cost of debt capital can be
found using discounted cash flow methods of investment analysis to find the
Internal Rate of Return – the return on capital that an investor gets by investing
in redeemable loan stock. The example that follows describes a situation in which
this approach would be used and states the result. The calculation leading to this
result is set out in chapter 12.

worked example 6.7

Pierrot plc has redeemable 10 per cent loan stock, redeemable on 31 December year 4, with a current market
price on 31 December year 1 of £95.57 per £100 nominal. The corporation tax rate is 30 per cent.

Required
Find the cost of the loan stock capital.

Answer
Pierrot plc will make the following cash payments to a holder of £100 nominal of 10 per cent redeemable loan
stock: £10 in interest on 31 December in each of the years 2, 3 and 4 and repayment of £100 capital on 31
December year 4. Pierrot will receive tax relief on interest paid (for this example, we assume that tax relief is
given one year after each interest payment is made: £3.00 on 31 December in each of the years 3, 4 and 5).
The cash payments for each £100 nominal of 10 per cent loan stock are set out in Table 6.1.
10733_CH06.QXD 26/10/07 14:18
88 COST OF CAPITAL AND CAPITAL STRUCTURE
discounted cash flow (DCF)
analysis
Technique for evaluating
investment projects by
identifying the future cash
flows attributable to the
project and calculating their
present values so that they
can be compared on a like-
for-like basis. The present
value of a future cash flow is
the amount of money at
today’s date that has an
equivalent value. The
present value is calculated
by discounting the future
cash flow to allow for its
timing and the cost of
capital. The sum of the
present values of all the
project’s cash flows is the
net present value (NPV) of
the project. The discount
rate that makes the NPV of a
project zero is the project’s
Internal Rate of Return.
present value
The amount of money at
today’s date that is
equivalent to a sum of
money in the future.
Calculated by discounting
the future sum to reflect its
timing and the cost of
capital (see discounted cash
flow analysis).
discount rate
Cost of capital used to
define interest rates or to
discount cash flows to find
present values (see
discounted cash flow
analysis).
Page 88
table 6.1 Cash payments for each £100 nominal of loan stock
Cash flow
£
Interest (31 Dec year 2) 10
Tax relief (31 Dec year 3) (3)
Interest (31 Dec year 3) 10
Tax relief (31 Dec year 4) (3)
Interest (31 Dec year 4) 10
Redemption (31 Dec year 5) 100
Tax relief (31 Dec year 5) (3)
Total 121
Instead of making these payments, Pierrot plc has the option of buying the loan
stock in the market at the market price of £95.57. By paying £95.57 now, Pierrot
can free itself of the obligation to make the future cash payments shown above.The
sum of £95.57 now is therefore equivalent to the total future cash payments. The
reason why the total of the cash payments shown above (£121.00) is greater than
the current market price of the stock is that the series of cash payments are deferred.
By investing £95.57 now, Pierrot expects to get a return by not having to pay out
larger amounts in the future. The total amount of money now that is equivalent to
the future payments is calculated by discounting each of the future cash flows (i.e.
discounted cash flow analysis) to express it in terms of money at today’s date (in
the example, 31 December year 1). This value expressed in today’s money is the
present value of the future cash flow. The calculation of present values uses a
discount rate equal to the cost of capital and is explained in detail in chapter 12.
For the moment, we show the present values of the cash flows below, using a
discount rate of 9 per cent:
table 6.2 Present values of cash flows
Cash Present
flow value of
cash flow
£ £
Interest (31 Dec year 2) 10 9.17
Tax relief (31 Dec year 3) (3) (2.52)
Interest (31 Dec year 3) 10 8.42
Tax relief (31 Dec year 4) (3) (2.32)
Interest (31 Dec year 4 10 7.72
Redemption (31 Dec year 4) 100 77.22
Tax relief (31 Dec year 5) (3) (2.12)
Total 95.57
As we shall see, if a discount rate of less than 9 per cent is used the present values of
the cash flows in Table 6.1 total more than £95.57. If the discount rate is more than 9
per cent, the present values of the cash flows are less than £95.57. With a discount
rate of 9 per cent, the present values of all the cash flows for £100 nominal of loan
stock are exactly £95.57 – the same as the current market price of the loan stock.This
means that the cost of Pierrot’s loan stock capital is nine per cent.
test your knowledge 6.2
Why is the calculation of the cost of redeemable debt capital or convertible loan
stock more complicated than the calculation of the cost of irredeemable debt
capital or preference shares?
10733_CH06.QXD 26/10/07 14:18 Page 89

6 COST OF CAPITAL 89

4.3 Cost of floating rate debt

If a company has floating rate debt in its capital structure, then an estimated fixed rate
of interest should be used to calculate its cost of debt in a way similar to the above.The
‘equivalent’ rate will be that of a similar company for a similar maturity.

