Financial Management 2A

Unit 6c – Cost of Capital (Chapter 11)

FM22A2
 LEARNING OUTCOMES:

 Discuss the importance of the cost of capital for an entity

 Identify, calculate and interpret the various costs of capital

UNIT 6c : Cost of Capital

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 ASSESSMENT CRITERIA

 Perform advanced calculations to determine a firm’s cost of equity

capital as well as debt capital including the various debt instruments
available;

 Understand the concept of a firm’s overall cost of capital and

perform advanced calculations based on market values and costs of
different instruments to calculate a WACC; and

 Understand the pitfalls of overall cost of capital and how to manage

and adjust them for different risk scenarios.

UNIT 6c : Cost of Capital

 RESOURCES

 Textbook:
• Chapter 11
 Study Guide
• Unit 6c: Cost of Capital

 Calculator

UNIT 6c : Cost of Capital

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 NB!! RECAP SLIDE

WACC (Step 1 x Step 2)

Cost of
Cost of Ordinary
Preference Cost of Debt (Kd)
Equity (Ke)
Shares (Kp)

Non- Non-
Dividends CAPM Redeemable Redeemable
Redeemable Redeemable

Valuation Growth
Model Model Annuity Perpetuity Annuity Perpetuity

D0 𝑖(1−𝑡)
=/ +g = +β(-) TVM 5 variables K 𝑝= TVM 5 variables K 𝑑=
UNIT 6c : Cost of Capital
P0 P0
 INTRODUCTION

 Main goal - Maximizing shareholders’ wealth

 Therefore, generate a return to pay providers of capital

 Return to providers of capital is cost to the company for the finance

provided.

 There are two sources of finance:

• Debt
• Equity

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 INTRODUCTION

 All businesses need to raise finance to operate

Debt Equity
• Bond
• Debentures • Ordinary shares
• Loans • Preference shares
• Overdrafts

 COST = Providers of capital require a return on finance provided

 Cost examples: interest expense or dividends

 Companies need to generate a return that is suitable for the

providers of capital
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 INTRODUCTION

Return for providers

Cost of Capital
of capital

Return for
Cost of
providers
Capital
of capital

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 POOLING OF FUNDS

 Sources of finance (debt & equity) are group together (pooled) to

fund various projects.
 Companies decide on target capital structure (% debt and % of
equity).
 The pooling of funds results in weighted average cost of capital
(WACC).
 WACC is used to make decision on whether to make new
investments

UNIT 6c : Cost of Capital

 COST OF CAPITAL

WACC
Preference
Ordinary Equity Debt
Shares

Non- Non-
Dividends CAPM Redeemable Redeemable
Redeemable Redeemable

Valuation Growth Annuity Annuity

Perpetuity Perpetuity
Model Model (TVM) (TVM)

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 COST OF ORDINARY EQUITY

 Cost of ordinary shares/equity is a return that equity investors

require on their investment in the company

1. Dividends:
a) Dividend Valuation model (zero dividend growth)

b) Dividend growth model (constant growing dividend)

= cost of ordinary shares / cost of equity

= x (1 + g) dividend expected in next period
= constant or current dividend paid
= share or market price of ordinary share
g = expected constant annual growth rate

UNIT 6c : Cost of Capital 11

 COST OF ORDINARY EQUITY

Dividend Method

ADVANTAGES DISADVANTAGES
Its simplicity - Can only be used by companies
that pay dividends
- Does not consider risk
- Relies on assumption that the
dividend remains constant or
grows at a constant rate annually

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 COST OF ORDINARY EQUITY

 Cost of ordinary equity is a return that equity investors require on

their investment in the company

2. Capital Asset Pricing Model - CAPM (incorporates risk)

= +(-)

= cost of ordinary shares

= risk-free rate of return
= market return on a portfolio
= beta coefficient of the share (i.e. measure of volatility)
(-) = market risk premium

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 COST OF ORDINARY EQUITY

CAPM Method

ADVANTAGES
- It incorporates risk, whereas the
dividend method does not
- It is applicable to all
companies, even to companies
that do not currently pay
dividends
DISADVANTAGES
- It requires both the return on
the market portfolio (or the
market risk premium) as well as
the beta coefficient to be
available and accessible
- It is a single-period model,
meaning it won’t be appropriate
to be used as a discount rate for
projects that exists for multiple
years

UNIT 5c : Cost of Capital

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 COST OF ORDINARY EQUITY

Constant Ltd has R1 par value ordinary shares in issue. The ordinary
shares are currently trading at R4.30 and a dividend of 30 cents per
share has just been proposed.

