Topic 6

COST OF CAPITAL
&
BUSINESS VALUATION TECHNIQUES
Dr Alex Reuben Kira

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 Cost of Capita & Company Valuation
Learning objectives
• By the end of this session students should be able
to:
– Calculate the weighted average cost of capital (WACC)
and understand what it means
– Understand the term Free Cash Flows and use these
to help calculate the value of a business using
discounted cash flow (DCF) and net present value
(NPV) techniques
– Understand the concepts of Residual Income (RI) and
Economic Value Added (EVA) and how these may be
used in company valuation
– Outline how ratios may be used to assist in company
valuation

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 The Cost of Capital
• In the capital structure we include common
equity, preferred shares, bonds and long-term
debt. Every component of this capital structure
has a cost of obtaining it.
• Every capital expenditure requires an estimate of
the cost of capital, which is used to discount cash
flows to the present values or to serve as
accept/reject criteria in the case of IRR.
• The capital structure affects both the size and
riskiness of the firm’s earnings stream and also
has an impact on the value of the firm.
• A number of other decisions, including those
related to leasing, working capital policy requires
estimates of appropriate cost of capital.
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 Continued….
• The amount paid for availing and using capital from a
particular source is known as cost of capital.
• The supplier of the fund expects a fair return on the
investments made based on the market rate. In case of
stock/equity if the firm fails to pay a fair return, the value of
stock also goes down.
• Thus in operational term, cost of capital refers the
minimum rate of return which a firm must earn on its
investment so that market value of the firm remains
unchanged, if not increases.
• Solomon Ezra has defined “Cost of capital is the minimum
required rate of earning or the cut-off rate for capital
expenditures”.
• According to the Milton H. Spencer, “Cost of capital is the
minimum rate of return which a firm requires as a
condition for undertaking an investment”

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 Continued………
• Another approach to explain the cost capital
may be pure in economic terms.
• The cost of capital is the cost of acquiring the
funds required to finance the proposed
investment project i.e. borrowing rate
expressed in terms of percentage of capital
obtained and used.
• Since the capital may be obtained from
different sources, the weighted average cost
of capital is computed.
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 Importance of cost capital
• The cost of capital constitutes an integral part of
investment decisions and provides a good yardstick to
measure the relative worth of investment proposal.
• Thus it is basic input information in capital
expenditure decisions as the cost of capital is used to
discount the future cash inflows.
• Each source of capital involves different cost and
different risk. The cost of capital plays an important
role in designing the balanced appropriate capital
structure.
• The cost of each source of capital should carefully be
considered and compared with the risk involved in it.
Thus it is a basic for making a comparative study of alternative
financial resources and selecting those, which have minimum 6
 Assumptions
• The cost of capital and its determination is based on
the following assumptions:-

• Business Risk is unaffected:

The term business risk refers to the variability in annual
earnings is due to change in sales. This variability is
not going to be affected by accepting a new
investment proposal.

• Financial Risk is also unaffected

Financial risk refers to the risk on account of pattern of
capital structure. Here we assume that the capital
structure would remain constant.

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 Measurements of cost capital

• The cost of capital is measured in two stages;-

1) Computation of cost of each component
of capital i.e. determination of specific
cost; and
2) Computation of combined or composite
cost termed as weighted average cost of
capital (WACC) which is used for decision
on capital investment.

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 Cost of Equity Share Capital
• The payment of Dividend on equity shares is not legally
binding and rate of dividend not pre-determined. Some
experts hold the opinion that equity share capital does
not carry any cost but this is not true.
• Equity shareholders expect fair return on investment
and the company also aims at maximizing the value of
shares. If the company will not pay fair dividend the
value of the shares would go down. Thus equity shares
carry a cost in terms of return on investment. Equity
shareholders have the following expectations.
• A fair amount of dividend per share available to them
every year
• E.P.S should continue to rise regularly over the period
• R.Es in the business to plough back profit resulting in
value of shares
• There are few approaches for calculating the Cost of
Equity capital.
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 The cost of equity
Return expected by shareholders will comprise:
a)Risk free return
Guaranteed returns (equivalent to return on
government securities)
b)Premium for business risk
Reflects riskiness of nature of company’s
business activities
c)Financial risk
Reflects individual circumstances of business
(e.g. gearing)

