Cost of capital

By the end of this topic, you should be able to:

◼ Use the dividend valuation model to measure the value of equity
◼ Measure the cost of equity using the dividend valuation model with and without growth
◼ Measure the pre-tax and post-tax cost of both irredeemable and redeemable debt
◼ Measure the cost of convertible bonds
◼ Calculate the weighted average cost of capital

Cost of equity, cost of debt and the weighted average cost of capital (WACC)
The cost of capital for investors is the return that investors require from their investment. Companies must be
able to make a sufficient return from their own capital investments to pay the returns required by their
shareholders and holders of debt capital.
The cost of capital for a company is the return that it must make on its investments so that it can afford to pay
its investors the returns that they require.
Comparing the cost of equity and the cost of debt
The cost of equity is always higher than the cost of debt capital. This is because equity investment in
a company is always more risky than investment in the debt capital of the same company.
❑ Interest on debt capital is often fixed: bondholders for example receive a fixed amount of annual
interest on their bonds. In contrast, earnings per share are volatile and can go up or down depending
on changes in the company’s profitability.
❑ Providers of debt capital have a contractual right to receive interest and the repayment of the debt
principal on schedule. If the company fails to make payments on schedule, the debt capital providers
can take legal action to protect their legal or contractual rights. Shareholders do not have any rights to
dividend payments.
❑ Providers of secured debt are able to enforce their security if the company defaults on its interest
payments or capital repayments.
❑ In the event of insolvency of the company and liquidation of its assets, providers of debt capital
are entitled to payment of what they are owed by the company before the shareholders can receive
any payment themselves out of the liquidated assets.

COST OF EQUITY

◼ Methods of calculating the cost of equity

◼ The dividend valuation model method of estimating the cost of equity
◼ The dividend growth model method of estimating the cost of equity
◼ Estimating growth
◼ The CAPM method of estimating the cost of equity

Methods of calculating the cost of equity

The cost of equity is the annual return expected by ordinary shareholders, in the form of dividends and share
price growth.
There are two methods that you need to know for estimating what the share price in a company ought
to be:
❑ The dividend valuation model; and
❑ The dividend growth model (Gordon growth model).

Another method of estimating the cost of capital is the capital asset pricing model (CAPM). This is an alternative
to using a dividend valuation model method, and it produces a different estimate of the cost of equity.
The dividend valuation model method of estimating the cost of equity
If it is assumed that future annual dividends are expected to remain constant into the foreseeable future, the
cost of equity can be calculated by re-arranging the dividend valuation model.
Formula: Dividend valuation model (without growth)
Market Value = Dividend/cost of Equity
Cost of Capital = Dividend/ market Value
Ke = d1/MV
Where:
rE = the cost of equity
d = the expected future annual dividend (starting at time 1)

MV = the share price ex dividend

Example: DVM
A company’s shares are currently valued at ₦8.20 and the company is expected to pay an annual dividend of
₦0.70 per share for the foreseeable future.
Practice question
A company’s shares are currently valued at ₦8.20 and the company is expected to pay an annual
dividend of ₦0.70 per share for the foreseeable future.
The next annual dividend is payable in the near future and the share price of ₦8.20 is a cum dividend price.
Estimate the cost of equity
The dividend growth model method of estimating the cost of equity
If it is assumed that the annual dividend will grow at a constant percentage rate into the foreseeable future,
the cost of equity can be calculated by re-arranging the dividend growth
Formula: Dividend valuation model (with growth)

MV = d(1+g)
Ke – g
Ke = d1(1+g) + g
Ke
Where:
rE = the cost of equity
d = the annual dividend for the year that has just ended
g = the expected annual growth rate expressed as a proportion
MV = the share price ex dividend.
Example: DVM with growth
A company’s share price is ₦8.20. The company has just paid an annual dividend of ₦0.70 per share,
and the dividend is expected to grow by 3.5% into the for next annual dividend will be paid in one year’s
time. Calculate the cost of equity
Practice question
A company’s share price is ₦5.00. The next annual dividend will be paid in one year’s time and
dividends are expected to grow by 4% per year into the foreseeable future. The next annual dividend
is expected to be ₦0.45 per share.

Estimating growth
The growth rate used in the expression is the growth rate that investors expect to occur in the future.
This can be estimated in one of two ways:
❑ Extrapolation of historical growth; and
❑ Gordon’s growth model

Extrapolation of historical growth

This is based on the idea that the shareholders’ expectations will be based on what has been
experienced in the past. An average rate of growth is estimated by taking the geometric mean of growth
rates in recent
The growth rate used in the expression is the growth rate that investors expect to occur in the future.
This can be estimated in one of two ways:
❑ Extrapolation of historical growth; and
❑ Gordon’s growth model.

