Corporate

Financial
Management
Group
Presentation
Cost of
Capital
Introduction
Cost of Capital
• The cost of capital represents the firm’s cost of financing, and is the
minimum rate of return that a project must earn to increase firm
value.
• The cost of capital is the rate of return that the enterprise must pay to
satisfy the providers of funds, and it reflects the riskiness of providing
funds.
Aspects of Cost of Capital
a. The cost of funds that a company raises and uses, and the return that
investors expect to be paid for putting funds into the company.
b. It is therefore the minimum return that a company should make on its
own investments, to earn the cash flows out of which investors can be
paid their return.
Significance of Cost of Capital
Cost of Capital
• Evaluating investment projects
• Designing a firms debt policy
• Appraising the financial performance of top management
• Determine the minimum expected rate of return
• To know the mix of fund to use in the capital structure
Cost of Capital & Risk
Cost of Capital and Risk
Risk free rate of return xx
Premium for business risk xx
Premium for financial risk xx
Cost of Capital xx
Risk-free rate of return
This is the return which would be required from an investment if it were completely free
from risk. Typically, a risk-free yield would be the yield on government securities.
Premium for business risk
This is an increase in the required rate of return due to the existence of uncertainty about the
future and about a firm's business prospects.
Premium for business risk
This relates to the danger of high debt levels (high gearing). The higher the gearing of a
company’s capital structure, the greater will be the financial risk to ordinary shareholders,
and this should be reflected in a higher risk premium and therefore a higher cost of capital.
Weighted Average Cost of Capital
Weighted Average Cost of Capital
Weighted Average Cost of Capital (WACC) is the composite
cost of capital. It represents the aggregate of the cost of
various sources of finance in use by an organization.
Components of Weighted Average Cost of Capital
•Cost of Equity
•Cost of Preference Shares
•Cost of Debts
Steps in Calculating WACC
Weighted Average Cost of Capital

Source of Capital Weight of Individual Weight ×

Market/Book Costs (%) Costs
Values (%)
Equity X X X
Preference X X X
Debt X X X
WACC X
Relative Cost of Capital
Cost of Equity Capital
This is the minimum required rate of returns expected by providers of
equity capital. It is denoted by Ke
Methods of Calculating Cost of Equity
There are several methods of calculating the cost of equity. These are;
•The dividend valuation model method,
•The dividend growth model method and the
•Capital Asset Pricing Model (CAPM) method.
Relative Cost of Capital
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Relative Cost of Capital

Relative Cost of Capital Contd.
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Illustration 1
The earnings and dividend of COVID Plc is as follows;
Year Dividend Earnings
$ $
2011 150,000 400,000
2012 192,000 510,000
2013 206,000 550,000
2014 245,000 650,000
2015 262,350 700,000

The company is financed by equity and there are 1,000,000 shares in

issue, each with a market value of $3.35 ex-div.
Calculate the cost of equity for Covid Ltd.
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Illustration 2
You are given the following information about EBOLA Plc
which is an all equity finance company. The number of
shares in issue is 150,000 of $1 each.
Current Dividend $6,158
Market Value of shares $3.42
Current Earnings $62,858
Net Assets $315,000
Dividend 5 years ago $2,473
You are required to estimate the cost of capital for the
company.
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Cost of Preference Shares

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Cost of Debt
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Illustration
CORONA Plc has in issue 10% debenture of a nominal value of $100.
The market price is $90 ex-interest. Calculate the cost of debt capital if
the debenture is;

a.Irredeemable

b.Redeemable in 10 years time.

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Question
• A company has 8 million shares each with a value of $7.90, whose
cost is 8.4%. It has 6% bonds with a market value of $50 million and
an after-tax cost of 3.6%. It has a bank loan of $10 million whose
after-tax cost is 4.1%. 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.
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Capital Asset Pricing Model

Another approach to calculating the cost of equity in a company is to use the
CAPM and the equity beta for the company’s shares.
CAPM is a set of predictions concerning equilibrium expected returns on
risky assets.
The CAPM formula is written as follows;

Rs = Rf + β ( Rm - Rf )
where
Ke = the cost of equity in the company
Rf = the risk-free rate of return
Rm =the return on the market portfolio of securities that are not risk-free
β = the beta factor for the company’s equity.
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Assumptions of CAPM
a. Investors hold diversified portfolios
This assumption means that investors will only require a return for the systematic
risk of their portfolios, since unsystematic risk has been diversified and can be
ignored.
b. Single-period transaction horizon
A standardized holding period is assumed by the CAPM to make the returns on
different securities comparable. A return over six months, for example, cannot
be compared to a return over 12 months. A holding period of one year is
usually used.
c. Investors can borrow and lend at the risk-free rate of return
This is an assumption made by portfolio theory, from which the CAPM was
developed, and provides a minimum level of return required by investors. The
risk-free rate of return corresponds to the intersection of the security market
line (SML) and the y-axis (see Figure 1). The SML is a graphical
representation of the CAPM formula.
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Risk and CAPM

Risk is associated with uncertainties surrounding the outcome
of a future event.
While investors and creditors make subjective evaluation of
risk, scholars offer statistical measures of risk arising from
beta coefficient theory.
Beta coefficient theory asserts that total risks associated with
an investment is made up of two elements;
•Systematic Risks
•Unsystematic Risks
Total Risk
Total Risk

Unsystematic Risk Systematic Risk

Financial Risk – Business Risk –

(Equity Beta) (Asset Beta)

•Systematic Risks
This is the risk attributed to prevailing market movements
•Unsystematic Risks
This is the risk unique to a specific security.
•Financial Risk
This refers to the associated risks with the financing mode of an entity.
•Business Risk
This relates to uncertainty regarding a companies ability to earn a
satisfactory return.
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Estimating Beta
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Gearing & Beta Factor

The gearing of a company will affect the risk of security.