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 Capital Asset Pricing Model (CAPM)
• Cost of equity = Rrf + B(Rm – Rrf)
Where:
• Rrf = Return on risk free investment (eg:
government bonds)
• Rm = Market return (ie: return achieved from
investing across whole of stock market)
• B (Beta) = Measure of riskiness of investment
being appraised (Risk Free investment would
have Beta of 0; Investment in market as a
whole would have a Beta factor of 1)

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 CAPM - Example
• The current return on government
securities is 8%, the average stock market
rate of return is 12% and Jones plc has a
beta value of 0.9.
• Calculate the cost of equity for Jones plc

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 Solution
• Cost of equity = Rrf + B(Rm – Rrf)
= 8% + 0.9(12% - 8%)
= 8% + 3.6
= 11.6%

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 Understanding Beta as a Measure of Risk:
• An investor is concerned with the risk of his entire
portfolio and that the relevant risk of a particular security
is the effect, the security has on the risk of the entire
portfolio.
• This leads us to the following proposition:The
contribution of a security to the risk of a diversified
portfolio is measured by the security’s Bata.
• The higher the security’s beta, the more the security
raises the risk of diversified portfolio.
• A security’s beta indicates how closely the security’s
returns move with the returns from diversified portfolio
Since the returns from the diversified portfolio move with
the market as a whole, beta, also measures how closely
the security’s returns move with the market. 14
 Continued……
• A beta of 1.0 for a given stock means, that if the total value of
stocks in the market moves up by 10% the stock’s price on an
average moves up by 10%.
• If the stocks beta is 2.0, its price will rise by 20% under same
condition.

• The Beta of the market as a whole is 1.0

• The beta of any portfolio of securities is the weighted average

of the beta of the securities, where the weights are the
proportions invested in each security. For example if 40% has
been invested in stock A & 60% in stocks B. and A has a beta of
1.0 & B has a beta of 1.5 Then the portfolio has a beta of 1.3 = .4
(1) + .6 (1.5)
• Thus beta makes sense as a measure of security risk. A low or
negative beta security is a low risk security because adding it to
the portfolio reduces the risk of the portfolio. 15
 Continued….
• A stock’s beta can be estimated statistically from
the history of its returns and are also available in
published reports.
• We can conclude about beta as measure of risk:
1. The value of a diversified portfolio moves with the
market as a whole (up and down together).
2. Beta measures how sharply and closely a security’s
price moves on a with the market.
3. Adding a high beta (more than 1.0) security to a
diversified portfolio increase the portfolio risk.
• Thus a security’s beta is an important indicator of
risk, and a determinant what the people are willing
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to pay for the security.
 Cost of equity: Earning Yield Method
• It is also called Earning Price Ratio Method.
According to this method, it is the E.P.S which
determines the market Price of the share.
• ke = E x 100
P
• ke = cost of equity
• E = Earning Per Share
= Total Earnings after tax
No equity shares
• P = Market Price per Share

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 Example
• A Company is earning currently shs.100,000 after tax.
It has issued 10,000 shares of shs.100 each fully paid.
The market price per share is shs.160. Find out the
cost of Equity share capital.
• Soln: ke = E x 100
P
• E = 100,000 or shs.10
10,000
• ke = 10 x 100 or 6.25%
160

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Cost of equity: Dividend Yield Method
• It is also called Dividend Price Ratio Method.
According to this method the cost of capital is
equal to the expected normal rate of dividend
on the equity.
• ke = D x 100
P
• D = Dividend per share in shillings
• P = Market Price per share
• Net proceeds from fresh issue per share