REQUIRED:

Calculate the cost of ordinary shares.

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 COST OF ORDINARY EQUITY

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 COST OF ORDINARY EQUITY

Growth Ltd has R1 par value ordinary shares in issue. The ordinary
shares are currently trading at R4.00. A dividend of 30 cents per share
has just been paid and the directors estimate that dividends will
increase by 10% each year in perpetuity.

REQUIRED:

Calculate the cost of ordinary shares.

UNIT 6c : Cost of Capital

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 COST OF ORDINARY EQUITY

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 COST OF ORDINARY EQUITY (Page 49)

Capital Ltd has a beta (β) of 1.3. The expected return on the market
portfolio is 16% and the current risk-free rate is 8%.

REQUIRED:

Calculate the cost of ordinary shares.

UNIT 6c : Cost of Capital

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 COST OF ORDINARY EQUITY

= +(-)

= 8% + 1.3(16% - 8%)

= 0.184

= 18.40%

UNIT 6c : Cost of Capital

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 COST OF PREFERENCE SHARES

Cost of preference shares is also the return that equity investors

require on their investment in the company
(dividend on preference share)

1. Non-redeemable: (perpetuity principle)

= cost of preference shares

D = fixed annual dividend
= ex dividend market price of preference shares

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 COST OF PREFERENCE SHARES

2. Redeemable: (annuity principle)

PV; FV; N; PMT
[COMP] I/Y

= cost of preference shares

PV = current market price of preference shares
FV = redemption amount (or par value of the preference shares)
N = number of periods until the shares are redeemed
PMT = dividend payment on par value
I/Y = cost of preference shares

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 COST OF PREFERENCE SHARES

Non-Redeemable Ltd 9% non-redeemable preference shares in issue.

The preference shares have a par value R1 and are currently trading at
R1.08.

REQUIRED:

Calculate the cost of preference shares.

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 COST OF PREFERENCE SHARES

= 8.33%

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 COST OF PREFERENCE SHARES

Redeemable Ltd has 9% redeemable preference shares in issue. The

preference shares have a par value R1 and are currently trading at
R1.08. The preference shares are redeemable at par in five year’s
time.

REQUIRED:

Calculate the cost of preference shares.

UNIT 6c : Cost of Capital

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 COST OF PREFERENCE SHARES

N 5

PV (R1.08)

PMT R1 x 9% = R0.09

FV R1

[COMP] I/Y 7.05%

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 PREFERENCE SHARES vs COST OF DEBT

Preferenc Debt
e Shares • Interest Tax
• Dividends deductible
not Tax • Paid pre
deductible tax
• Paid post
tax

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 COST OF DEBT

Cost of debt is a return that lenders require on new long term debt
(bonds, debentures, etc.)
Therefore: The interest rate that a company must pay on new debt

NB! Interest on debt is tax-deductible (dividend on pref shares NOT)

1. Non-redeemable: (perpetuity principle)

= after-tax cost of debt

i = fixed annual interest
t = company’s tax rate (%)
= ex-interest market price of debt

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 COST OF DEBT

2. Redeemable: (annuity principle)

PV; FV; N; PMT
[COMP] I/Y

PV = current market price of debt (negative)

FV = redemption amount (or debt par value)
N = number of periods until debt is redeemed
PMT = fixed after tax interest (the net amount)
I/Y = cost of debt

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 COST OF DEBT

Non-Redeemable Ltd has 8% non-redeemable debentures in issue.

The non-redeemable debentures have a par value R100 and are
currently trading at R90. Company tax is currently 28%.

REQUIRED:

Calculate the cost of non-redeemable debentures.

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 COST OF DEBT

= 6.40%

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 COST OF DEBT

Redeemable Ltd has 8% redeemable debentures in issue. The

debentures have a par of R100 and are currently trading at R90. The
debentures are redeemable at R105 in five years’ time. Company tax is
currently 28%.

REQUIRED:

Calculate the cost of debentures.