4.4 Cost of fixed rate bank loans

The cost of this major source of finance is given by:
Kd  Interest rate  (1  t)

4.5 Cost of short-term funds and overdrafts

The cost of short-term bank loans and overdrafts is the current interest rate being
charged on the capital lent.

4.6 Cost of convertible stock

To determine the cost of convertible stock we have to find the internal rate of return
(IRR) as the value of r that satisfies the following equation:
K(1  t) K(1  t) K(1  t) K(1  t) VnCR
P0       ... 
(1  r) (1  r) 2 (1  r)3
(1  r)n
(1  r)n
where: P0  current market price of the convertible ex interest (i.e. after paying
the current year’s interest)
K  annual interest payment
t  rate of corporation tax
r  cost of capital
Vn  projected market value of the shares at year n, when conversion can
take place
CR  conversion ratio.
What this equation means is that the cost of the convertible loan stock to the
company is the after-tax cost of the interest payments in future years, together with
the value of the shares issued when the stock is converted. The terms on the right
hand side of the equation represent these cash flows, discounted to bring them to
today’s values.The company could discharge its liability to make these payments by
buying back the convertible loan stock at today’s price. This is the figure on the left
hand side of the equation.The discount rate r that makes the two liabilities equal is
the cost of capital.
The calculation above assumes that the stock will be converted n years from now.
If the projected value of the stock Vs at that time is greater than the conversion value
Vn  CR, investors will not convert, so VnCR should be replaced by Vs in the
equation above.

worked example 6.8

Quality plc has 10 per cent convertible debentures due for conversion in two years’ time. They have a current
market value of £165.32 per cent. The conversion terms are five shares per £10 of debentures. All the debenture-
holders are expected to convert and the shares are expected to have a price of £4 at the conversion date.

Required
What is the cost of capital? Assume the rate of corporation tax is 30 per cent and is payable in the same year as
profits are made.

Answer
The ‘market value of 165.32 per cent’ means that the market price of £100 nominal of 10 per cent.
10733_CH06.QXD 26/10/07 14:18 Page 90

90 COST OF CAPITAL AND CAPITAL STRUCTURE

worked example 6.8 continued

convertible debentures is £165.32. Interest on convertible stock can be offset against tax and is shown as a
saving in the following calculation:
Year 0 1 2
£ £ £
Current market value of debenture (165.32)
Interest 10 10
Tax relief (3) (3)
Value of shares on conversion
((5  100/10)  £4) 200
Total yearly cash flow (165.32) 7 207

Using a cost of capital of 40%:

Year 0 1 2
£ £ £
Total yearly cash flow (165.320) 7 207
Discount factor at 40% 1 0.877 0.769
Present value (165.320) 6.139 159.183

Net present value  (165.32)  6.139  159.183  (0.002)

This shows that with a discount rate (cost of capital) of 14 per cent, the present value of the future cash flows
is equal to the market value of the debenture. This means that the cost of capital is 14 per cent.

Remember that discounted cash flow calculations will be covered in greater detail in
chapter 12.