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 Example
• Y Ltd. offers for public subscription equity shares of
shs.10 each at a Premium of 10%. The Company has
to pay underwriting commission @ 5%. The rate of
Dividend expected by the shareholders is 20%. The
market prices of the existing equity share is shs.15.
Calculate the cost of equity capital.
• Soln. D = 20 x 10 = shs.2 Per Share = P shs.15 for Existing shares
100
• For Existing shares = ke = D x 100 or 2 x 100 or 13.33%
P 15
• For Fresh issue Proceed = 10 – (U/C ).50 + 1.00 Premium = shs.10.50

• ke = D x 100
P
= 2 x 100
10.5 Or 19.05%

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 Cost of Preferred Share Capital
• The cost of Preference share capital can be calculated with reference to
stipulated rate of dividend on such shares. The Preference shares can be
irredeemable or redeemable.
• Cost of Irredeemable Pref. Shares
• kps = P x 100
C
• P = Dividend Payable
• C = Net Proceeds from Pref. shares issue
• i. When pref. shares are issued at Par
• C = Par value – Flotation charges
• ii. When Pref. Shares are issued at premium
• C = par value + Premium – Flotation charges
• Tax implications: - Dividend payable on Pref. shares is
not allowed as an expense under Income Tax Act. While
computing the cost of Pref. Shares Capital no adjustment
is required for tax factor.
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 Example
• R Ltd has issued 1000, 9% Irredeemable Pref. Shares
of shs.100 each at shs.95 per share. The floatation
charges are underwriting 2%, Brokerage 0.5%, and
Printing 0.5%. The Company is subject to Income Tax
at the rate of 30%. Find out the cost of capital after
tax and before tax. What would be such cost if shares
had been issued at shs.105?
• Soln: Given; P = 9; C= 100 – 5 – 3 = 92
• kps = P x 100
C
• Cost of Capital after Tax = 9 x 100 = 9.78%
92
• If the shares are issued at shs.105; P = 9; Therefore, C = 105 – 3 = 102
• kps = 9 x 100 = 8.82%
102
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 Cost of Debt Capital
The Sources of capital are:-
• Debt capital: Such capital is generally obtained
through the issue of debentures/bonds. The issue
may involve a number of flotation charges such as
printing of prospectus, advertisements, underwriting,
brokerage, etc.
• Again debentures/bonds can be issued at par
Discount or Premium. The cost of Debt capital is
computed by the following formula:-
• kd = P x 100
C
kd = Cost of Debt Capital
P = Interest Payable
C = Capital Received (Proceeds from issue) less
flotation charges – discount + premium 23
 Cost of capital of Irredeemable debentures
Example: 1
• A company is willing to issue 10,000, 7% debenture (irredeemable) of shs. 100 each
and for which the company will have to incur the following expenses. Underwriting
commission 1.5%, Brokerage 0.5% Printing and other expenses shs. 5000. Assume
corporate tax rate is 30%. Find out the cost of capital.
Soln: Flotation charges per Debenture shs
• Underwriting Commission 1.5
• Brokerage 0.5
• Printing 5000
• 10000 .5
• 2.5
• C = 100 – 2.5 = 97.5; P = 7
kd = P x 100
C
= 7 x 100 = 7.18% x(1-.3) = 5.03%
97.5

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 Example
• A company has issued 10,000 $100 9.5%
irredeemable debentures which has a book value
of $1,000,000.The debentures have a market
value of $ 94 per debenture. The corporate tax
rate is 30%. Find the cost of irredeemable
debentures.
• Soln: Cost of Debt= (face value of debenture X
rate of Interest in %) X(1-rate of Tax)/Market
value per irredeemable debenture
• = 9.5 X 100= 10.1% x (1-.3) =7.07%
94
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 Cost of marketable debt
• Example
• A company has 1m irredeemable 8% debentures
each with a nominal value of £1. The debentures
are currently valued at £1.2m. The company pays
corporation tax at 30%.
• Cost of debt = (£1 million x 8%) x (1 – 0.30)
£1.2 million
• = £80,000 x 0.70
£1.2 million
• = 4.67%

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 Example
• X Ltd. has 10% irredeemable Debentures of shs. 100,000,000. Par value of debenture is
shs. 100. Find out the cost of capital, if debentures have been issued: (i) At par; (ii) At
discount of 10%; (iii) At premium of 10%. Assume tax rate is 30%.
Soln: C = 100 at par
C = 100 – 10 = 90 at discount
C = 100 + 10 = 110 at premium