Extrapolation of historical growth

This is based on the idea that the shareholders’ expectations will be based on what has been
experienced in the past.
An average rate of growth is estimated by taking the geometric mean of growth rates in recent years.
Example:

Year Dividend
20X1 100
20X2 110
20X3 120
20X4 134
20X5 148

Calculate the dividend growth

Gordon growth model (or earnings retention model)

The Gordon growth model is similar to the dividend growth model, with the difference that the expected
growth in annual dividends is calculated from the proportion of annual earnings that are retained and
the rate of return on those retained profits.
The growth estimate is based on the idea that retained profits are the only source of funds. With no re-
invested profits, the investment base of the company would not increase. Practically, this means no
new funds invested in new products, new market, new factories, stores, and so on. Therefore, profit
will not grow, and by implication, dividends (taking a long-term view) will not grow.
Growth therefore, comes about by retaining and reinvesting profits on which a return is earned. The
relationship between these variables is shown by:

g = rb
Where: g = growth in future dividends
r = the current accounting rate of return
b = the proportion of profits (earnings) retained

Problems with the Gordon growth model/earnings retention model

The major problem with this model is:
Its reliance on accounting profits;
The assumption that r and b will be constant;
Inflation can substantially distort the accounting rate of return if assets are valued on an historical
costs basis; and
The model also assumes all new finance comes from equity

Shortcomings of the dividend valuation model (DVM)

Whilst the basic premise of the DVM is perhaps reasonable, being that a share is worth more if it is
expected to pay out higher future dividends, there are a few problems with the underlying assumptions
and with the data used.
Underlying assumptions:

- Shares have value because of the dividends. This is not always true – some companies have a
deliberately low payout policy which can attract investors who prefer capital gains to an income stream.
Some companies pay no dividends at all; for example, until some years ago Microsoft paid no dividends
but Microsoft shares had a high value.

- Dividends either do not grow, or grow at a constant rate – the former is unrealistic, the latter is true
in the long term if one takes the view we are estimating a long-term average.

Nevertheless, short-term variations in expected dividend growth would change the share price.
- Estimates of future dividends based on historical data, such as historical growth rate and retention
rates, implicitly assume dividend patterns will remain unchanged – it will be more useful to consider
future market conditions, investor confidence, economic conditions, and so on when making the
estimate of future dividends.

Data used:

- The share price is used in the DVM to help estimate the cost of equity to the company or the required
rate of return to the investor.

Share prices change on a daily basis, and not always in a perfectly efficient or rational manner.
- The growth in future dividends.

This is perhaps more likely to be linked to the growth in future earnings, than to past dividends.
Earnings do not feature as such in the dividend valuation model. However, earnings should be an
indicator of the company’s long-term ability to pay dividends and therefore, in estimating the rate of
growth of future dividends, the rate of growth of the underlying profits must also be considered. For
example, if dividends

The CAPM method of estimating the cost of equity

Another approach to calculating the cost of equity in a company is to use the capital asset pricing
model (CAPM).
The formula for the model is as follows:

Formula: Capital asset pricing model (CAPM) RE = RRF +β (RM – RRF)

Where:
RE = the cost of equity for a company’s shares
RRF = the risk-free rate of return: this is the return that investors receive on risk-free investments such
as government bonds
RM = the average return on market investments as a whole, excluding risk-free investments
β = the beta factor for the company’s equity shares

Advantages of the CAPM

The CAPM has several advantages over other methods of calculating required return, explaining why
it has been popular for more than 40 years. These are:
It considers only systematic risk, reflecting a reality in which most investors have diversified portfolios
from which unsystematic risk has been essentially eliminated;

It is a theoretically-derived relationship between required return and systematic risk which has been
subject to frequent empirical research and testing;

It is generally seen as much better method of calculating the cost of equity than the dividend growth
model (DGM) in that it explicitly considers a company’s level of systematic risk relative to the stock
market as a whole; and

It is clearly superior to the WACC in providing discount rates for use in investment appraisal.
Among the major difficulties inherent in the practical application of the CAPM are:
Determining the excess return Rm – Rf.

The term relates to the expected return of the market portfolio over the riskless asset. This is difficult
to determine in practice.
Determining the risk-free rate - Problems are found in identifying a riskless security. In view of the
term structure of interest rates, the interest rate to be used is the yield on a security with the same
approximate life as the project to be appraised.

Estimation of beta for the firm’s equity and for the firm as a whole - The coefficient for equity
may be estimated by simple linear regression of security returns on market returns. To overcome
possible sampling error, confidence limits on the beta estimate may be required. Unless the firm is all
equity-financed, the equity beta must be converted into a firm beta in order to obtain an overall average
required return.

