By Ejaz Khan

COST OF CAPITAL
A fundamental calculation for all companies is to establish its financing costs, both individually for
each component of finance and in total terms. These will be of use both in terms of assessing the
financing of the business and as a cost of capital for use in investment appraisal.

Risk and Return

The relationship between risk and return is easy to see, the higher the risk, the higher the required to
cover that risk.

Overall Return
A combination of two elements determines the return required by an investor for a given financial
instrument.
1. Risk-free return – The level of return expected of an investment with zero risk to the investor.
2. Risk premium – the amount of return required above and beyond the risk-free rate for an
investor to be willing to invest in the company

DEGREE OF RISK

RISK FREE HIGH RISK

Government Secured Loans Un-Secured Loans Preference Ordinary

Debt Shares Shares

“The Higher the Risk the Higher the Return”

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 By Ejaz Khan

WACC

Capital
structure
theories

Ke=Cost Kp=Cost of Project

of Equity Kd= Cost of preference specific
debt share Discount
rate

Different types of Cost of Capital

Cost of equity: the rate of return that is required by the equity holders of the company. The symbol
used to represent cost of equity is Ke.

Cost of debt: this the after-tax return required by the debt holders of the company. The symbol
used to represent after-tax cost of debt is Kd (1 – t).

Cost of preference shares: the return required by the the preference shareholders of the company.
The symbol used to represent cost of preference shares is Kp.

Methods of calculating the cost of Equity

It can be calculated using two of the following methods:

 Dividend Valuation Model: used for companies that pay: Constant dividend Constant growth in
dividends
 Capital Asset Pricing Model (CAPM)

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 By Ejaz Khan

The Dividend Valuation Method

Constant Dividend per Year

M.V = Current Dividend

Ke

Ke = Current Dividend
Po

Where,
𝑃0= Current market value of equity share

𝐾𝑒= cost of equity

Dividend with Constant Growth

M.V = Current Dividend (1+g)

Ke

Where,
𝑃0= Current Ex-market value of equity share

g = sustainable growth rate

Difference between cum dividend and ex dividend price

Ex-dividend price (P0) is the market price excluding dividend and cum-dividend price is the
market price including dividend.

Cum-Dividend Price Less: Dividend = Ex-Dividend Price

Calculating the sustainable growth rate for dividends

1. Average Method

g = [do/dn]1/n - 1

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 By Ejaz Khan

Example
ABC Ltd paid a dividend of 6p per share 8 years ago, and the current dividend is 11p. The current share
price is $2.58 ex div
Required: Calculate Cost of Equity
Solution
g = [11/6]1/8 - 1 = 7.9%

Ke= 0.11(1+7.9%) + 7.9% = 12.47%

2.58

2. Gordon Growth Model

g = rb Where, r = return on invested funds

b = Proportion of funds retained

Example
The ordinary shares of Titan Ltd are quoted at $5.00 ex div. A dividend of 40p is just about to be paid.
The company has an annual accounting rate of return of 12% and each year pays out 30% of its profits
after tax as dividends.
Required: Estimate cost of equity
Solution
g = 12% X (1-30%) = 8.4%

Ke = 0.4(1+8.4%) + 8.4% = 17.07%

5

Capital asset pricing Model (CAPM)

There are two types of risk

1.Market or systematic risk is risk that cannot be diversified away.

2.Non- systematic or unsystematic risk applies to specific individual company or
industry, and can be reduced or eliminated by diversification.
Systematic risk is how market factors effect that investment. Market factors are:-
 Macroeconomic variables
 Political factors
CAPM assumes that the investor has eliminated the unsystematic risk

See next page for elimination of unsystematic risk

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 by Ejaz Khan

Diversification
By holding a portfolio, the unsystematic risk is diversified away but the systematic risk is not and
will be present in all portfolios. If we were to enlarge our portfolio to include approximately 25
shares we would expect the unsystematic risk to be reduced to close to zero, the implication
being that we may eliminate the Unsystematic portion of overall risk by spreading investment
over a sufficiently diversified portfolio.

CAPM
Unsystematic Risk Systematic Risk
 Specific to company  Related to general economy
 individual industries  includes Macro-economic factors and affects
 A method for reducing this risk is through the whole economy
diversification.  Cannot be reduced through diversification.
 E.g. employees on strike, key employee  E.g. political risk, interest rate, inflation rate
 Diversification: it is process whereby Beta:It is a relative systematic risk of
we spread our investment by holding company's earnings with the market
a portfolio of unrelated stocks which systematic risk.
results in the reduction of un As market risk =1
 CAPM assumes that all investors are Beta can be > 1 More risky compare to
rational and will hold well diversified market Beta can be < 1 Less risky compare
portfolio (means there is no to market
unsystematic
risk.)