• Id = P x 100
C
i. At Par Id = 10 x 100 = 10%x(1-.3) = 7%
100
ii. At Discount Id = 10 x 100 = 11.1%x(1-.3)=7.7%
90
iii. At Premium Id = 10 x 100 = 9.09% x(1-.3) = 6.36%
110

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 Cost of Redeemable Debentures
When the issue involves floatation charges
P= Coupon Rate + Floatation costs
(Int. payable per debenture) Period of issue
C = Par value – Floatation costs
2

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 Example
Y Ltd. issued a new 10% debentures of shs. 1000 face value to be
redeemed after 10 years. Debentures have been issued at par.
However flotation costs amount to 4%. Find out the cost of
capital. Assume Corporate tax is 30%.
Floatation cost = 1000 x 4 = shs. 40
100
P = 100 + 40 = 104
10
C = 1000 – 40 = shs. 980
2
kd = P x 100 or 104 x 100 = 10.61% x(1-.3) = 7.47%
C 980

(ii). When debenture are issued at Premium

P = Coupon Rate – Amount of Premium per share

(Int. Payable per debenture) Period of issue

C = Par value + Amount of Premium

2
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•
Example
A Company issues 10% debentures of shs.100 each for an aggregate
amount of shs.100, 000,000 at 10% premium, redeemable at par after five
years. Determine the cost of debt. Assume corporate tax rate is 30%.

• P = 10 – 10 C = 100 + 10
• 5 2

• P = 10 – 2 = 8 C = 100 + 5 = 105

• Id = P x 100
• C

• = 8 x 100 = 7.62% x(1-.3) = 5.334%

• 105

• When debentures are issued at Discount

• P = Coupon Rate + Amount of discount Per Debenture

• Period of issue
• C = Par value – Amount of Discount
• 2
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 Example
• A company has issued 7% debenture of shs.100 each
at a discount of 6%, repayable after 12 years. Find
out the cost of capital. Assume tax rate is 30%
• Soln: P = 7 + 6 P = 7 + .5 = 7.5
12
• C = 100 – 6 or 100 – 3 or 97
2
• Id = 7.5 x 100 = 7.7% x(1-.3) = 5.39%
97

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 Example: 6
• Y Ltd is willing to issue 5,000 6% debenture of shs.100
each at a discount of 10% repayable after 10 years. The
floatation cost is shs.3 per debenture. Assume corporate
tax rate is 30%. Find out the cost of capital.
• Soln: P = 6 + 10 + 3
10 10
• P = 6 + 1 + .3 = 7.3

• C = 100 – 10 – 3
2 2

• Id = 7.3 x 100 = 7.81% x(1-.3) = 5.47%

93.5

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 Cost of Loan repayable
= Rate of Interest X (1- tax rate)
• Example
• A company took a loan of $ 250,000 payable after 15
years at the rate of 20% fixed interest rate. What is
the cost of debt capital? Corporate tax rate is 30%.
• Solution
• Cost of Debt(Loan) = rate of interest X (1 – Tax rate)
= 20% X (1 – 0.30)
= 20% X 0.70
=14%

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 Cost of Retained Earnings:
• The Company may retain some of its profits for
expansion. If this money would have been paid to the
shareholders, they might have invested else where.
Thus R.E carries opportunity cost this could be taken as
cost of R.Es.