Determining beta for individual projects – Frequently, there is little objective evidence concerning
a project’s beta and so an estimate, necessarily subjective and open to argument, must be made.

The concentration only on systematic, rather than overall, risk - A risky project which has a
return uncorrelated with the market will be treated as financially equivalent to a risk-free project. Whilst
this may be justified in the context of a well-diversified portfolio, they are unlikely to be considered
equal by corporate management.

The CAPM is a single period return model - Hence it should be used with caution in the analysis
of any multi-period capital project.

Example: CAPM
The rate of return available for investors on government bonds is 4%. The average return on market
investments is 7%. The company’s equity beta is 0.92.

Using the CAPM, the company’s cost of equity is therefore: 4% + 0.92 (7 – 4)% = 6.76%.

Practice questions
A company’s shares have a current market value of ₦13.00. The most recent annual dividend has just
been paid. This was ₦1.50 per share.
Required
Estimate the cost of equity in this company in each of the following circumstances:

a) Using the DVM and when the annual dividend is expected to remain ₦1.50 into the foreseeable
future.

b) Using the DVM and when the annual dividend is expected to grow by 4% each year into the
foreseeable future
c) The CAPM is used, the equity beta is 1.20, the risk-free cost of capital is 5% and the expected
market return is 14%.

COST OF DEBT CAPITAL

Cost of irredeemable fixed rate debt (perpetual bonds)

◼ Cost of redeemable fixed rate debt (redeemable fixed rate bonds)
◼ Cost of convertible debt
◼ Cost of preference shares

Cost of irredeemable fixed rate debt (perpetual bonds)

The expressions for the market of irredeemable fixed rate bonds (perpetual bonds) and the
rearrangement to provide an expression for the cost of debt are as follows:

Pre-tax cost of debt (the lender’s Post tax cost of debt required rate of return)
MV = Interest MV = Interest (1-tax)
Cost of debt cost of debt

Cost of debt = interest Cost of debt = interest (1-tax)

Market Value Market value

Where:
rD = the cost of the debt capital
i = the annual interest payable
t = rate of tax on company profits.
MV = Ex interest market value of the debt
Note that calculations are usually performed on a nominal amount of 100 or 1,000.

Example: Cost of debt

The coupon rate of interest on a company’s irredeemable bonds (‘perpetual bonds’) is 6% and the
market value of the bonds is 103.60. The tax rate is 25%.
(a) The pre-tax cost of the debt is 6/103.60 = 0.058 or 5.8%.
(b) The after-tax cost of the bonds is 6 (1 – 0.25)/103.60 = 0.043 or 4.3%.

Cost of redeemable fixed rate debt (redeemable fixed rate bonds)

The cost of redeemable bonds is their redemption yield. This is the return, expressed as an average
annual interest rate or yield, that investors in the bonds will receive between ’now’ and the maturity
and redemption of the bond, taking the current market value of the bonds as the investment. It is the
investment yield at which the bonds are currently trading in the bond market.
This is calculated as the rate of return that equates the present value of the future cash flows payable
on the bond (to maturity) with the current market value of the bond. In other words, it is the IRR of the
cash flows on the bond to maturity, assuming that the current market price is a cash outflow.
The redemption of the principal at maturity is not an allowable expense for tax purposes. This means
that post-tax cost of redeemable debt cannot be calculated by multiplying the pre-tax cost by (1 t). A
full IRR calculation must be carried out.
The approach is to calculate the post-tax cost of debt as the IRR of the future cash flows, allowing for
tax relief on the interest payments and the absence of tax relief on the principal repayment using the
market value as the cash flow at time 0.

The cash flows used to calculate an IRR (redemption yield) are:

❑ The current market value of the bond, excluding any interest payable in the near future (shown as
a cash outflow).
❑ The annual interest payments on the bond (shown as a cash inflow).
❑ Tax relief on these annual interest payments : these are cash outflows (the opposite of the interest
payments) and occur either in the same year as the interest payments or one year in arrears,
depending on the assumption used about the timing of tax payments (shown as a cash outflow)
❑ The redemption value of the bonds, which is often par

Cost of convertible debt

The cost of a convertible bond is the higher of:
❑ The cost of the bond as a straight bond that will be redeemed at maturity, and
❑ The IRR of the relevant cash flows assuming that the conversion of the bonds into equity will take
place in the future.
The cost of capital of the bond as a straight bond is only the actual cost of the bond if the bonds are
not converted into shares at the conversion date. The IRR of the relevant cash flows is the cost of the
convertible bond assuming that conversion will take place.
The relevant cash flows for calculating this yield (IRR) are:
❑ The current market value of the bonds (Year 0 outflow);
❑ Annual interest on the bonds up to the time of conversion into equity (annual inflows);
❑ Tax relief on the interest (annual outflows);
❑ The expected market value of the shares, at conversion date, into which the bonds can
be converted.

