BAF 361 INTRODUCTION TO CORPORATE FINANCE

AND BANKING

LECTURE 6- Cost of Capital I

Samuel Gameli Gadzo

2 Learning outcomes
By the end of this lecture, you should be
able to:
´discuss the importance of cost of capital
´explain what is meant by pooling of funds
´Estimate and interpret the cost of equity
´Estimate and interpret the cost of debt
´Estimate and interpret the cost preference
shares
3 Introduction
´ Costs of capital is the cost to an entity for raising
capital
´ Cost = price
´ Capital = finance or funds
´ Cost of capital: price it will cost to raise finance
´Two categories of capital exist:
´Debt instruments
•bonds, loans, overdrafts
´Equity instruments
•ordinary shares, preference shares
4 Pooling of funds
´Various sources of finance are pooled or
grouped together
´Investments are financed out of this pool of
funds
´Entities aim to establish a long-term target
capital structure
´WACC is the preferred cost, rather than the
cost of each individual source
5 Cost of capital
´Cost of capital is the cost of raising
finance
´Cut-off rate between worthwhile and
unworthwhile investments
´Includes three components:
´ Cost of ordinary shareholders’ equity
´ Cost of preference shares
´ Cost of debt
6
Cost of ordinary shareholders’ equity
´Fairly challenging to calculate as the cost
must include the risk undertaken by the
shareholders
´Also known as cost of ordinary shares or
cost of equity
´Cost of equity can be calculated in one
of two ways:
´Dividends
´Capital Asset Pricing Model (CAPM)
7 Dividends
´Use of dividends depends on company’s
policy
´If the entity does not declare dividends,
this method cannot be used to calculate
cost of ordinary shares
´Dividend options to calculate cost of
equity:
´Dividend valuation model
´Dividend growth model
8 Dividend valuation model
´Market price of a share is assumed to be present value
of future dividends where annual dividend is paid in
perpetuity
´Dividend valuation model formula:
!!
Ke =
"!
Where:
Ke = cost of ordinary shares
D0 = constant annual dividend (in perpetuity)
P0 = ex-dividend market price of ordinary shares
9 Dividend growth model
´ Market price of share assumed to be present value of future
dividends where growing dividend is paid in perpetuity
´ Dividend growth model formula:
!! (#$%)
Ke = + g.
'!
!! (#$%)
Where there is floatation cost in cedis Ke = +g
'!()
!! (#$%)
Where there is floatation cost in percentage Ke = ' (#()%) + g
!
Where
ke = cost of ordinary shares
D0 = current dividend
P0 = ex-dividend market price of ordinary share
g = expected constant annual growth rate in dividend
F = Floatation cost in cedi
f% = Percentage of floatation cost
 Illustration 1: Cost of ordinary share without
10 floatation cost
Question
Gidimadjor ltd has issues a GH¢ 1 ordinary shares. The ordinary
shares are currently trading at GH¢ 400. A dividend of GH¢ 0.30 per
share has just been paid and the directors estimate that dividends
will increase by 10% each year in perpetuity. Calculate the cost of
ordinary shares.