5 Internally generated funds

internally generated funds
Retained earnings, together
with cash generated by the
business other than profit
(for example, provisions for
depreciation). The preferred
source of investment funds
for many companies.
As we have seen, retained earnings are the most important source of investment
funds for many businesses and are usually the first choice of managers. Internally
generated funds include retained earnings and in addition, cash generated by the
business other than profit.An example is provisions for depreciation: non-cash costs
that are deducted in calculating the profits, but which do not involve payments by the
company, with the result that the amount of cash available for investment is greater
than the profits.
One reason why many businesses choose internally generated funds first as a
source of investment funds is that this avoids the expenses associated with new
equity issues (see above). Other reasons for preferring to use internally generated
funds to other sources of capital are:
(a) All equity-based capital growth usually has lower immediate costs than
borrowing, as dividend yields are usually much less than interest rates on debt
capital; retained profits have no immediate additional dividend costs.
(b) Increased profits arising from new investments raise earnings per share and
present and prospective profit growth may also increase the P/E ratio.With rising
share prices, shareholders may be content to see part or all of their return in the
form of a rising share price rather than increased dividends.This conserves cash.
(c) The limited need for authorisation by non-management stakeholders: if
managers retain the confidence of shareholders, they remain free to make many
10733_CH06.QXD 26/10/07 14:18 Page 91
weighted average cost of
capital (WACC)
A weighted average of the
costs of different kinds of
long-term capital,
calculated to reflect the
amounts of different kinds
of capital (most importantly
shareholders’ funds and
debt) in the company’s
capital structure. The
weights used for the
different kinds of capital
may be either the book
values or the market values.
The WACC is commonly
used as the cost of capital in
evaluating projects. It
represents the cost of
capital for projects with a
normal level of business risk
and where funds are raised
in similar proportions to the
existing capital structure.
6 COST OF CAPITAL 91
decisions on investments and funding and can rely on shareholder support for
larger decisions that need to be approved by general meetings of the company.
(d) No change is involved in the balance of equity control. New equity issues can
lead to dilution of the control exercised by existing shareholders.
(e) Bank borrowing, including overdrafts, brings with it third party scrutiny that
may be salutary but is often not welcomed by managers.
(f ) Fixed interest borrowing raises gearing and with it the possibility that operating
cash flows may not cover interest payments if profits come under pressure.
There are some factors limiting the use of internally generated funds:
(a) There may not be enough internally generated funds. Particular cases are new
companies that may need a lot of cash for investment but may not yet be making
profits – or even generating revenue! Examples of the latter could be fledgling
biotechnology or e-commerce companies.
(b) The flow of funds may not match the timing of investment requirements.
(c) Interest on debt attracts corporation tax relief. Dividends do not.
(d) It may be possible to determine an ideal mix of equity and debt in the capital
structure.This is discussed in chapter 9.
(e) Although the immediate cash cost of new equity may be low and of retained
funds nil, the total cost of equity includes capital growth as well as income
(growth in the share price as well as dividends). Investments should be limited
to those that give a rate of return that justifies this cost, plus a margin for risk.
This is discussed in chapter 12. If no suitable investments are available, share-
holders are incurring an opportunity cost by having their money kept in the
company and may be able to use it more profitably elsewhere. The money
should be paid out to them. In recent years several large companies (including
privatised utilities and de-mutualised building societies) have made special
dividend payments for this reason.
test your knowledge 6.3
Why may companies choose to provide capital from internally generated funds?
6 Weighted average cost of capital
Companies tend to have a mixture of the different types of capital in their structure
and when considering the cost of capital used to finance a project it is common to use
the cost of the mix of capital held by the company.We use the weighted average cost
of capital (WACC).This is because the cost of capital that should be used in evalu-
ating projects is the marginal cost of the funds raised to finance the project and the
WACC is considered to be the best estimate of marginal cost (the capital structure of
a company changes slowly over time). Note, however, that it only gives the most reli-
able estimate if the company is investing in projects with a normal level of business
risk and funds are raised in similar proportions to its existing capital structure.
WACC can be calculated using the following formula:
E
( )
WACC  Keg   Kd (1  t) 
ED
D
ED ( )
where: Keg  is the cost of equity in the geared company
Kd  the cost of debt before tax relief
E  the market value of the company’s equity
D  the market value of the company’s debt
t  the rate of corporation tax applicable to the company
10733_CH06.QXD 26/10/07 14:18 Page 92

92 COST OF CAPITAL AND CAPITAL STRUCTURE

The formula above assumes that debt is irredeemable, which means that the cost of
debt capital is purely interest, all of which qualifies for tax relief. If debt is
redeemable, the cost of debt is calculated as described in section 4.2 and used to
replace Kd (1  t) in the formula above.
The weighted average cost of capital is the average of costs of the different types of
finance in a company’s structure weighted by the proportion of the different forms of
capital employed within the business.The financial manager needs to ensure that any
project under consideration will produce a return that is positive in terms of the busi-
ness as a whole and not just in terms of an issue of capital made to finance it.
Investments which offer a return in excess of the WACC will increase the market value
of the company’s equity, reflecting the increase in expected future earnings and divi-
dends arising as a result of the project.
There is no one accepted method of calculating the weighting factors for different
forms of capital. Some companies use book values from the company’s balance sheet
and some use market values. Unquoted companies may have to use book values
because of the problems that we have discussed earlier in estimating market values.
The choice between market values and book values is discussed further in chapter 9.

worked example 6.9

(a) Using book values in the proportions in which they appear in the company’s accounts:
Weighting Cost Weighted cost
Ordinary shares 60 per cent 12 per cent 7.2 per cent
Debentures 40 per cent 8 per cent 3.2 per cent
WACC 10.4 per cent
(b) Using market values:
Number Price Market Cost Market
value per cent value 
Cost
£ £ £ £
Ordinary shares 6,000 2.50 15,000 12 per cent 1,800
Debentures 4,000 1.50 6,000 8 per cent 1,480
21,000 2,280
The WACC is then calculated as:
£2,280
  10.86%
£21,000
Both methods produce the historic WACC (based on the relative weights of equity and debt capital in the past).
You should remember that raising fresh capital may alter the weighting and therefore the cost of capital. A
change in the company’s level of risk will also affect the company’s cost of capital.

test your knowledge 6.4

Which companies are relatively more likely to calculate WACC using book
values?

