UNIVERSITY OF PRETORIA
FINANCIAL MANAGEMENT 200
2021
COST OF CAPITAL
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STUDY OUTCOME
In order to achieve the specific outcome you should be able to:
– Identify and describe sources of capital;
– Describe cost of capital; and
– Identify components of cost of capital
– Understanding the difference between equity and debt
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FINANCIAL MANAGEMENT
INVESTING FINANCING
DECISIONS DECISIONS
COST OF
RETURNS
CAPITAL
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COST OF CAPITAL
• It is the cost of funds obtained by the company
• An important financial concept that links the firm’s long term
investment decisions with the wealth of the owners.
• It is the minimum return required by investors
• Cost of capital (Pooling of funds):
– Cost of Equity
– Cost of debt
• Weighted Average Cost of Capital (WACC)
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Capital Structure
• Entity is financed in parts: partly financed by equity, partly
financed by debt (Assets = Equity + Liabilities)
• Referred to as Capital Structure
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Purpose of WACC
• Measure our return on investment against WACC.
• When our return on investment (yield) equals WACC, then
we have kept all our shareholders happy, as we have
neither created nor destroyed value.
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Example to illustrate purpose of WACC
• Cost of Debt: 9%
• Cost of equity: 15%
• Capital structure: 60% equity, 40% debt
• Entity has opportunity to invest in project with a
return of 12%.
• Accept project?
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SOURCES OF FINANCE
DEBT EQUITY
• Debentures • Ordinary shares
• Mortgage bonds • Preference shares
• Loans • Retained Earnings
• Leases
• Creditors
• Bank overdraft
• Factoring of debts
Note: which is more expensive: debt or equity? Why?
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Equity vs Debt as a source of finance
Equity Debt
• No fixed repayments
• Fixed repayments at
• Return in the form fixed/semi-fixed rate.
dividends and capital
• Return: interest
growth
• Less risky than equity, as
• More risky, as investors
investor is guaranteed of
not guaranteed of return,
return (interest), therefore
therefore expect higher
cheaper source of finance
return to compensate for
than equity.
extra risk.
Conclusion: equity is more expensive than debt!
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Cost of Equity
• Sources of equity include:
– Retained earnings
– Preference shares
– Ordinary shares
• Retained earnings cheapest source of equity finance,
as it is readily available (already in entity)
• Second cheapest is preference shares, as investor has
slightly less risk than ordinary shares (guaranteed of
preference dividend; will receive money back before
ordinary shareholder in case of liquidation).
• Most expensive equity finance is ordinary shares, as
the risk is the highest! (Investor is last in line to receive
any return).
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Cost of debt
• Cheaper than equity because:
– Interest is tax deductible
– Investors require a lower return on their investment
because risk is lower than with equity
• When determining cost of debt (kd), usually an after
tax rate because of tax deductions.
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Capital Structure
If debt is cheaper than equity,
why not only use debt?
• RISK! Remember, debt has fixed repayment terms.
• Even though debt is cheaper, company might run into
cash flow problems to repay debt, which increases risk
of insolvency (think repayment of debtors: cash might
take long to enter business, but lender will not wait for
repayment)
• Board must therefore decide on optimal structure: good
combination of both equity and debt.
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COMPONENTS OF WACC
– Ordinary Shares (Cost of equity)
– Preference shares (cost of PS)
– Debentures (cost of debt)
– Long term loan (cost of debt)
PERMANENT
SOURCES OF
FINANCE
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How to calculate WACC
1. Determine weight of each component of finance
(equity / equity + debt; or debt / equity + debt)
2. Assign a cost to debt (kd) and equity (ke) – you
will learn how to do this later.
3. Calculate a weighted cost:
(ke x % equity finance) + (kd x % debt finance)
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