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    Business Finance Unit

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    13 views12 pages

    Cost of Capital Study Text

    Uploaded by

    Emmanuel
    Business Finance Unit

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    of 12
    STUDY TEXT CHAPTER 6 COST OF CAPITAL SYNOPSIS Tnwodustin, The concept and signiiance of 05 o ap Faso infusing eos oF expt ns Componens cos of capital Weighed average cost of capital (WACO). Marginal cost of eapital (MCC) nn INTRODUCTION The cost of funds isso known asthe cost of capital or cost of finance. Is the pie the company ays to obtain and finance fr its operations. It ea also be defined as the return the sompany pays to the pates” which provide the finance to finance the company’s operations. The ests of obtaining finance are Known implicit cost r flotation costs. The cox ofcpital that amount which spa he puviders of cpa. ether appears asa charge want the business to arrive at the profits © Jmereston debentures ori appears a a farm of distrbaion of profits eg. dividens on preference shses and oninary shares. he interest and dividends both represent the cost of obning and using the apt The concep ofthe cost of capitis significant in designing the fms capital struct. A fim shoul sim a minimizing tho cos of capital and raxiizing the markt value of the in. The cost of capital of retin; the finds wed should prods to justify thee wse within the Fa in she light of ‘wealth maxinization objective. An investment should be made only ifthe rate af retun on tis Jvestnent exceeds the cost of eapital, ‘THE CONCEPT AND SIGNIFICANCE OF COST OF CAPITAL DrFINITION hse the prise the ompany’pays to Stan and a fiance. Toobin Finance eompany wil p3y implicit costs which are commonly known g& Noaston oss. Thase ilu: Undersrting on, Buokerae costs, ost of printing» rospectus, Commission css, eal es, uit ons Cost of priming se ceria, aveising costs ec. For debt tee is lel, vation cons {Ge soir, et fes, Bankers commission et) such cot are knocked off rom i) The marke valve of shares if these has ely ben sold ata pic above pa value, ii) For debs fine ~ from the par vale af debt. once pe sare ey are given for the total finance ai i FUNDAMENTALS OF FINANCE STUDY TEXT Importance of Cost of Finance “The cost of capitals important because {)Longterm investment dessins of capital i used to dizount the cash ows oonpared with TRR to determine whether to acceptor eject project iy Capa sructre dessins ~ The composition of vows compen of cays is ‘Gtemined by the cot ofeach cpital component iy Eraunon of perormanc of management ~ high cost of aptly an inter of high 8 aansarjaa the frm, This is usually tributed to poor perfomance ofthe im. wierd policy and decions~ Eg if the cont of eid caring bw compres OF ac Ea edinay share capital, the Frm will rain more and py less dividend sestitsealy, the ace of retained carnings as an internal source of Finance & prefered because: 1 tedoes nt involve any flotation costs | «Tegde not lute ownership and conta ofthe finn, ince no new shares Fe su “Rm may finance the acquisition of an ase though fess oF ase Tn ese or buy decisions, the cost of debt interest oft appicaton in the following ares: meant badging decison, using NPV method the cost Under IRR method the cost of capital i Lease or buy deisions ~ oerowing long-term debt o Buy an tic on loan borrowed) used the discounting ate actors Tht Fafluence the Cost of Finance dere nat ference if short erm, the costs usally low and wise verse Se arn cenion prevailing ~ If company i operating under inflainary condions, st) ary ll pay hgh costs nfs nlinsry fff finance willbe passe om he company. aad o vente ~ if» company is operating wider ihc somos, sch 5) aenscn il py high ott nde lenders wav finance ot base the clement of Fk shi be added onthe est of finance which may compound 4. Sues boone A smal company wl indi ificlt wraise ane and as such wt Ss eit or cost of finance to obtain de from lenders \ re aby Cost of finance (COP) pies wil abo be infleced by the ocr of demand and seen euch hat low demand andl upp wil lad ohh os of ian ‘6. biten ot tration - Debt finance is cheaper bythe amount equ foo inesest Gnnes equivalent ax on interest. hen this will cmipound implicit est and his cans that debt finance wl etal a saving i cost of ‘Nau af seewity ~ IF security given: