LECTURE-5

COST OF CAPITAL
Cost of capital is the required rate of return for a given security. It’s the minimum return
that the security must promise to the investors for it to appeal to them.

For purposes of determining the cost of capital, there are FOUR main classes of
securities/sources of capital:

1. Ordinary shares
2. Preference shares
3. Debt
4. Retained earnings

Component cost of capital;

This refers to the cost of each of the above sources of finance. Thus;

Component Particulars Formulae Narrative

Ordinary Zero dividend D D- dividend per
Ke 
shares growth model P0 share

P- market price per

share
Constant D1 This model builds
Ke  g
dividend growth P0 from;
model
D0 1  g 
P0 
r  g 
D0- DPS just paid

D1- DPS to be paid

after 1 year.

g- constant growth
rate

Ke- cost of equity

P0- market price

per share

Page 1 of 20
Preference D D- preference
Kp 
share P0 dividend per share

P0- market price

per share
Debt Irredeemable Kd- after tax cost of
Kd 
I
1  T  debt
Vd

I- amount of
interest

Vd- value of debt

T- tax rate
Redeemable  Mn  Pb  I- amount of
I   interest in ksh.
1  T 
K d  YTM   n
 Mn  Pb 
  Mn- Redemption
2 value

Pb- Market value

or issue price

T- Tax rate

n- Number of years
to maturity

Retained Zero dividend D Kr- cost of retained

Kr 
earnings growth model P0 earnings
Constant D
Kr  1  g
dividend growth P0
model

Note:

Re deemable Value  Sale Value

I
Kd  n 1  T 
Re deemable Value  Sale Value
2

Page 2 of 20
Illustration-1

The Blue Chip ltd has ordinary shares outstanding that has a current price of ksh. 20 per share
and a ksh. 0.50 dividend. The company’s dividends are expected to grow at a rate of 3% per
year, forever.

Required:

Calculate the cost of equity for the company

Solution:

D1
Ke  g
P0

D0= Ksh 0.50

D1 = D0(1+g) = 0.50(1+0.03) =0.515

Ke = {[0.50(1 + 0.03)] /20} + 0.03 = 0.05575 or 5.575%

Illustration-2
The Safcom ltd has ordinary shares outstanding that has a current price of ksh. 126 per share
and a ksh. 3.20 dividend. The company’s dividends are expected to grow at a rate of 7% per
year, forever.

Required:

Calculate the cost of equity for the company

Solution:

D0 = 3.20

D1 = 3.20(1+0.07) = 3.424

Ke = (3.424÷126) + 0.07 = 0.0972 = 9.72%

Illustration-2

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Additional-illustration

The Telcom ltd has ordinary shares outstanding that has a current price of ksh. 76 per share
and a ksh. 1.20 dividend. The company’s dividends are expected to grow at a rate of 8% per
year, forever.

Required:

Calculate the cost of equity for the company

Additional-illustration

The Telcom ltd has ordinary shares outstanding that has a current price of ksh. 76 per share
and a ksh. 1.20 dividend per year forever.

Required:

Calculate the cost of equity for the company

Illustration-3

MRM ltd has a ksh. 4,000,000 irredeemable bond with an interest rate of 12%. The
corporation tax applicable to the company is 30%.

Required:

Calculate the after-tax cost of debt to MRM

Solution:

Kd 
I
1  T 
Vd

I = 12% x 4,000,000 = ksh 480,000

Vd = 4,000,000

Kd = (480,000÷4,000,000)x(1-0.30) = 0.084 = 8.4%

Illustration-4

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A company has ksh. 1 million loan with a 5% interest rate and ksh. 200,000 loan with a 6%
rate. It has also issued bonds worth ksh. 2 million at a 7% rate. The corporation tax rate
applicable to the company is 30%. All these debts are irredeemable.

Required:

Calculate the after-tax cost of debt for this company

Solution:

 Interest on 1,000,000 loan = 50,000

 Interest on 200,000 loan = 12,000
 Interest on 2,000,000 bond = 140,000
 Total value of debt = 3,200,000
 Total amount of interest = 202,000

Loans Value of loans Interest rates Amount of interest

(ksh)
(ksh)

Loan-1 1,000,000 5% 50,000

Loan-2 200,000 6% 12,000

Loan-3 2,000,000 7% 140,000

3,200,000 202,000

Therefore;

Kd 
I
1  T 
Vd

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Kd 
202,000
1  0.3  0.0441875 or 4.41875%
3,200,000

Example-1

CocaCola ltd has ksh 28,000,000 debt at an interest rate of 9%. calculate the after-tax cost of
debt for CocaCola ltd. The tax rate is 30%.

