Module 14 - Cost of Capital PDF

SCHOOL OF ACCOUNTANCY UNIVERSITY OFAfrica
LIMPOPO
Finding Solutions for
“Empowerment Solutions For Accountancy Professionals”
Management Accounting and Finance III

(CMAA030)
2023
SCHOOL OF ACCOUNTANCY
Management Accounting & Finance ll
Module 14
Cost of capital
1) Cost of Capital
2) Risk management
3) Strategy
The Cost of Capital
Learning Objectives
1. Understand the advantages and disadvantages of debt
finance in terms of financial risk and increased
shareholder return
2. Understand “cost of capital”
3. Explain the uses and importance of WACC
4. Determine the cost of debt.
5. Determine the cost of preference shares
6. Calculate the cost of equity using dividend growth.
method and CAPM.
7. Calculate the firm WACC.
Learning Outcome 1: Debt vs Equity finance:
Risk & Return
R100 000
(28 000)
R70 000
R20 000
Cost
Debt Equity
Risk Less risky – Why?? Riskier – Why??
INVESTOR
Dillution control Lower return – Why?? Higher return – Why??
Riskier Less risk

COMPANY
Cheaper Expensive
Risk & Return
Debt Equity
Less risky – Periodic Riskier – At the back of
INVESTOR
payments to be the queue on
received liquidation
Lower return – Lower Higher return – Higher
risk, lower return risk, higher return
Riskier - May default Less risk – Dividends

COMPANY
may not be paid
Cheaper – Lower return Expensive – Higher risk,
required + Tax higher return + Not tax
deductible deductible
Learning Outcome 1: Debt vs Equity finance: Risk
SCHOOL OF ACCOUNTANCY & Return
Debt providers often require lower return for their
investment due to the following reasons:
• Their capital repayment is guaranteed.

• There is a specific time frame within which the full
amount must be repaid.
• Sometimes the debt is secured over assets – which
may be sold to recover the money in case of default.
• In case of liquidation, they may be paid before
preference and ordinary shareholders.
SCHOOL OF ACCOUNTANCY Risk & Return
Risks faced by ordinary shareholders.
• Dividend payment is not guaranteed
because it depends on the policy of the
company.
• Dividends also depend on whether the
company is profitable or not.
• If the case of liquidation ordinary
shareholders are the last to share in the
profits of the company.
• So the return required by ordinary
shareholders is not guaranteed.
Learning Outcome 2: What is cost of capital
• Cost of capital for all the company's long term

sources of finance – Why do we exclude short term
finance??
• Minimum return required by capital providers for their
investment in the company
• The cost of capital measures the opportunity cost of
all of the sources of capital you invested in your
business.
• Opportunity cost is what you give up by investing
some scarce resource in one project or initiative
instead of another.
Learning Outcome 2: What is cost of capital
• NB. Only includes capital sources that come from

investors and excludes all liabilities that are not debt,
For example, includes:
• Loans
• Ordinary shares
• Preference shares
• Debentures
Learning Outcome 2:What is Weighted Average
Cost of Capital
• The weighted average cost of capital (WACC) is a
calculation of a firm's cost of capital in which, each
category of capital is proportionately weighted.
• WACC is weighting of debt and equity in the
company capital structure.
Learning Outcome 2: Class example
• Indicate which of the finance sources below would

form part of your cost of capital:
• Ordinary Shares
• Preference shares redeemable in 6 months
• Debentures redeemable in 6 years
• Non redeemable preference shares
• Bank overdraft - part of long term financing
• Retained income and Non distributable reserves
• Deferred taxation
Learning Outcome 3: Uses and importance
SCHOOL OF ACCOUNTANCY of WACC
Reasons for calculating WACC include:
• For evaluation of capital projects.

– Only those projects that have a return higher than WACC will
be accepted.
– Hurdle rate
• For valuation of companies
– e.g using Free Cash Flow (FCF) method, WACC is used as a
discount rate.
• Determination of company EVA
– Assets are regarded as adding value if they generate a return
higher than the cost of capital.
* May indicate how investors perceive the company, higher
WACC higher risk
SCHOOL OF ACCOUNTANCY Learning Outcome 4:The Cost of debt - Kd
• The cost of debt is the return an enterprise must pay to
its lenders.
• Lenders are only willing to lend money to the company
if they are benefiting from such transaction.
• The return to shareholders may be in the form of
interest payments.
• Tax deductible costs of debt should be after tax, to take
into account the tax benefit
• How about withholding tax, e.g on preference shares??
• Dividends taxed in the hand of the investor, therefore
include cost before tax as there is no tax benefit
Learning Outcome 4:The Cost of debt - Kd
Bank loans: Kd = I(1-t)
Kd = the shareholders required rate of return = Cost of
debt
I = Interest rate payable
1-t = Interest less tax
Non - redeemable debt (Non – redeemable)
Kd = I(1-t)
MV
Kd = Cost of debt (Required return)
I (1-t) = Debenture Interest less tax
MV = Market price of the loan
Learning Outcome 5:The Cost of preference
shares
Non - redeemable preference shares