CAPM Formula

Cost of Equity = Rf + β (Risk Premium)

Cost of Equity = Rf + β (Rm-Rf)

Where,
Rf = Risk free rate
β = measure of relative systematic risk
Risk Premium = RM - Rf
RM = Expected Return on Market
(Rm-Rf)= Market risk premium or equity risk premium

It is assumed that investors are rational & will hold a well-diversified portfolio (unsystematic risk will
be reduced to minimum level).
 Transaction cost is low or nil.
 Investors have homogeneous expectations about the market.
 Market is perfect and all investors have same level of information & no individual can dominate
the market.

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 By Ejaz Khan

 Debt beta is zero.

 there is no cost of acquiring information.
 No individual can dominate the market.

Advantages of CAPM
 It considers only systematic risk, reflecting a reality in which most investors have
diversified portfolios from which unsystematic risk has been essentially eliminated.
 It generates a theoretically – derived relationship between required return and
systematic risk which has been subject to frequent empirical research and testing.
 It is generally seen as a much better method of calculating the cost of equity than the
dividend growth model (DGM) in that it explicitly takes into account a company’s level of
systematic risk relative to the stock market as a whole.
 It is clearly superior to the WACC in providing discount rates for use in investment
appraisal.
 The CAPM is really just a single Period model. Few investment projects last for one year
only and to extend the use of the return estimated from the model to more than one
time period would require both project performance relative to the market and the
economic environment to be reasonably stable.
 CAPM assumes no transaction costs associated with trading securities.
 Additionally, the idea that all unsystematic risk is diversified away will not hold true if
stocks change in term of volatility. As stock change over time it is very likely that the
portfolio becomes less than optimal.
 CAPM assumes investors can borrow and lend at the risk- free rate of return.
 CAPM assumes that debt beta is zero which may not be appropriate in many cases

Dividend Growth Model vs CAPM

The dividend growth model allows the cost of equity to be calculated using empirical
values readily available for listed companies. Measure the dividends, estimate their
growth (usually based on historical growth), and measure the market value of the share
(though some care is needed as share values are often very volatile). Put these amounts
into the formula and you have an estimate of the cost of equity.

However, the model gives no explanation as to why different shares have different costs
of equity. Why might one share have a cost of equity of 15% and another of 20%? The
reason that different shares have different rates of return is that they have different risks,
but this is not made explicit by the dividend growth model. That model simply measures
what’s there without offering an explanation. Note particularly that a business cannot
alter its cost of equity by changing its dividends.

Dividend valuation model might suggest that the rate of return would be lowered if the
company reduced its dividends or the growth rate. That is not so. All that would happen is
that a cut in dividends or dividend growth rate would cause the market value of the
company to fall to a level where investors obtain the return they require.
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 By Ejaz Khan

The CAPM explains why different companies give different returns. It states that the
required return is based on other returns available in the economy (the risk free and the
market returns) and the systematic risk of the investment – its beta value. Not only does
CAPM offer this explanation, it also offers ways of measuring the data needed. The risk
free rate and market returns can be estimated from economic data. So too can the beta
values of listed companies. It is, in fact, possible to buy books giving beta values and
many investment websites quote investment betas.
When an investment and the market is in equilibrium, prices should have been adjusted
and should have settled down so that the return predicted by CAPM is the same as the
return that is measured by the dividend growth model.
Implications of systematic risk & unsystematic risk
 If an investor wants to avoid risk altogether, he must invest entirely in risk-free securities.
 If an investor holds shares in just a few companies, there will be some unsystematic risk as well
as systematic risk in his portfolio, because he will not have spread his risk enough to diversify
away the unsystematic risk. To eliminate unsystematic risk, he must build up a well-diversified
portfolio on investments.
 If an investor holds a balanced portfolio of all the stocks and shares on the stock market, he will
incur systematic risk which is exactly equal to the average systematic risk in the stock market as
a whole.
Factors determining the beta of a company’s equity shares
 Sensitivity of the company’s cash flow to economic factors, as stated above. For example
sales of new car are more sensitive than sale of basic food and necessities.
 The company’s operating gearing. A high level of fixed cost in the company’s cost
structure will cause high operating profit compared with variations in sales.
 The company’s financial gearing. High borrowing and interest cost will cause high
variation in equity earnings compared with variation in operating profit, increasing the
equity beta as equity returns become more variable in relation to market as whole. This
effect will countered by the low beta of debt when computing the weighted average beta
of the whole company.
Cost of Debt Capital