dpreiates fist {costs of manaining that secu), ‘8. Companys growth stage ~ Young companies usually pay Is Crit nance wil be tltvely cheaper atthe eal stages ofthe company's development iden in which case the cos FACTORS INFLUENCING COST OF CAPITAL Tem of ference ifshort em the costs usualy Hw ad vce vers 3} Eeanom conitons prevailing ~ I company is operating unde iflaionary conditions, such ‘company wpa high cost in 50 fra natonary effet of france willbe passed onto the company. "FUNDAMENTALS OF FINANCE STUDY TEXT 7% 3, Risk exposed to venture - if a company is operting under high risk conditions, such a company will pay’ high costs to induce lenders to aval Fnace to it becuse he element of sk ‘ill be added on the costo finance which may compound i ' 4. Size ofthe business A small company will ind it fcuk to raise Finance and as such will H ay heavily in form of cost of fnance to obtain debt from lenders i 5. Availability ~ Cost of finance (COF) prices will also be influenced by the fres of demand and supply such ht low demand and low supply wil ead to high cost of finance. I 66. Eflacts of taxation ~ Debt finance is cheaper by te amount equal 1 tax of intrest and this ‘means that debt faance wil ental saving in cost of Fiaanes equivalent to taxon interes. 7. Nature of seeuriy ~ If security given deposits fast, thn this will compound implicit costs (cost of maintaining that security) Company's growth stage ~ Young companies usually pay lst dividends in wiih ease the cost ofthis Finance wil be relatively cheaper a the eri stages ofthe company’s development COMPONENTS COSTS OF CAPITAL Dinost Costs OF Obtaining Finance 18) To obtain debt finance: Thee nce costs of insurance forthe scary given to sear the fans “aluer”fee pd to asses the value ofthe security to secre su loan, eal fees paid othe Company lawyers who wil be party tothe lon agreement, ad Fes paid o auditors to ceri the Financial statements which wil be provided to lenders to assess the company’s fnacal positon. 1) To obtain share capital: These include costs of pining a prospectus cost of advertising, costs of. csimunication with shareholders as regard the allotment & regrets, brokerage ecsts, underwriting commissions, aut foes clerical cos. 2) Cost of equity (K.)- Tis eam be determined with respect 1) Zero grower iy Constant roth im Zero growth frm Conot eu he) 2, 100 where; (a= expected vd pre Po “markt pice po alia share oatatin cst i 1) Constam growth em ‘Cost of equity (ke) ‘INDAMENTALS OF FINANCE sTUDY TEX 20 ‘Where = ividend per share gogowth ate <4 (14g) expeted ivdend per share { =foataton cost 1) Con of perpetual preference share capital (KP) Roca vale of preference share, Po Therefore cot ‘p= Preference dividend per share «Cast of perpetual debenture (a) ~ Deters py ites hares wish wae ywable tapenses for purposes ‘Deentres may ie be: 4) Perpetua Girredcemable debentures Merrie prmaent ods ery becuse eas wl rein 0 lend expects. The followin isthe ste of retu that formal are wed to Where Ke> Pretax cost of debt a= Marke vale of debenture nt.) Ka Ke = AReetax cost of debt STUDY TEXT a Example ABC Lid desided 1 perpetual 1296 debentures of S00 each. The tx ae wns 30% eget Cnt cont of eens bot prety cst an alr cox sotuton Imcrat= 445100 Sh12 o = ie ne comeing? ee 00 ees ern cos of dehetre: _s inva wee 2? vers 00 Ww Fs ; oo man _ 20 2207 aS, LD) _ BUD OT goehS 1005 34% 1) Cost of Redeemable Debentures Redeemable ined retin secu havea definite maturity period. ‘The cost of such securitis fs called yield 10 maturity (YTM) or sedemption yield (RY). Foe a reenable debenture Ka (cost of y ” +int(i-T) qi" n= Numb of years to maturity WEIGHTED AVERAGE COST OF CAPITAL (WACC) Tis is aso calle the overall or compte cost of capital. Sines various capita components have 4tfreat percentage cost important to determine a single average ost of eaptlatrbutble 10 ‘avions cost of capital. This i determined onthe bass of percentage cost ofeach capital component Market valve weight or yopor ofeach capil component co =H ElonP}onyt-1{2) wace = Kl yjemty)xt-thy) Where: Ka Kyand Ke } era: STUDY TEXT [Nas Marke value = Market price ofa security x No of secunis, ‘¥= Total market vlue ofthe fim = E + P+, ru1usTRaTion Pete faving capt sre hihi consid oti } er | Deve (ar @st.100) 250,000 Prefered stock (pa @sh 100) 150,000 [Common sok (par @ sh. 100) 600,000 ‘The investors of Magosero td expect earings and dividends to grow at constant rate of 26 inthe fare, The company has just paid a dividend ofs3.6 per share did its stock curently sll at a ree (Fah per sare. Treasury bond yield 11% and the feta onthe markets 14%, Mugoser id bts ist Nev prefered stock canbe soldat sh.100per share witha dividend ofsh.11 per share and tation ‘costs of sh pershae rhe company’s tax rate is 30% and it pays out all ts earings as dividend. 