Answer
!! (#$%)
´ Ke = '!
+g
+,¢-./- (#$-.#)
´ Ke = + 0.1
+,¢0--

´ Ke = 0.1825 𝑜𝑟 18.25%
 Illustration 2: Cost of ordinary share with
11 floatation cost
Question 1 Question 2
Gidimadjor ltd has issues ordinary shares Gidimadjor ltd has issues ordinary shares
incuring a floatation cost of GH¢ 30 per incuring a floatation cost of 21% per share.
share. The ordinary shares are currently The ordinary shares are currently trading at
trading at GH¢ 400. A dividend of GH¢ GH¢ 400. A dividend of GH¢ 0.30 per share
0.30 per share has just been paid and has just been paid and the directors estimate
the directors estimate that dividends that dividends will increase by 10% each year
will increase by 10% each year in in perpetuity. Calculate the cost of ordinary
perpetuity. Calculate the cost of shares.
ordinary shares.
Answer
Answer
!! (#$%)
!! (#$%) ´ Ke = +g
´ Ke = +g '!()
'!()
*+¢,.., (#$,.#)
*+¢,.., (#$,.#) ´ Ke = + 0.1
´ Ke = + 0.1 *+¢/,,(#(,.0#)
*+¢/,, (*+¢.,
´ Ke = 0.1015 𝑜𝑟 10.15%
´ Ke = 0.1009 𝑜𝑟 10.09%
12 Dividend methods
Advantage of the dividend methods
´Fairly simple to calculate (if a dividend is paid)
Disadvantages of dividend methods
´Neither dividend method can be used if a
dividend is not paid
´Risk not considered
´The growth model assumes a constant growth
rate
13 CAPM
´ Capital Asset Pricing Model
´ CAPM technique considers
risk
´ CAPM formula:
Ke = rf + 𝛽 (rm –rf)
Where:
ke = cost of ordinary share
rf = risk-free rate of return
ß = beta coefficient of the share
rm = return on the market portfolio
rm – rf = market risk premium
Question
Capital ltd has a beta (𝛽) of 1.3.
The expected return on the
market portfolio is 16% and the
current risk-free rate is 8%.
Calculate the cost of ordinary
shares.
Solution
Ke = rf + 𝛽 (rm –rf)
Ke = 8%+ 1.3(16% – 8%)
Ke = 18.4%
14 CAPM method
Advantages of CAPM
´ CAPM incorporates risk, while the dividend
methods do not
´ Dividends are not required to estimate the cost of
equity
Disadvantages of CAPM
´ Requires a beta coefficient and the return on the
market portfolio
´ CAPM is only a single-period model
15 Cost of preference shares
´Related to the dividend paid on preference
shares
´Preference dividends are not deductible for
tax purposes
´Calculation of cost of preferences shares
depends on whether preferences shares are
redeemable or not
´Non-redeemable – use perpetuity principles
´Redeemable – use annuity principles
16 Non-redeemable preference shares
Question
´ The cost of non-
redeemable preference Non-Redeemable ltd has 9% non-
shares can be calculated redeemable preference shares in
as follows: issue. The preference shares have a
par value of GHC 1and are currently
!
Kp = trading at GHC 1.08. Calculate the
"! cost of preference shares.
Solution
Where: "
kp = cost of preference Kp =
#!
shares D= 9% * GHC1 = GHC 0.09
D = fixed annual dividend
(in perpetuity) Po = GHC 1.08
P0 = ex-dividend market $%& '.')
Kp = $%& *.'+
price of preference
shares Kp = 0.083 or 8.33%
 Non-redeemable preference shares with
17
floatation cost
Non-cumulative preference shares: These are preference shares whose dividends
do not get carried forward to the next year if they are not paid during a year.
If the company issues new preference shares, the cost of preference capital
would be:

Kp = Annual dividend / Net proceeds - floatation costs, if any.

Example: A limited company issues 8% preference shares which are

irredeemable. The face value of share is GH¢ 100 but they are issued at GH¢ 105.
The floatation cost is GH¢ 3 per share.
Kp = GH¢ 8/(GH¢ 105-GH¢ 3) = 7.84%

If the floatation costs are expressed as percentage, the formula will take the
following shape:
Kp = Annual dividend/Net proceeds(1-floatation costs)
18 Redeemable preference shares
The cost of redeemable preference shares can be calculated using
annuity principles
"#$##%&'(# )&(*# +,&(*# -&(*# ")+78
899:;< =>?>@A9@$ .*%'#/ 01 2#&/, 10/ /#$#%34506 =$
Kp = (BA@AAC;D<A ?;<:A$E;<:A ?;<:A)/G
or Kp =(BH$EH)/G
.