Each item of debt finance for a company has a different cost. This is because debt capital has
differing risk, according to whether the debt is secured, whether it is senior or subordinated
debt, and the amount of time remaining to maturity. Cost of debt is adjusted for taxation
because of the tax savings available on annual interest. The different types of debt are:
 Irredeemable debt
 Redeemable debt (redeemable fixed rate bonds)

 Variable rate debt (floating rate debt)

 Non-tradable debt

 Convertible debt

 Corporate debt

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 By Ejaz Khan

COST OF IRREDEEMABLE DEBT

Kd(net) = (1-t)/Po

where i = interest paid

t = marginal rate of tax
P0 = ex interest (similar to ex div) market price of the loan
stock.

Example

The 10% irredeemable loan notes of Rifa plc are quoted at $120 ex-interest. Corporation tax is
payable at 30%.

Required:

What is the cost of debt net?

SOLUTION
10(1−30%)
𝐾 = 𝑋100% = 5.83%

Cost of Redeemable Debt

The cost of redeemable bonds is their redemption yield. This is calculated as the rate of
return that equates the present value of the future cash flows payable on the bond (to
maturity) with the current market value of the bond. In other words, it is the IRR of the cash
flows on the bond to maturity, assuming that the current market price is a cash outflow. In
order to calculate Kd calculate after tax value of interest.

Year Cash Flow D.F @ 5% P.Values D.F @other rate P.Values

0 (M.v) 1.000 (××) 1.000 (××)

1–5 Interest(1-t) A.f ×× A.f ××

5 Redemption Value D.f ×× D.f ××

×× ××

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Example of Cost of Redeemable Debt

The current market value of a company’s 7% loan stock is 96.25. Annual interest has just been paid. The
bonds will be redeemed at per after four years. The rate of taxation on company profits is 30%.

Required: Calculate the after-tax cost of the bonds for the company.

Solution:

Year Cash Flow D.F @ 5% P.Values D.F @ 10% P.Values

0 (96.25) 1.000 (96.25) 1.000 (96.25)

1–4 4.90 3.546 17.38 3.170 15.53

4 100 0.823 82.30 0.683 68.30

3.43 (12.42)

IRR

Kd (1-t) = 5% +[[3.43/(3.43+12.42)]x(10-5)] = 6.08%

Cost of Convertible Debt

Here bond holders have choice to either redeem the debt or convert the debt into predetermined
number of shares. The method of calculating cost of debt for convertible is same as calculating
the cost of debt of redeemable debt.
The problem here is that we do not know whether the bond holder would exercise the
conversion option or not. Therefore we take higher value of redemption value or conversion
value.
Conversion Value is calculated as:
Conversion Value = M.V per share at time of conversion x No. of Shares
M.V at the time of conversion = Current M.v × (1+g)^n
Where,
g = Share price growth
n = no. of years in conversion

Example of Cost of Convertible Debt

The current market value of a company’s 7% loan stock is 96.25. Annual interest has just been
paid. The bonds will be redeemed at per after four years or convertible into 20 ordinary shares.
Current share price is $4.44 and it is expected that it will grow with a growth of 5% per year. The
rate of taxation on company profits is 30%.
Required: Calculate the after-tax cost of the bonds for the company.

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SOLUTION:

Conversion Value = 20× 4.44 × 1.05^4= $108

Redemption Value=$100

Investors are rational and will choose the higher Value

Year Cash Flow D.F @ 10% P.Values D.F @ 5% P.Values

0 (96.25) 1.000 (96.25) 1.000 (96.25)

1–4 4.90 3.170 15.53 3.546 17.38

4 108 0.683 73.76 0.823 88.88

(7) 10

IRR

Kd(1-t) = 5%+[[10/(10+7)] x(10-5)] = 7.94%

Cost of Variable Rate Debt & Non-Tradable Debt

Variable or Floating Rate Debt

Company will pay what you demand. Interest rate and required rate if same then market
value will be same as redemption.
Because
Kd = Interest % x (1-t) book value = market value

Non-tradable Debt
An example of non-tradable debt is bank loan.