Example:
The current market value of a company’s 7% convertible debenture is ₦108.70. Annual interest has
just been paid. The debenture will be convertible into equity shares in three years’ time, at a rate of 40
shares per debenture. The current ordinary share price is ₦3.20 and the rate of taxation on company
profits is 30%. Calculate The post-tax cost of the bonds

Practice question
A company has issued 4% convertible bonds that can be converted into shares in two years’ time at
the rate of 25 shares for every ₦100 of bonds (nominal value).
It is expected that the share price in two years’ time will be ₦4.25.
If the bonds are not converted, they will be redeemed at par after four years. The yield required by
investors in these convertibles is 6%.
What is the value of the convertible bonds?

Cost of preference shares

For irredeemable preference shares, the cost of capital is calculated in the same way as the cost of
equity assuming a constant annual dividend, and using the dividend valuation model.

Cost of preference share KP= Divident (d)

Market Value MV

MV = Dividend
Cost of preference share
Where:
rp = the cost of preference shares
d = the expected future annual dividend (starting at time 1)
MV = the share price ex dividend

For redeemable preference shares, the cost of the shares is calculated in the same way as the pre-
tax cost of irredeemable debt. (Dividend payments are not subject to tax relief, therefore the cost of
preference shares is calculated ignoring tax, just as the cost of equity ignores tax.)

Method of calculating the weighted average cost of capital (WACC)

The weighted average cost of capital (WACC) is the average cost of all the sources of capital that a company
uses. This average is weighted, to allow for the relative proportions of the different types of capital in the
company’s capital structure. The weighted average cost of capital (WACC) is a weighted average of the (after-
tax) cost of all the sources of capital for the company.
Example: WACC
A company has 10 million shares each with a value of ₦4.20, whose cost is 7.5%.
It has ₦30 million of 5% bonds with a market value of 101.00 and an after-tax cost of 3.5%.
It has a bank loan of ₦5 million whose after-tax cost is 3.2%.
It also has 2 million 8% preference shares of ₦1 whose market price is ₦1.33 per share and whose
cost is 6%.
Calculate the WACC.

QUESTION ON COST OF CAPITAL

The capital structures of 2017 Double Star is as follows:
₦1 ordinary shares 500,000,000
Revenue Reserve 185,000,000
Share Premium 375,000,000
Retained earning 250,000,000
12% ₦1 Preference Shares 100,000,000
6% Convertible debenture stock 150,000,000
8% Unsecured loan stock 300,000,000
9% Irredeemable debt 100,000,000

The ordinary shares have a current market price of ₦3.50 each on the 28th of December 2017.
The dividend for 2017 of 70 kobo per share was proposed on the 25 th of November 2017 but
paid on the 30th of December 2017. Dividends per share in the preceding years were as
follows:
2012 – 45 kobo 2013 – 50 kobo 2014 – 55 kobo 2015 – 60 kobo

Dividends are paid once in a year and expected to grow in the future at the same annual rate
as they have since 2012.
The preference shares have a market price of ₦0.8 each. The 2017 preference dividend of 12
kobo per share has been paid. Dividends on preference shares are paid once in the year.
The convertible debenture stock has a market price of ₦120 per nominal. The stock is
convertible into ordinary shares in five years’ time at a rate of ₦100 nominal stock for 50
ordinary shares. The market price of the shares at the time of conversion is expected to be
₦4.00 each. If not converted the stock will be redeemed in four years’ time at a price of ₦125
percent.
The unsecured loan stock has a market price of the irredeemable bond is at par. The company
has just paid the interest for 2017 on all bonds except the irredeemable bond. The company
pays corporate tax at a rate of 25%.
The shareholders complained bitterly on the on the 2016 Dividend of 64 kobo as it was lower
than what other similar companies paid as dividend.
The Finance Director is not satisfied with the cost of capital figured calculated. He believes the
Capital Asset Pricing Model (CAPM) model is preferable to the dividend valuation model
(DVM) Approach.
The average market return over the period is 23% from the treasury bills (Risk free rate) is 8%
while the Equity beta is 1.2.
Required
a Estimate the weighted average cost of capital of Double star plc without the Finance
Director’s recommendation
b calculate the cost of Equity using CAMP as advised by the Finance Director