Solution:

Kd = 9%(1-0.3) = 6.3%

Illustration-5

A company raised preference share capital of ksh. 7,500,000 by the issue of 11% preference
share of ksh. 8.25 each.

Required:

Calculate the cost of preference share capital

Solution:

Kp = 11%

Illustration-6

A company raised preference share capital of ksh. 1,000,000 by the issue of 10% preference
share of ksh. 10 each.

Required:

Calculate the cost of preference share capital when it is issued at (i) par, (ii) 10% premium,
and (iii) 10% discount

Page 6 of 20
Solution:

a) Issue at Par

Issue price at par = ksh 1,000,000

Kp = Div÷Issue Price

Div = 10% of Par = 10% x 1,000,000 =100,000

Kp = 100,000÷1,000,000 =10%

b) Issue at a premium

D= 10% x 1,000,000 =100,000

D
Kp 
P0

100,000
Kp   0.0909 or 9.09%
1,100,000

c) Issue at a discount

D= 10% x 1,000,000 =100,000

100,000
Kp   0.1111 or 11.11%
900,000

Example-2

HH ltd has a ksh 14,500,000 6% preference shares on issue. Calculate the cost of preference
shares if it’s issued at (i) par value; (ii) discount of 10%; and (iii) premium of 12%.

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Solution:

Div = 6% of 14,500,000 = ksh 870,000

i) At Par:

Kp = 6%

ii) At Discount of 10%:

Issue price = 14,500,000 x 90% = ksh 13,050,000

Kp = Div ÷Issue Price = 870,000÷13,050,000 = 0.06666 =6.7%

At Premium of 12%;

Issue price = 14,500,000 x 112% = ksh 16,240,000

Kp = Div ÷Issue Price = 870,000÷16,240,000 = 0.07412 = 5.36%

Example-3

PQ ltd has a ksh 38,500,000 8% preference shares on issue. Calculate the cost of preference
shares if it’s issued at (i) par value; (ii) discount of 9%; and (iii) premium of 6%.

Illustration-7

Calculate the cost of debt on:

a) An 8% irredeemable debenture with a par value of ksh. 10,000, currently trading at

(Issue price) ksh. 9,552. Tax rate is 30%.

b) An 8% debenture with a par value of ksh. 10,000, currently trading at ksh. 9,552 and
is redeemable in 5 years at a premium of 5%. Tax rate is at 30%.

Solution:

a) Irredeemable debt:

Page 8 of 20
I = 8% x Par value = 0.08 x 10,000 = 800

Kd 
I
1  T 
Vd

Kd 
800
1  0.3  0.0586 or 5.86%
9,552

b) Redeemable debt

I = 800

Redemption amount = 1.05 x 10,000 = 10,500

Par value = 10,000 only relevant for interest calculation

Redemption amount = 5% above par value = 1.05 x 10,000 = 10,500

Sales value/issue price = 9,552

Re deemable Value  Sale Value

I
Kd  n 1  T 
Re deemable Value  Sale Value
2

10,500  9,552
800 
Kd  n 1  0.3  0.069 or 6.9%
10,500  9,552
2

Illustration-8

Calculate the cost of debt on:

a) A 12% irredeemable debenture with a par value of ksh. 14,000,000, currently trading
at ksh. 12,940,000. Tax rate is 30%.

b) A 12% debenture with a par value of ksh. 14,000,000, currently trading at ksh.
12,940,000 and is redeemable in 8 years at a premium of 4%. Tax rate is at 30%.

c) A 12% debenture with a par value of ksh. 14,000,000, currently trading at ksh.
12,940,000 and is redeemable in 8 years at a discount of 6%. Tax rate is at 30%.

Page 9 of 20
At premium of 4%;
I = 12% x 14,000,000 = 1,680,000
Redemption amount at of 4% = 14,000,000 x 1.04 = 14,560,000

Sale value or issue price = 12,940,000

n= 8 years
Re deemable Value  Sale Value
I
Kd  n 1  T 
Re deemable Value  Sale Value
2

Kd= 9.58%

At discount of 3%:
I = 12% x 14,000,000 = 1,680,000
Redemption amount at discount of 3% = 14,000,000 x 0.97 = 13,580,000
Sale value or issue price = 12,940,000
n= 8 years

solution:

(13,580,000 – 12,940,000)÷8 =80,000

1,680,000 +80,000 = 1,760,000

(13,580,000+12,940,000)÷2 = 13,260,000

(1,760,000÷13,260,000) x 0.7 = 9.29%

Illustration-9

Kenya Breweries ltd (KBL) is evaluating its cost of capital under alternative financing
arrangements. In consultation with investment bankers, the company expects to be able to
issue new debt at par with a coupon rate of 8% and to issue new preferred stock with a ksh.
2.50 per share dividend at ksh. 25 a share. The common stock of the company is currently
selling for ksh. 20.00 a share. KBL expects to pay a dividend of ksh. 1.50 per share next year.
Market analysts foresee a growth in dividends at a rate of 5% per year. KBL’s corporation’s
tax rate is 30%.