Kd=Interest % x (1-t)

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 COST OF PREFERENCE SHARES

Irredeemable Preference Shares Redeemable Preference Shares

The cost of capital is calculated in the same way as The cost of capital is calculated in the same way as
the cost of equity, assuming a constant annual the cost of redeemable debt. Assuming before tax
dividend. preference dividend as no tax deduction is
allowable on preference dividend.
M.v = Preference Dividend
r

r or KD = Preference Dividend
Market value

Weighted Average Cost of Capital

The WACC is a weighted average of the (after-tax) cost of all the sources of capital for the company.

Steps for Calculating WACC

 Calculate cost of each source of finance. e.g Kd, Ke , Kp
 Calculate market value of each source of finance
 M.v of Equity = (Issued share capital / par value) × M.v per share
 M.v of Debt = (Book value / par value) × M.v per bond
 M.v of Preference share = (Book value / par value) × M.v per share
 Bank loan market value = book value 

Calculate WACC using this formula:

Source Proportion (in Market Values) X Cost WACC

Equity Proportion of Equity x Ke X%
Debt Proportion of Debt x Kd(net) X%
Preference Share Proportion of Preference x Kp X%
WACC X%


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Example

Bar plc has 20m ordinary 25p shares quoted at $3, and $8m of loan notes quoted at $85. The cost of
equity has already been calculated at 15% and the cost of debt (net of tax) is 7.6%.

Required: Calculate WACC?

SOLUTION

Source Propotion X Cost WACC

Equity (60/66.8) X 15% 13.47%
Debt (6.8/66.8) X 7.6% 0.77%

14.25%
Market Value of Equity = 20m X $3 = $60m
Market Value of Debt = $8m X 85/100 =
$6.8m Total capital (60+6.8) = $66.8m

See WACC with capital structure on next page

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 Capital Structure and WACC

Gearing Theories

The Traditional View

Cost of equity: At relatively low levels of gearing the increase in gearing will have relatively
low impact on Ke. As gearing rises the impact will increase Ke at an increasing rate

Cost of debt: There is no impact on the cost of debt until the level of gearing is prohibitively high.
When this level is reached the cost of debt rises

Gearing D/E

Key point: As the gearing level increases initially the WACC will fall. However, this will happen up
to an appropriate gearing level. After that level WACC will start to rise. There is an optimal level
of gearing at which the WACC is minimized and the value of the company is maximized.

The MM View (With Out Tax)

Cost of equity: Ke rises at a constant rate to reflect the level of increase in risk associated with gearing.
Cost of debt: There is no impact on the cost of debt.

Assumptions:
1. Perfect capital market exist where individuals and companies can borrow unlimited
amounts at the same rate of interest.
2. There are no taxes or transaction costs.
3. Personal borrowing is a perfect substitute for corporate borrowing.

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 4. Firms exist with the same business or systematic risk but different level of gearing.
5. All projects and cash flows relating thereto are perpetual and any debt borrowing is also
perpetual.
6. All earnings are paid out as dividend.
7. Debt is risk free.

The increase in Ke directly compensates for the substitution of expensive equity with cheaper debt.
Therefore, the WACC is constant regardless of the level of gearing.

Gearing D/E

If the weighted average cost of capital is to remain constant at all levels of gearing it follows that
any benefit from the use of cheaper debt finance must be exactly offset by the increase in the cost
of equity.

The MM View (With Tax)

In 1963 M&M modified their model to include the impact of tax. Debt in this circumstance has the
added advantage of being paid out pre-tax. The effective cost of debt will be lower as a result.

Implication: As the level of gearing rises the overall WACC falls. The company benefits from
having the highest level of debt possible.

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 GEARING D/E

(a) Market imperfections:

This suggests that companies should have a capital structure made up entirely of debt.
This does not happen in practice due to the existence of other market imperfections
which undermine the tax advantage of debt finance.

(b) Bankruptcy costs:

MM’s theory assumes perfect capital markets so a company would always be able to
raise finance and avoid bankruptcy. In reality however, at higher levels of gearing there is
an increasing risk of the company being unable to meet its interest payments and being
declared bankrupt. At these higher levels of gearing, the bankruptcy risk means that
shareholders will require a higher rate of return as compensation.

(c) Agency costs:

At higher levels of gearing there are also agency costs as a result of action taken by
concerned debt holders. Providers of debt financed are likely to impose restrictive
covenants such as restriction of future dividends of the imposition of minimum levels of
liquidity in order to protect their investment. They may also increase their level of
monitoring and require more financial information.

(d) Tax exhaustion:

As companies increase their gearing they may reach a point where there are not enough
profits from which to obtain all available tax benefits. They will still be subject to
increased bankruptcy and agency costs but will not be able to benefit from the increased
tax shield.

