Marginal Cost of Capital

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Cost of capital: Recall

• Cost of capital is the required rate of return by the

investors on the capital that they finance the firm.
• The firm borrowing the capital, the return that they
pay is therefore a cost of the capital.
• As the minimum required rate of return from an
investment that the firm takes.
• It can also be defined as the investor‘s opportunity
cost of finance.

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• The required rate of return by the investor’s should be
commensurate to the amount of risk that their capital
will be exposed.
– The higher the risk exposure the greater will be their
required rate of return, c.t.

Return = risk-free rate + Risk premiums

• The risk premiums compensates the investors from
financial risk and business risk exposure.

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Cost of equity

• This the required rate of return that the equity

shareholder’s requires on their equity capital
investment in the firm.
• We can estimate the cost of equity using 2 models:
– Dividend valuation model
– Capital asset pricing model

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i. Dividend valuation model
• It is based on the fundamental theory of valuation:
– the theory dictates that the market value of a financial
instrument is the sum of present values of all future
receipts that that security will yield over its entire life/until
maturity.

• Thus, the market value of an equity is equal sum of

PV of all future dividends that the investors will
receive.

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• Case of no dividend growth:
Recall:
PV =
P0 =
Re = *100%
Where, P0 = ex-dividend share price
Re = the cost of equity

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Example

• A firm has been paying dividends over the last 10

years at a pay-out ratio of 20%. The current net profit
for the year is Kes 20m and the market capitalisation
is Kes 50 million. If there are 1 million issued shares
and assuming no dividend growth, what is the cost of
equity?

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Case of Dividend Growth

• Recall:
PV =
P0 =
Where d0= most recently paid dividend
g= annual growth rate in dividends
Re =

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Example

• The following are the dividends that a firm has been

paying since 2018.
2018 2019 2020 2021
9c 10c 10.5c 12.7c

This year’s dividend, payable before end of this month,

is 15c. If the current MPS, cum-div is $4.35, what is the
current cost of equity?

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Example 3

• A co. has pay-out ratio of 20% and return on equity

of 15%. The current net profit was Kes 10 million. If
the current MPS is Kes 25 and the firm intends to
raise Kes 40 million from equity for an upcoming
project incurring an issue cost of Kes 5 per share,
what would be the cost of new equity shares to be
issued?
• Assume the firm has 1 million currently issued shares

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Capital Asset Pricing Model

• Required rate of return to the equity shareholders is

pegged on their systematic risk exposure:
– Recall that there are 2 types of risk:
• Systematic risk/market-wide risk/non-diversifiable risk/priced risk
• Non-systematic risk/firm-specific risk/diversifiable risk/unpriced
risk
– The compensation/premiums only applies to the systematic
risk exposure not any non-systematic risk exposures.
– NB: the non-systematic risk is unpriced since the investors
are assumed to hold a well diversified portfolio.

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• The systematic risk exposure is measured using the
beta coefficient:

𝐶 o 𝜈 𝑖 ,𝑚
β 𝑖=
𝛿2𝑚

Where =beta coefficient of asset i

=covariance of returns of asset i and the market portfolio.
= variance of market portfolio returns

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• Beta coefficient of the market portfolio is equal to 1.
• Thus, a security whose beta;
=1, then it has an equal systematic risk to the market portfolio
>1, it has more systematic risk exposure than the market
portfolio (thus higher required rate of return)
<1, it has lower systematic risk exposure, compared to market
portfolio, thus lower required rate of return.

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Example

• An equity share has a beta of 1.2. The market

portfolio return is 11% while the risk-free rate of
return is 5%. Calculate the cost of equity of the
security?

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Cost of Debt
i. Irredeemable bonds

• Bonds are irredeemable, if they don’t have an end

life. No maturity period.
• Thus, interest receipts are received from the bond to
the foreseeable future/infinity.
• Based on the fundamental valuation theory:
P0= Sum of PV of cash flows; 1- α
Recall: PV =
Thus, the P0 =
=* 100%

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Redeemable bond

• These bonds have a redemption option; the bond covenant details,

the final payment for every bond the issuer issued in the market.

P0= (int.*(1-t)*PVAF.n,r%) + (RV*PVIF.n,r%)

Where r%=cost of debt.

RV=redemption value,
P0= ex-interest bond market value
t=corporate tax rate
int=fixed interest receipt

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• To estimate the cost of debt, we use the trial and error
method; the IRR.

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iii. Convertible bonds

• The bond grants the holder the option of converting

the bonds to equity shares, on some predetermined
future date.
• Assuming the investor is a wealth maximiser, they
will take the option that grants the higher wealth:
conversion or redemption.
Conversion value = market value of equity shares received per bond.
CV= Conversion ratio * Pn
Conversion ratio=no. of equity shares received per bond
Pn = Share price at the conversion time.

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 P0 = (Int.*(1-t)*PVAF n. r%) + (RV/CV*PVIF n. r%)
To estimate the cost of debt, we use trial and error
method; IRR method.

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Example
• An 8% bond $100 has a current market value of $102.5.
The bond covenant provides that 5 year from now, at
redemption, 1-bond can be redeemed at 5% premium to its
nominal value. The covenant also provides for conversion
option, where the conversion ratio is 19 equity shares. The
current market price per share is $5. Assuming a 4.5%
annual growth in share price; determine the cost of debt, if
the bond was:
i. irredeemable
ii. Redeemable (and not convertible)
iii. Convertible
(corporate tax rate=30%)

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iv. Bank loan

• The cost of a bank loan is the interest payable, net of

tax shield.
• NB: bank loans are not tradable in the market; there’s
no market value.
rd=Interest(1-t)
Example:
A 10% $3m bank loan was taken by a firm 3 years go.
What’s the cost of the bank loan if t=30%p.a.?
rd=10%(1-.3)=7%

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Cost of preference shares

• Conveniently, preference shares are irredeemable and

tradable in the market.
• The preference dividend is fixed and non-tax
deductible.
P0=
Thus, =
Where, =preferred dividend
= ex-div share price
= cost of preference shares

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Example

• A 4% $1.5 preference shares have a current market

price of $1.2. Estimate their cost.
Dp= 4%*1.5 = 6c
=
= *100% = 5%

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Estimating WACC

• Weighted average cost of capital is the average

required rate of return that the different capital
provider’s requires for every dollar that they have
invested in the firm.
• The proportion/weight of every capital source can be
obtained using either the book values or their market
values.

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Marginal Cost of Capital

• MCC is the extra cost that the firm will incur for
every dollar that they intend to raise from the market.
• It’s cost for every one new dollar raised.

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