Page 10 of 20
Required:

Calculate the component cost of capital for the three sources of finance to KBL.

Solution:

Kd = 0.08 (1 – 0.30) = 0.56 or 5.6%

Kp = 2.50 / 25 = 10%

Ke = (1.50 / 20) + 5% = 7.5% + 5% = 12.5%

Illustration-10

Juveniles ltd is evaluating its cost of capital under alternative financing arrangements. In
consultation with investment advisers, the company expects to be able to issue new debt at
par with a coupon rate of 12% and to issue new preferred stock with a ksh. 8.50 per share
dividend at ksh. 105 a share. The common stock of the company is currently selling for ksh.
125.00 a share. Juveniles ltd expects to pay a dividend of ksh. 11.50 per share next year.
Market analysts foresee a growth in dividends at a rate of 4.5% per year. Juveniles ltd
marginal tax rate is 30%.

Required:

Calculate the component cost of capital for the three sources of finance to Juveniles ltd.

Supplementary Illustration-1
Juveniles ltd is evaluating its cost of capital under alternative financing arrangements. In
consultation with investment advisers, the company expects to be able to issue new debt with
a par value of ksh 6,000,000 with a coupon rate of 12% at a discount of 3% and to issue new
preferred stock with a ksh. 8.50 per share dividend at ksh. 105 a share. The common stock of
the company is currently selling for ksh. 125.00 a share and currently paying a dividend of
ksh 7.50 per share. Market analysts foresee a growth in dividends at a rate of 4% per year.
Juveniles ltd marginal tax rate is 30%.

Required:

Calculate the component cost of capital for the three sources of finance to Juveniles ltd.

Page 11 of 20
Supplementary Illustration-2
Juveniles ltd is evaluating its cost of capital under alternative financing arrangements. In
consultation with investment advisers, the company expects to be able to issue new 6year
debenture/debt with a par value of ksh 6,000,000 with a coupon rate of 12% at a premium of
5% and to issue new preferred stock with a ksh. 8.50 per share dividend at ksh. 105 a share.
The common stock of the company is currently selling for ksh. 125.00 a share and currently
paying a dividend of ksh 7.50 per share. Market analysts foresee a growth in dividends at a
rate of 4% per year. Juveniles ltd marginal tax rate is 30%.

Required:

Calculate the component cost of capital for the three sources of finance to Juveniles ltd.

The weighted average cost of capital (WACC)

This is the average cost of all the sources of finance already employed by the company. The
higher the WACC, the riskier the company and vice versa.

Steps in calculating WACC

i. Calculate the component cost of each source of finance

ii. Calculate the weights of each source of finance in the current capital structure
iii. Multiply the component cost by the corresponding weight and sum up to determine
the WACC.

WACC = wp Kp + wd Kd + weKe

Page 12 of 20
Illustration-11

Juveniles ltd is evaluating its cost of capital under alternative financing arrangements. In
consultation with investment advisers, the company expects to be able to issue new debt at
par with a coupon rate of 12% and to issue new preferred stock with a ksh. 8.50 per share
dividend at ksh. 105 a share. The common stock of the company is currently selling for ksh.
125.00 a share. Juveniles ltd expects to pay a dividend of ksh. 11.50 per share next year.
Market analysts foresee a growth in dividends at a rate of 4.5% per year. Juveniles ltd
marginal tax rate is 30%.

Required:

a) If Juveniles ltd raises capital using 30% debt, 20% preferred stock, and 50% common
stock, what will Juveniles ltd 's weighted average cost of capital be?

b) If Juveniles ltd wishes to revise its capital structure to 30% debt, 30% preferred stock,
and 40% common stock, what will the weighted average cost of capital be?

