COST OF CAPITAL (FINANCE )

In this we have to calculate the separate costs of capitals.

Types of capital in a company.

1. Equity = Own money e.g Ordinary Shares

2. Debt = Borrowed money e.g Bonds, Loan notes etc

3. Hybrid finance = mixture of above two e.g Preference Shares

Difference between Debt and Equity

Debt Equity

Preference Share
Fixed Income Fixed Income NO Fixed Income

NO ownership in the NO ownership in the ownership in the

company company company

Gearing ( Leverage ) = Debt/ Equity or Debt / Debt +Equity

Return is directly proportional to RISK

Which one is Riskier : Debt or Equity ??
Wealth Maximization
Capital Gains : Increase in the value of shares
Dividend : Profit earned by Co. and paid to shareholder

We have to determine : At what rate the Debt or Ord.

Shares will cost the company.
E.g MCB provides debt /loan @ 8% p.a.
What is Tax %. i.e 30%

Cost of loan = Interest ( 1- Tax )

8% ( 1- 30% ) = 8% ( 70% ) = 5.6%

5.6%

Types of debt capital

1. Bonds
 Redeemable ( IRR )

Redeemable at Premium
Redeemable at Par
Redeemable at Discount
 Irredeemable Int.( 1-T)
 2. Debenture
3. Loan Notes
4. Bank loan
5. Bank Overdraft

E.g A company has issued bonds with a return rate of 8%.

These are redeemable in 5 years time at par. Tax is 30%.

IRR= ?? = Cost of Debt

IRR Required

1. CFs x 3
Initial payment to buy Bonds, = -$100
Interest= $8 ( 1-tax) = $5.6
Redemption value = $100
2. NPV x 2
3. Discount Factors x 2 ,assume 2 DF , 5% and 10%
$ Time DF @5% PV @5% DF @ 10% PV@10%
Initial -100 Year0 1.00 -100 1.00 -100
Payment
Interest 5.6 Year1-5 4.329 24.24 3.791 21.23
Redemptio 100 Year 5 0.784 78.4 0.621 62.10
n
2.64 -16.67

IRR = LR + (LRNPV /LRNPV-HRNPV) x ( HR-LR )

= 5% + [ (2.64/ 2.64+16.67) x ( 10%-5% )]

=5% + 0.1367 x 0.05

5% +0.68%

5.68%

This means these bonds are costing the company at 5.68%

Example : ABC co has in issue $ 5 million Bonds,

redeemable in 6 years time. Interest payable on these bonds
are 9% and redeemable at 15% premium. The bonds are
trading in market at $108.75. Find Cost of debt. Tax rate is
20 %.

Solution :

To find out the cost of debt, we have to find IRR. And to find
IRR we need

1. CF x 3
Market value of Bond = $108.75
Interest (1 –tax) = 9% of Face Value = $9 ( 1 – tax) = $ 7.20
Redemption value = Face value x 1.15 = $ 115

2. DF X 2
3. NPV X2
 Then we put these above in the IRR formula.
$ CFs Time DF @5% PV @5% DF @ 10% PV@10%
Initial -108.75 Year0 1.00 -108.75 1.00 -108.75
Payment
Interest 7.20 Year1-6 5.076 36.55 4.355 31.36
Redemptio 115 Year 6 0.746 85.79 0.564 64.86
n
13.59 -12.53

IRR = LR + (LRNPV /LRNPV-HRNPV) x ( HR-LR )

= 5% + [ (13.59/13.59+12.53) x ( 10%-5% )]

=5% + 2.6%

Kd=IRR= 7.6%

Number of Bonds = $ 5000,000 / $ 100 = 50,000

Cost Of Equity = Kequity = KOrd Shares

we have to consider 2 Formula

Ke= do ( 1 + g ) / MV + g
Where d0 = dividend recent
Growth = g = in dividends
MV = Market value of Ordinary Share
From where we have to dine the growth ???

Dividend
2006 07 08 09 10 11 12 13
11 11 13 17 17 19 21 28

Growth = [(Most Recent / Oldest)n-1 – 1] x 100 = g %

[(28 cents / 11 cents )1/7 - 1 ] x100 = % growth = 14.37%

28 x 1.1437 = 32.06 cents

There is another formula to find g =

G=rxb
R= ROCE
B = % of retained earnings

EXAMPLE :
ABC co has just paid the dividend of 15.57 cents per
share.the oldest known dividend is 11.07 cents 8 years ago.
The co shares are floating at $3.85. what will be cost of
equity?
The formula we will use for Ke will be
Ke = do ( 1 +g ) / MV + g
So now, we have to find the g , and the formula for g will be
G = [( most recent /oldest )1/n-1 – 1] x 100
= (15.57/11.07)1/7
1.410.1430 = 5%
= (15.57( 1.05) / 385) + 5%
= 4.24% +5 % =
Ke= 9.24 %

The figures MUST be in cents

The other formula for Ke =

Ke =Rf + Beta ( Rm –Rf )
= CAPM
Capital Assets Pricing Model ( formula )
Rf = Risk free investment , the lowest return
Rm = Market risk , return is higher than Rf
Beta is risk factor that is VITAL.
Beta will be given in exam e. g 1.15
Beta = 1 = your risk = avg risk
Beta = 0.90 = risk is less than avg = its low risk co
Beta = 1.20 = risk is greater than avg = its ahigh risk co.

Example : A co has a beta of 1.05, Rf = 4 % and Risk

premium is 7% . Find cost of equity
Ke = Rf + B( Rp)
= 4% + 1.05 (7% )
4% + 7.35%
Ke = 11.35 %

WACC
Rs 100,000
Euity =75000
Bank Loan = 15000
Bonds ( Redeemable ) = 10000

[12% ( 75000)+10%( 15000)+9.2%( 10000) ] /100,000

WACC = 11.42%

Example :
ARC Co. has a cost of equity = 14.10% , Cost of debt ( loan ) =
7.8% , and Bonds = 8.56% . ARC has total capital of $ 540
million . WACC = ? Assume that Equity covers 80% of capital ,
while the two source of debt covers 10% each.

If the costs are not given, then we have to find them, one by
one , applying different formula for each source of finance.

Equity = 540 x 80 % = 432

Debt Loan = 540 x 0.10 = 54
Debt Bonds = 54 x 0.10 = 54

$432( 0.1410) + $54( 0.078) +$ 54 ( 0.0856 ) = 69.75 / 540

60.912 + 4.212 +4.62= 69.75 / total capital
69.75/540 = 12.90 % this our WACC and will be used in inv
app as discount factor to find NPV in the questions.

BKB = Exam Practice Question

Ke = Rf + B ( Rp )
= 4% +1.2 ( 5% )
10%

Preference shares
Kp = d / MV
5 / 62.5 = 8%

Loan= Debt = Kd = Interest ( 1 – tax )

6% ( 1- 30% )
Loan= Debt = Kd = 4.2%

Kd = Convertible Bonds = 6.44 %