Question
Redeemable ltd has 9% redeemable preference shares in issue. The preference
shares have a par value of GH 1 and are currently trading at GHC 1.08 . The
preference shares are redeemable at par in five years time. Calculate the cost of
preference shares.
Solution
"#$%&
,-
Kp = '
. D = 9% * GHC 1 = 0.09
(/0-10)/4
($(.*+
'.')-
Kp = ,
Kp= 0.0712 or 7.12%
(*-*.'+)/4
19 Redeemable Pref. Shares with floatation
cost
Question
A company issues 10,000, 8% preference shares of GH¢ 100 each
redeemable after 20 years at face value. The floatation costs are
GH¢ 3 per share.
Solution
Redeemable value = GH¢ 100;
Sale value = GH¢ 100-GH¢ 3 = GH¢ 97
Annual dividend = 8% * GH¢ 100 = GH¢ 8 per share.
9::+;<
I$
Kp = =:
Kp= 0.0827 or 8.27%
(#--$#JK)/G
20 Cost of debt
´Cost of debt is the return that the company’s
lenders demand on new debt i.e. interest rate
that a company must pay on new debt
´It can be calculated by observing current interest
rates in the market
´Difference between cost of preference shares
and cost of debt is that interest on debt is tax-
deductible
´Dividend on preference shares not tax-
deductible
21 Non-redeemable debt
´ Use perpetuity principles Question

´ The cost of non-redeemable Non- Redeemable ltd has 8% non-

redeemable debentures in issue. The non-
debt can be calculated as redeemable debentures have a par value
follows: of GH¢100 and are currently trading at
#(%&') GH¢90. Company tax is currently 28%.
Kd = Calculate the cost of the non-redeemable
"! debentures
Where: Solution
kd = after-tax cost of debt
i= 8%* GH¢100 = GH¢5.76 8
i = fixed annual interest in perpetuity GH¢8(#(,.01)
Kd =
t = rate of company tax (%) GH¢90
P0 = ex-interest market price of debt GH¢5.76
Kd =
GH¢90
Kd = 0.064 or 6.4%
22 Redeemable debt/ Bond
The cost of redeemable debt Question
or bond valuation can be ABC ltd has issued 8% GH¢100 5 years bond
which are currently trading GH¢90. The bonds
calculated are redeemable at GH¢105 in 5 years time.
!"# $"%&' ()&##'*+ !#,-' Company year’s time. Company tax is currently
567869- ."+&#,+/ !'#,01 28%. Calculate the cost of bonds.
Kd =
(:;< 0;=7>-57<<>9? :<@A>)/4 Solution
After tax cost of debt = Kd (1-t) Coupon = 8%* GH¢100 = GH¢8
Where Par Value= GH¢100
Current Price = GH¢ 90
Coupon = Coupon rate * Par value
Maturity Period = 5 years
Par Value= Face value of Bond GH¢8 2 GH¢100 !GH¢90
" #$%&'
Kd =
Current Price = Market Price (GH¢1002 GH¢90)/6

Maturity Period = Number of year GH¢8 2GH¢2

left for the bond to mature Kd = = 0.1052
GH¢95
Kd= 0.1052*(1-0.28) = 0.0757 or 7.57%
23 Conclusion
´ The cost of capital is the rate of return that an entity’s providers of capital
require on the funds they have provided.

´ Cost of capital relating to an investment depends on the risk of that

investment.

´ Cost of capital depends primarily on the use of funds and not the source.

´ When a suitable project is identified, the investment in the project is financed

from a pool funds rather than by a specific form of finance.
´ Cost of capital consists of:
§ Ordinary shares
§ Preference shares
§ Debt
´ The cost of ordinary shares can be calculated by either making use of
dividends or the Capital Asset Pricing Model.
24 Conclusion (cont.)
´ If dividends paid are not constant, then a constant average
annual growth rate can be calculated for use in the dividend
growth model.

´ The CAPM method of estimating the cost of ordinary shares

specifically incorporates risk into the calculation.

´ The beta coefficient is a measure of the change in the price of

an individual security compared with the change in the return
on the overall market or a market index.
25 Conclusion (cont.)
´ The dividend paid on preference shares is not deductible for tax
purposes, whereas the interest paid on debt is tax-deductible.

´ The calculation of the cost of preference shares and debt

depends on whether these sources of finance are redeemable or
non-redeemable.
26

END OF
LECTURE