SOLUTION:

Kd = 12% x (1-0.3) = 8.4%

Kp = 8.50/105 = 8.1%

Ke = (D1/P0) +g = 11.50/125 + 0.045 = 13.7%

Weights;

Wd = 30%; Wp =20% We = 50%

WACC = wp Kp + wd Kd + weKe

a) WACC = 0.3*8.4% +0.2*8.1% + 0.5*13.7% = 10.99% =11%

b) WACC = 0.3*8.4 + 0.3*8.1 +0.4*13.7 = 10.43%

Page 13 of 20
Example-1

Astra Zanecca ltd is evaluating its cost of capital under alternative financing arrangements. In
consultation with investment advisers, the company expects to be able to issue new debt at
par with a coupon rate of 8% and to issue new preferred stock with a ksh. 18.50 per share
dividend at ksh. 250 a share. The common stock of the company is currently selling for ksh.
350.00 a share. Astra Zanecca ltd expects to pay a dividend of ksh. 22.50 per share next year.
Market analysts foresee a growth in dividends at a rate of 6% per year. Astyra Zanecca ltd
marginal tax rate is 30%.

Required:

a) If Astra Zanecca ltd raises capital using 40% debt, 20% preferred stock, and 40%
common stock, what will its weighted average cost of capital be?
b) If Astra Zanecca ltd wishes to revise its capital structure to 20% debt, 20% preferred
stock, and 60% common stock, what will the weighted average cost of capital be?

Solution:

After tax cost of debt = 8% (1-0.3) = 5.6%

Cost of pref stock = D/P = 18.50/250 =0.074 =7.4%

Cost of equity = (D1 /P)+g =( 22.5/350) + 0.06 = 0.124 = 12.4%

Weighted average cost of capital = (Wd x Kd )+(Wp x Kp) + (We x Ke)

WACC = (0.4x 5.6)+(0.2x7.4)+(0.4x12.4)=8.68%

Illustration-12

The following is the capital structure of a firm:

Source of capital Amount Weights
Equity capital 450,000 0.45
Retained earnings [reserves] 150,000 0.15
Pref. share capital 100,000
Debt 300,000
1,000,000
The firm’s expected after-tax component cost of the various sources of finance are as follows;
Source of capital Amount
Equity capital 18%
Retained earnings [reserves] 18%
Pref. share capital 11%
Debt 8%

Page 14 of 20
Required:
Compute the WACC of the firm.
18%x0.45+18%x0.15
Solution:
Source Amount[ksh] Proportion After-tax cost WACC
Equity capital 450000 0.45 18% 8.1%
Retained earnings 150000 0.15 18% 2.7%
Pref. capital 100000 0.1 11% 1.1%
Debt 300000 0.3 8% 2.4%
1000000 1 14.3%

Book-value verses market value

The weighted cost of capital can be computed by using the book value weights or market
value weights. If there is a difference between these two, then the weighted average cost of
capital would differ according to the weights used.
The WACC calculated using book value weights will be understated if the market value of
the share is higher than the book value and vice versa.
Note:
The book values are used mostly because of the ease of getting accurate data on the same.
However, the market values are better because they reflect the current market condition under
which new funds would be raised. If market value weights are used, the cost of retained
earnings is not calculated on its own since it is already included in the market value of
ordinary shares.

Illustration-13
Zain company ltd has the following capital structure:
Source of capital Amount
Equity capital [200,000 shares] 4,000,000
10% Pref. shares 1,000,000
14% Debt 3,000,000
8,000,000
The share of the company sells for ksh.20. It’s expected that the company will pay in the
coming year a dividend of ksh 2 per share which will grow at 7% forever. The corporation
tax rate applicable to the company is 30%.
Required:
a) Compute a WACC based on the existing structure

b) Compute the new WACC if the company raises an additional ksh 2,000,000 debt by
issuing 15% debenture. This would result in an increase in dividend to ksh 3 per share

Page 15 of 20
 and leave the growth rate unchanged, but the price of the share would fall to ksh 15
per share.

c) Compute the WACC if in [b] above, the growth rate increases to 10%

Solution:
i) Existing capital structure;

Cost of equity;
D1 2
Ke  g  0.07  0.17 =17%
P0 20

Cost of pref. shares;

Assuming the shares are issued at par;
Dividend =10% of ksh 1,000,000 = ksh 100,000
Issue price =ksh 1,000,000
D 100,000
Kp    0.10 =10%
P0 1,000,000

Cost of debt;
Before tax cost of debt
14
Interest coupon = x3,000,000  420,000
100
I 420,000
Kd    0.14
B0 3,000,000

After-tax cost of debt = Kd[1-t] = 0.14[1-0.3]= 0.098 = 9.8%

Source Amount[ksh] Proportion After-tax cost WACC

Equity capital 4000000 0.5 17.0% 8.50%
10% Pref. capital 1000000 0.125 10.0% 1.25%
14% Debentures 3000000 0.375 9.8% 3.68%
8000000 1 13.43%

ii) new capital structure;