6.1 Assumptions when using WACC

To use WACC in capital investment appraisal the following assumptions have to
be made:
 the cost of capital used in project evaluation is the marginal cost of funds raised to
finance the project;
10733_CH06.QXD 26/10/07 14:18 Page 93

6 COST OF CAPITAL 93

 new investments must be financed from new sources of funds, including new
share issues, new debentures or loans;
 the weighted average cost of capital must reflect the long-term future capital struc-
ture of the company.

6.2 Arguments against using the WACC

There are arguments against using WACC for investment appraisal based mainly on
the assumptions underlying WACC.
(a) Businesses may have floating rate debt whose cost changes frequently and as we
have seen only an estimate is used to calculate the cost of this type of finance.
Thus the company’s cost of capital will not be accurate and will need frequent
updating.
(b) The business risk of individual projects may be different from that of the company
and will thus require a different premium included in the cost of capital.
(c) The finance used for the project may alter the company’s gearing and thus its
financial risk.

7 Assessment of risk in the debt versus equity

decision
7.1 Effect on market value
The direct cost of borrowing consists of interest, together with any fees charged by
the lender. Both interest and fees are generally deductible for tax purposes.Although
borrowing may appear cheaper than equity, there is a risk to the company that should
be taken into account when comparing costs. Consider the following example.

worked example 6.10

A company has a current profit before interest and tax (PBIT) of £5m pa and current interest payable of
£1.7m. The company’s issued share capital comprises 10m £1 ordinary shares and the earnings per share
(EPS) are 5p.
The firm wishes to invest £7.5m of new capital and it expects to increase its PBIT by £1.25m pa as a result.
The alternatives under consideration by the directors are as follows:
(a) To issue 3.75 million shares at 200p, representing a discount on the current market price of 240p.
(b) To issue £7.5 million of 10-year debentures with a 12 per cent interest coupon.
Assume a corporation tax rate of 30 per cent.

Answer
One approach to decide on the better route would be to attempt to predict the effect on the market value of the
ordinary shares. The company would then elect for the opportunity which gives the best return to shareholders
(remember the dominant objective of financial management). Table 6.2 below shows the effect on the earnings
per share.
EPS will be improved if capital is raised in the form of debt rather than equity, provided PBIT really does
increase by £1.25m.
However, the use of debt has a higher level of risk than equity, because:
 interest payments and debt capital repayments cannot be deferred if projected returns fail to materialise,
whereas dividends can be reduced or passed (not paid at all);
 use of debt capital could result in a lower price/earnings ratio for the shares (reflecting this increased risk).
In our example the debt option would increase the gearing ratio and the interest cover (PBIT/interest) would
fall from the present 2.94 to 2.4. (We shall consider gearing in detail in chapter 9.)
10733_CH06.QXD 26/10/07 14:18 Page 94

94 COST OF CAPITAL AND CAPITAL STRUCTURE

worked example 6.10 continued

table 6.2 Effect on earnings per share

Current Projected Projected
equity debt
(£m) (£m) (£m)

PBIT (5.00 (6.25 (6.25

Interest payable (1.70) (1.70) (2.60)
Profit before tax (3.30 (4.55 (3.65
Tax at 30 per cent (0.99) (1.365) (1.095)
Profit after tax (2.31 (3.185 (2.555
Issued ordinary shares (10m (13.75m (10m
Earnings per share (23.1p (23.2p (25.6p

A higher interest cover means a smaller risk that, in the event of a fall in PBIT, there
will not be enough profits to pay the interest.