• kre = AD x 100
RE

• AD =Earnings from alternative Investments of R.Es (R.E

are subject to reduction of Brokerage and Income Tax)

• R.E = Retained Earnings

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 Example
• The company has net earning amounting to shs.50,000. It is expected if the R.Es,
are given to the shareholders, can be invested by them at a return of 10%. The
shareholders of the company are in 30% tax brackets. The shareholders will have
to incur 2% brokerage cost on making new investments. From the facts given
below, calculate the cost of R.Es.
• Soln:
R.Es shs. 50,000
Less: I. Tax (Shareholders) 15,000
35,000
Less: Brokerage 2% 700
Earnings available for Reinvestment 34,300

• AD = 34,300 x 10 = shs.3430
100
• kre = 3430 x 100
50,000
= 6.86%

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 Weighted Average Cost of Capital
• The following steps are required to be taken: -
– Calculate cost of each specific source of capital
– Each source of capital is assigned weight in any of the following
two ways. However, the total weights assigned should not
increase one.
– Historical Weight Method
• The relative proportions of various sources of capital to the existing
capital structure are used to assign weights.
– Marginal Weight Method
• In this method specific costs are assigned weights in the proportion
of funds to be raised from each source to the total funds.
– Each specific cost is multiplied by the corresponding weight
– The total of the Weighted Average cost is made which is Weighted
Average Cost of capital.
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 Example
• The following is the capital structure of X Ltd.
Book Value
Debentures Shs. 300,000
Pref. Share Capital Shs. 200,000
Equity share capital Shs. 400,000
R.E Shs. 100,000
• Calculate weight Average cost of capital using Book
Values as weights. The after tax cost of capital of specific
source is as under.
Debentures 4.77%
Pref. Shares 10.53%
Equity Shares 14.59%
R.E 14.00%

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 Solution
• Calculation of weighted Average cost of capital
Shs. Weight Cost of Capital (%) W.A Cost (%)
• Source of Capital
• Debentures 300,000 0.3 4.77 1.431

• Pref. Shares 200,000 0.2 10.53 2.106

• Equity Shares 400,000 0.4 14.59 5.836

• Retained Earnings 100,000 0.1 14.00 1.400

•
• Total Capital 1,000,000 1.0 WACC 10.773

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 Example
• The capital structure of R. Ltd is as under Shs.

• 2000, 6% shs.100 Debentures first issue 200,000

• 1000, 7% shs.100 Debentures second issue 100,000

• 2000, 8% shs.Cum Pref. Shares of shs.100 cash 200,000

4000, equity shares of shs.100 each 400,000

R. Earnings 100,000

• The E.P.S of the company in past many years has been shs.15
• The company tax rate is 30%, Find out the weight average cost capital.

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 Solution

• Ie = E x 100 P = 400,000 + 100,000 = 125 = 15 x

100 or 12%
P 4000
125

• (First Issue) Id = P x 100 (1- t) = 6 x 100 (1-.3) = 6 x .7 or 4.2%

C 100
• (Second Issue) Id = 7 x 100 (1-.3) = 7% x .7 = 4.9%
100
• Ip = P x 100 = 8 x 100 or 8%
C 100

• Ir = 15 x (1 – t) = 15 x .7
125 125

= 10.5 x 100 or 8.4%

125
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 Weighted Average cost of Capital
•
• Shs. Weights Cost of Capital (%) W.A Cost (%)
• Source
• Debentures I 200,000 0.2 4.2 0.84
•
• Debenture II 100,000 0.1 4.9 0.49
•
• Prof. Shares 200,000 0.2 8.0 1.60
•
• Equity Shares 400,000 0.4 12.0 4.80
•
• Retained Earnings 100,000 0 .1 8.4 0.84
• 1,000,000 1.0 WACC 8.57
•
•
•

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Question One
An entity has the following information in its balance sheet.
Ordinary shares of shs 50 each Tshs 2,500,000
12% Unsecured loan notes 1,000,000
The ordinary shares are currently quoted at shs 130 each
and the loan notes are trading at shs72 per shs100
nominal. The ordinary dividend of shs 15 has just been
paid with an expected growth rate of 10%.
Corporation tax is currently 30%

Calculate the weighted average cost of capital (WACC) for

this entity.
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Question Two
•A limited company has a capital structure presented below:
Equity capital 2,000,000 sharesTshs 40,000,000
6% preference shares 10,000,000
8% debentures 30,000,000
80,000,000
The company’s shares are traded on the market at 200/= it is
expected that the company will pay a current dividend of 20/=
per share which will grow at 7% forever. The tax rate is 30%.

Compute the weighted average cost of capital for the firm.

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