Page 16 of 20
Cost of equity;
D1 3
Ke   g   0.07  0.27 =27%
P0 15

Cost of pref. shares [not changed]

Assuming the shares are issued at par;
Dividend =10% of ksh 1,000,000 = ksh 100,000
Issue price =ksh 1,000,000
D 100,000
Kp    0.10 =10%
P0 1,000,000

Cost of debt;
Before tax cost of 14% debenture [not changed];
14
Interest coupon = x3,000,000  420,000
100
I 420,000
Kd    0.14
B0 3,000,000

After-tax cost of debt = Kd[1-t] = 0.14[1-0.3]= 0.098 = 9.8%

Cost of 15% debenture;
15
Interest coupon = x 2,000,000  300,000
100
I 300,000
Kd    0.15
B0 2,000,000

After-tax cost of debt = Kd[1-t] = 0.15[1-0.3]= 0.105 = 10.5%

Source Amount[ksh] Proportion After-tax cost WACC

Equity capital 4,000,000 0.4 27.0% 10.80%
10% Pref. capital 1,000,000 0.1 14.0% 1.40%
14% Debentures 3,000,000 0.3 9.8% 2.94%
15% Debenture 2,000,000 0.2 10.5% 2.10%
10,000,000 1 15.14%

iii) cost of equity with a growth of 10%

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 D1 3
Ke   g   0.10  0.30
P0 15

Source Amount[ksh] Proportion After-tax cost WACC

Equity capital 4,000,000 0.4 30.0% 12.00%
10% Pref. capital 1,000,000 0.1 14.0% 1.40%
14% Debentures 3,000,000 0.3 9.8% 2.94%
15% Debenture 2,000,000 0.2 10.5% 2.10%
10,000,000 1 16.34%

In all the above calculations book value weights have been used:
Illustration-14
Zain company ltd has the following capital structure:
Source of capital Amount
Equity capital [200,000 shares] 10,000,000
8% Pref. shares 6,000,000
12% Debt 4,000,000
20,000,000
The share of the company sells for ksh.50. It’s expected that the company will pay in the
coming year a dividend of ksh 4.5 per share which will grow at 5% forever. The corporation
tax rate applicable to the company is 30%.
Required:
a) Compute a WACC based on the existing structure

b) Compute the new WACC if the company raises an additional ksh 2,000,000 debt by
issuing 15% debenture. This would result in an increase in dividend to ksh 6 per share
and leave the growth rate unchanged, but the price of the share would fall to ksh 35
per share.

c) Compute the WACC if in [b] above, the growth rate increases to 8%

Solution:
Source of capital Amount Component cost Weights
Equity capital [200,000 shares] 10,000,000 22% 0.455
8% Pref. shares 6,000,000 8% 0.273
12% Debt 4,000,000 8.4% 0.182
15% Debt 2,000,000 10.5% 0.090
22,000,000

WACC = (22% x 0.455)+(8%x0.273)+(8.4%x0.182)+(10.5%x0.09) = 14.67%

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Marginal Cost of Capital
Marginal cost of capital (MCC) is defined as the cost of the last shilling of new capital a firm
raises, and the marginal cost rises as more and more capital is raised during a given period.

Illustration 15:
A firm has the following capital structure and after-tax costs for the different sources of funds
used:
Source of funds Amounts (ksh) After-tax cost (%)
Debt 450,000 7
Preference 375,000 10
Equity 675,000 15

Required:
(a) Calculate the weighted average cost of capital using book-value weights.

(b) The firm wishes to raise further ksh 600,000 for the expansion of the project as below:

Source of funds Amounts (ksh)

Debt 300,000
Preference 150,000
Equity 150,000
Required:

Assuming that specific costs do not change, compute the weighted marginal cost of capital.

Solution
a) Computation of weighted average cost of capital (WACC)
Source of funds Amounts Proportions After-tax cost WACC (%)
(%)
Debt 450,000 30% 7 2.1%
Preference 375,000 25% 10 2.5%
Equity 675,000 45% 15 6.75%
WACC 11.35%

b) Computation of weighted marginal cost of capital

Source of funds Amounts Marginal After-tax cost WACC (%)
Proportions (%)
Debt 300,000 50% 7 3.5%
Preference 150,000 25% 10 2.5%
Equity 150,000 25% 15 3.75%
WMCC 9.75%

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Page 20 of 20