7.2 Break-even profit before interest and tax

cost of capital
The cost to a company of the
return offered to different
kinds of capital. This may be
in the form of interest (for
debt capital) or dividends
and participation in the
growth of profit (for ordinary
shares) or dividends alone
(for preference shares) or
conversion rights (for
convertible loan stock or
convertible preference
shares) or capital gain (for
loan stock issued at a
discount). The cost of
retained profits is the same
as the cost of equity.
The financial manager may choose to compute the break-even PBIT at which the
earnings per share will be the same for the use of either equity or debt. For the
example above, this is done as follows (y represents the break-even level of PBIT):
Debt Equity
(1  t) (PBIT  Interest) 0.7(y  2.60) 0.7(y  1.70)
EPS     10  
no. of shares 13.75
which gives:
y  5.0
The break-even level of PBIT is £5m. Earnings per share will be greater using debt if
PBIT is greater than £5.0 million and greater using equity if PBIT is less than £5.0
million. In practice, more than one source of financing may be used and the financial
manager needs to consider the risks and rewards of the alternatives.
It is quite common for a company to use leases for a large part of its expenditure
on capital items and to use equity for its increased working capital needs (though the
expenses involved in an equity issue mean that a quoted company will be unlikely to
consider raising less than £250,000 in a new equity issue).While the calculations in
this chapter are easier to do for quoted companies (because share prices are known)
the underlying principles are applicable to all businesses seeking new capital.
stop and think 6.1
If a company calculates how its projected EPS will be affected by raising new
capital through (a) new equity or (b) new debt and makes its decision on whether
to issue equity or debt on the basis of which gives the higher EPS figure, what
risks is it ignoring?
8 Cost of capital for unquoted companies
Unquoted companies do not have market values for their shares and thus calculating
the cost of equity can be difficult. To estimate an approximate cost of capital the
firm can either use the cost of equity of a similar quoted company and adjust it for
10733_CH06.QXD 26/10/07 14:18 Page 95

6 COST OF CAPITAL 95

difference in financial and business risk, or it could add estimated premiums for its
financial and business risk to the risk-free rate given by government bonds.

9 Cost of capital for not-for-profit organisations

Government departments do not have a market value, nor do they have business or
financial risk. So they cannot calculate the cost of capital.To evaluate projects they use
a targeted ‘real rate of return’ set by the Treasury as a cost of capital. Not-for-profit
organisations do not have market values and have to determine their cost of capital in
other ways. Many use the cost of borrowing.You will appreciate from this chapter that
this gives only a partial picture.

stop and think 6.2

(a) What does this approach to identifying the cost of capital miss out?
(b) How does your organisation determine its cost of capital? What is the result?

chapter summary
In this chapter we considered the costs of the different types companies and other organisations. It is important when you
of capital individually, before looking at the cost of capital are revising this area to consider also the capital asset pricing
structure on the company as a whole. We also saw the model, which we shall discuss in chapter 8.
problems in determining the cost of capital for unquoted

practice questions
Section A (4 marks each)
6.1 ‘Companies should use retained earnings to finance new projects because they are free.’
Discuss this point.

6.2 Describe the difficulties in obtaining a cost of capital for a private limited company

Section B (20 marks each)

6.3
(a) (i) Describe the purpose of the dividend valuation and dividend growth models.
(ii) State the relevant formulae.
(iii) State the assumptions underlying them.
(b) A company has a share value of £1.27 (ex-div) and has recently paid a dividend of 8p per share. If dividend growth is
expected to be approximately 3 per cent per annum into the foreseeable future, calculate the cost of equity.
(c) What is the attraction of issuing debt capital as opposed to preference shares?

6.4
(a) Why should the weighted average cost of capital (WACC) be used to evaluate the required return on a project?
(b) Calculate the WACC from the following, using two different approaches to calculate the weighting factors:
10733_CH06.QXD 26/10/07 14:18 Page 96

96 COST OF CAPITAL AND CAPITAL STRUCTURE

Balance Sheet Extract from CD Plc

Capital Balance sheet value Market value
Ordinary shares
(20,000 – 50p ordinary) £10,000 £1.72 per share
8% Preference shares
(£1 nominal value) £5,000 £0.98 per £1
Long-term liabilities
10% debentures £7,500 £1.04 per £1
The cost of equity has been calculated at 9.5 per cent. The corporation tax rate is 30 per cent.

6.5 Zeta plc is planning to raise £2.5 million (before expenses) through an issue of ordinary shares. The issue price is £1.25.
The expenses of the issue are expected to be £300,000. The company has just paid a dividend of 4 pence per share for
2002. Three years ago it paid a dividend of 3 pence for 1999. Investors expect future dividend growth at the same rate as in
recent years.

Required
(a) Calculate the cost of equity capital using the Gordon dividend growth model.
(b) Calculate the dividend yield, and explain the difference between this and the cost of capital in (a).
(c) Calculate the cost of Zeta’s irredeemable 8 per cent debenture capital, the market price of which is £110 per £100
nominal (Zeta pays corporation tax at 30 per cent). State any assumptions you make, and justify any choices you make
in doing your calculations.
(d) Explain (without doing any calculations) how you would calculate the cost of redeemable debt capital.