2% debentures with a mati of 10 ears ea be soldat sh 92 per debenture Required ‘The weighed average cost of capita WAC) wsing market values SOLUTION srr Cale ot of sei ours of ail LS kee g ’ Ke 2822+ 009 = 155496) . a frien 3 = 150% ii, Cont of S on ina fg = ee tah c= Wels In =Ierest charges pa 1 =Coror trie - M_—=Parormatriy value ofa debenture 4 Ve =Cument market aie of a debentre ¢ 0 [Nee of ens to mat =1 _ aov— 92,04 120-03) T0033) aaa STUDY TEXT 33 srer2 (Caeulate markt values iL Cont of dts = 222808 599 = 230,000,000 ii p= S828 5 200 = 150,900,000 | ii, Ke= Be 5 60 = 360,000,000 | srera i DETERMINE ACC J Sour ‘Amount (mkt Weights Cost Weighs Cos tal) | comorase —Hhonoo” sion 0008 | “Preiredstock 0.000000 02027” tisk 00035 | Commonstock 0.000000 aB6s—1558 4.00.009 wace | usrestion2 | is th capital stucueof Nase Ld ah cpa oct of Nama La | 0 00 00 Preterece share xpi (pr Sh 100) | 35,000,000 | Debentrs (par Sh 100 __| 2rooo'nea ‘Addons iforetion Ute shrchldes of Ngan Ld. expet caring nd dividends to row ta ost to theft. Th company bas ust sia dividend of Sh per sae a 2. ‘The erent maket pric of one oedinsry share of Nea Li. h.80 | 3. Treasury bonds yield 126The return om the markets 14%, The Sompany’s is 10, 44/ "Now poference shares canbe sold at Sh 120 pe share with a dividend of Sh. 12 per sare nd Aoanation oss af Shi per share, x 5. The caporation tix 30% 6. “The company pays ot all its earings as dividends Tecoma wi 1 dene wis my of 10 rr SAA pede. The L ‘The weighted average cost of capital (WACC) J Ko : é 'FURDAMENTA:S OF FINANCE 3 LL STUDY TEXT a £808.99 +5 =1025% Cont of preference shares Kem prscy” 10° De sthe dividends paid fis the lataton cost MSs the market rie pe share il * 10 = 10500 cont of Debontures (redeemable) (Ka) (ow — vayn + int —D) tn van ee where: | tat: = Interest charges T= Corporate ta ate | Mt marr maturity vale of debents | Mi —Cumrent market value ofa debenture (100 90)i0 + 120-0: 209 = 90)18+ 1204 0) _ 07% [Saree diac | Proportion “T Gomponent Cast “Oadinary share 1025 Frscenecsive | 2a08 | Betenee prec & — 990 _ WREE=T035% yore! NOTE re wih of pops of isc compre awn a may te wd: fe Maker yaes/ Book values / {Replarament values v 1 sins values / arte Value ~ This inoles dining he wets ot poprions eng e SoTe rakes Mae rium cpt componens. The robles wih he se of mare Wp sa ech sort Rep Ochi on daly Ess te marek vals At be ‘computed only ane point i tin ale of ech seu Hy te incoect dus to eases of over or unde valuation in the FUNDAMENTALS OF FINA STUDY TEXT = ‘ ook values — Tis involves the use ofthe par vale of capital as shown in he balance sheet. The rain problem with book values i hat they are Historial/pastvalesindeting the valve of 2 security when it was oviinally sold in the marhet fr the first time. Replacement values This involves determining the weights proportion a He basis f amount tat an be pai 0 replace the existing se. The problem with replacement sie i that assets can never b replaced at ago and replacement valves may not be ajetvely detrined. Tnrinsie values In shiscase the weight ae determine on the bass of the je ale of tiven secur. nisi valves may not be accurate since hey ave computed sing historias i information and are usualy estimates, Weakness of WACC ata discounting rate WACCiOveral cst fsa ha he ellowing problems a a discounting ate + ican only be used asa discounting rte assuming tht the risk ofthe projet sequal tothe busines isk ofthe Fm. Ihe project as Nahr rik then a percentage premio wil be added 10 WACC to determine the appropriate discounting rt ‘+ Tasumes that apt structure optimal which is not achievable in real wos + 18s based on market vals of eapal which Ke on chaning ths WACC wil change over 1 time bts assumed 0 remain constant thoughout the economic i ofthe pret ‘ | ‘+ tis based on past information especially when determining th-cost of cach component ein

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