UNIT 6c : Cost of Capital

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 COST OF DEBT

N 5

PV (R90)

PMT R100 x 8% x (1 – 28%) = R5.76

FV R105

[COMP] I/Y 9.18%

UNIT 6c : Cost of Capital

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 HOMEWORK - Textbook

 Multiple choice questions Q1 to Q15

UNIT 6c : Cost of Capital

 WEIGHTED AVERAGE COST OF CAPITAL

Weighted Average Cost of Capital (WACC) overall return company

must generate on existing assets to maintain value of:
• Ordinary shares (highest risk = highest cost of capital)
• Preference shares (2nd lowest risk = 2nd cheapest cost of capital)
• Debt (lowest risk = lowest cost of capital)

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 WEIGHTED AVERAGE COST OF CAPITAL

• Calculate the after-tax component cost of each category of

Ste
capital.
p
1:

Ste • Determine the relevant weighting of each component.

p
2:
• Determine the contribution of each component and then
Ste
add each contribution together to obtain the WACC.
p
3:

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 WEIGHTED AVERAGE COST OF CAPITAL

x)+(x)+(x)

;; = refer to the previous slides

E = value of the ordinary equity shares
P = value of preference shares
D = value of the debt
V = E + P + D (market values

UNIT 6c : Cost of Capital

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 WEIGHTED AVERAGE COST OF CAPITAL

After-
tax Value Weighting Contribution
Component
cost (R) (%) (%)
(%)
Ordinary shares K V V/V total K x V/V total
Preference shares K V V KxV
Debt K V V/V total K x V/V total
V total 100% WACC

Step 1: Step 2: Step 3:

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 WEIGHTED AVERAGE COST OF CAPITAL

WACC Ltd has provided the following information at 31 December

2016:
Before-tax margin
Book value (R) Market value (R)
cost (%)

Ordinary share capital 6 000 000 8 000 000 12.00

Preference share capital 2 000 000 2 500 000 10.00
Debentures 4 000 000 4 500 000 9.00
12 000 000 15 000 000

Company tax is currently 27%.

REQUIRED:
Calculate the WACC using market values.

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 WEIGHTED AVERAGE COST OF CAPITAL

Formula:

x ) + ( x ) +( x
9% (1 – 0.27)
x 12% + x 10% + x 6.57%

= 0.064 + 0.0166 + 0.0197

= 0.1004

= 10.04%

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 WEIGHTED AVERAGE COST OF CAPITAL

Table:

After-tax Value Weighting

Component Contribution (%)
cost (%) (R) (%)
Ordinary shares 12.00 8 000 000 53.33 6.40
Preference shares 10.00 2 500 000 16.67 1.67
Debt 6.57 4 500 000 30.00 1.97
15 000 000 100.00 WACC=10.04%

Component

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 WEIGHTED AVERAGE COST OF CAPITAL

Assumptions:

1. WACC assumes pool of funds.

2. WACC can be used as discount rate.

3. WACC assumes capital structure of company is constant (Target

capital structure).

4. New investments do not have different risk to entity’s existing

investments.

5. All cash flows = constant perpetuities.

UNIT 6c : Cost of Capital

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 WEIGHTED AVERAGE COST OF CAPITAL

Investment Decisions:

 Invest in a project if the expected return > WACC

 New investments must be financed by new sources of finance

 WACC reflects entity’s long-term future capital structure

 Appropriate discount rate

 New investments risk ≠ Entity Risk

UNIT 6c : Cost of Capital

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 NB!! RECAP SLIDE

WACC (Step 1 x Step 2)

Cost of
Cost of Ordinary
Preference Cost of Debt (Kd)
Equity (Ke)
Shares (Kp)

Non- Non-
Dividends CAPM Redeemable Redeemable
Redeemable Redeemable

Valuation Growth
Model Model Annuity Perpetuity Annuity Perpetuity

D0 𝑖(1−𝑡)
=/ +g = +β(-) TVM 5 variables K 𝑝= TVM 5 variables K 𝑑=
UNIT 6c : Cost of Capital
P0 P0
 HOMEWORK QUESTION

Additional learning material:

a. Sincro Ltd’s (LAO CFM2A June 2013).

UNIT 5c : Cost of Capital

Thank you