Kp = D__
MV
Kp = Cost of preference shares (Required return)
D = Annual dividend
MV = Market price of the loan
SCHOOL OF ACCOUNTANCY Learning Outcome 5: Cost of equity
• dividend growth model formula.
– Price per share (Po) = D1
Ke –g
Then make ke the subject of formula
Ke = D1 + g
Po
• capital asset pricing model
– Ke= Rf + b (Rm-Rf)
Remember that Ke is before tax because dividends

are taxed in the hands of the investors
Learning Outcome 5: CAPM
“Empowerment Solutions For Accountancy Professionals” Example
Shares in Louie and Dewie have a beta of 0.9. The
market return is 10% and the risk free rate is 4%.
Calculate the cost of equity capital for Louie and Dewie.
Learning Outcome 5: CAPM
“Empowerment Solutions For Accountancy Professionals” Example
Shares in Louie and Dewie have a beta of 0.9. The
market return is 10% and the risk free rate is 4%.
Calculate the cost of equity capital for Louie and Dewie.
Suggested solution:
Ke = Rf + β(Rm) – Rf)
= 4 +0.9(10-4)
= 9.4%
Learning Outcome 6: Cost of equity
“Empowerment Solutions For Accountancy Professionals” The following data relates to the ordinary shares of
Stilton. Current market price, 31 December 20X1 250c
;Dividend per share, 20X1 3c
Expected growth rate in dividends and earnings 10% pa
;Average market return 8%; Risk-free rate 5%;Beta factor
of Stilton equity shares 1.40 and similar companies in the
industry has a beta of 1.8
(a) Calculate the estimated cost of equity using the
dividend growth model.
(b) Calculate the estimated cost of equity using the
capital asset pricing model.
(c) Comment on Stilton beta.
“Empowerment Solutions For Accountancy Professionals” Using P/E ratio to calculate market price per share
P/E ratio = market price per share
earnings per share
Making market price per share the subject of the
formula.
Market price per share = P/E ratio X

earnings per share
Remember :
Earnings per share = Profit after tax
Total number of shares issued
2. Using earnings yield to calculate market price per
share
• Earnings yield is the inverse of P/E ratio.
Earnings yield = Earnings per share
Market price per share
Making market price per share the subject of the formula
Market price per share = Earning Per Share

Earnings Yield
“Empowerment Solutions For Accountancy Professionals” 3. Using Gordon’s growth model
P0 = D0 (1+g)
Ke - g
Where: P0 = value of ordinary share
D0 = the current dividend
D1 = future dividend (current dividend x growth)
g = growth
ke = cost of equity
Remember that the same formula can be used to

calculate Ke by making it the subject of the formula.
“Empowerment Solutions For Accountancy Professionals” 4.Using value of ordinary shares
• Value of ordinary shares/equity = number of shares x
market price per share
• Making market price per share the subject of the
formula.
• market price per share = Value of ordinary shares
Number of shares
etc
Additional Example : calculating to total value of ordinary shares
Foschini Ltd has just paid a dividend of 30c per share.

Dividends are growing at a constant rate of 4% p.a. The
shareholders required rate of return is 15% p.a with
total number of 100 000 shares.
Required:
Calculate the value of ordinary shares to be used in the
WACC calculation.
Additional Example : calculating to total value of
ordinary shares
Suggested solution:
Value of ordinary shares =number of shares x price
per share.
The number of shares are given.
The market price per share is calculated using
Gordon growth model because we have information
relating to that formula.
P0 = D0 (1+g)
Ke - g
P0 = 30(1+0.04) = 31.20 = R2.84 per share
15-4 11
Total value of shares = 100 000 x 2.84= R283 636
ordinary shares
Foschini Ltd is a non-JSE listed company and has
issued a total of 100 000 ordinary shares. 80% of the
shares is owned by Mr Joseph and his wife Marina. The
remaining shares is bought by Tiger Ltd. Tiger Ltd
performed valuation of their shares in order to sell their
stake because they are discouraged by the non-
payment of dividends by the company. The value of
Tiger Ltd shares as performed by valuation experts is
R1 million.
Required:
Calculate the value of all ordinary shares in Foshini Ltd
that will be used in WACC calculation.
SCHOOL OF ACCOUNTANCY ordinary shares
Total number of shares = 100 000
Shares owned by Tiger Ltd = 100 000 x 20%

=20 000
Value of shares = Number of shares x market price per
share.
The value of the 20% shares is given as R1000 000.
market price per share = Value of shares
number of shares issued.
= R1 000 000/20 000 = R50 per share
Total value of ordinary shares = total shares issued x
price per share
100 000 shares x R50 = R5 000 000.
Learning Outcome 7: Calculation of WACC
Financing Market values Weightings Cost WACC

method (A) (B) AxB
Ordinary shares 40 000 0,4 or 40% Ke 1
Preference 10 000 0,1 or 10% Kf after tax 2
shares
Debentures 30 000 0,3 or 30% Kd after tax 3
Bonds 20 000 0,2 or 20% Kd after tax 4
100 000 1 or 100% Column
added
together.
• Market values or Book values???
Learning Outcome 7: Calculation of WACC
Thank you!!

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SCHOOL OF ACCOUNTANCY UNIVERSITY OFAfrica

Management Accounting and Finance III

Riskier Less risk

Riskier - May default Less risk – Dividends

• Their capital repayment is guaranteed.

• Cost of capital for all the company's long term

• NB. Only includes capital sources that come from

• Indicate which of the finance sources below would

• For evaluation of capital projects.

Non - redeemable preference shares

Remember that Ke is before tax because dividends

Market price per share = P/E ratio X

Making market price per share the subject of the formula

Market price per share = Earning Per Share

Remember that the same formula can be used to

Foschini Ltd has just paid a dividend of 30c per share.

Shares owned by Tiger Ltd = 100 000 x 20%

Financing Market values Weightings Cost WACC

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