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Pecking Order Theory

Pecking order theory states that the firm will prefer certain types of finance over others. It comes
up with its ranking for the sources of finance that a company should prefer over other. The order
of preference is as follows:
 Retained earnings
 Straight Debt
 Convertible debt
 Preference shares
 Equity shares

Reasons Limitations of Pecking Order Theory

 lt is easier to use retained funds than go to the Pecking order theory fails to take into account
trouble of obtaining external finance and have to taxation, financial distress, agency costs or how
live up to the demands of external finance the investment opportunities that are available
providers. may influence the choice of finance.
 Pecking order theory is an explanation of what
 There are no issue costs if retained earnings are businesses actually do rather than what they
used, and the issue costs of debt are lower than should be looking forward to do.
those of equity.

 investors prefer safer securities i.e. debt with its

guaranteed income and priority on liquidation.

 Some managers believe that debt issues have a

better signaling effect that equity issues because
the market believes that managers are better
informed about shares' true worth than the market
itself is. Their view is the market will interpret debt
issues as a sign of confidence, that business are
confident of making sufficient profits to fulfill their
obligations on debt and that they believe that the
shares are undervalued
Marginal Cost of Capital

Marginal cost of capital is the incremental cost of capital of additional 1 $ raise of finance. It is the
incremental cost of capital of additional finance raised. Marginal cost of capital should be used if
following conditions does not fulfill.
 Financial risk of new project is not same as the existing financial risk of company
 The required return of investors increased from existing level
 Size of the new project is not smaller than the existing size of business.

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CAPM & MM Combined

SYSTEMATIC RISK
Equity Beta (βe)

BUSINESS RISK FINANCIAL RISK

Asset Beta (βa)

Business Risk Financial Risk

Business risk arises due to the nature of a Financial risk arises due to the use of debt as a
company's business operations, which determines source of finance, and hence is related to the
the business sector into which it is classified, and capital structure of a company. Financial risk is
to the way in which a company conducts its the variability in shareholder returns that arises
business operations. Business risk is the variability due to the need to pay interest on debt.
in shareholder returns that arises as a result of Financial risk can be assessed rom a shareholder
business operations. It can therefore be related to perspective in two ways. Firstly, balance sheet
the way in which profit before interest and tax gearing can be calculated. Secondly, the interest
(PBIT or operating profit) changes as revenue or coverage ratio can be calculated
turnover changes. This can be assessed from a
shareholder perspective by calculating operational
gearing, which essentially looks at the relative
proportions of fixed operating costs to variable
operating costs. One measure of operational
gearing that can be used is (100 x contribution/
PBIT), although other measures are also
used.
Systematic Risk

From the shareholder perspective, systematic risk is the sum of business risk and financial
risk, Systematic risk is the risk that remains after a shareholder has diversified investments in
a portfolio, so that the risk specific to individual companies has been diversified away and the
shareholder is faced with risk relating to the market as a whole. Market risk and diversifiable
risk are therefore other names for systematic risk. From a shareholder perspective, the
systematic risk of a company can be assessed by equity beta of the company. If the company
has debt in its capital structure, the systematic risk reflected by the equity beta will include
both business risk and financial risk. If company is financial entirely by equity, the systematic
risk reflected by the equity beta will be business risk alone, in which case the equity beta will
be the same as the asset beta.

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 The Formula
βa = Ve × βe
Ve + Vd (1-t)
Where:
Ve = Market Value of Equity
Vd = Market Value of Debt

Should Company’s WACC be Used for Investment Appraisal?

If the Investment’s Business risk and Financial Risk are similar to the company, then we use the
company’s WACC to appraise the investment. However, if any of the risk is different then we
have to calculate investment specific cost of capital.

Project Specific Cost of Capital

Following are the steps for calculating project specific cost of capital.

Financial Risk is Different Business Risk is Different

1. Chose the βe of the company. 1. Identify a proxy company having same

2. Calculate the βa using the company’s Business Risk
current financial structure (Un-gearing 2. Chose the βe of that proxy company.
Beta). 3. Calculate the βa using the Proxy
βa = Ve x βe company’s current financial structure
Ve + Vd (1-t) (Un-gearing Beta).
3. Calculate βe of the investment using βa = Ve x βe
capital structure to be used for the Ve + Vd (1-t)
investment. (Re- gearing Beta) 4. Calculate βe of the investment using
𝑉𝑒 + 𝑉d(1 − 𝑇) capital structure to be used for the
𝛽𝑒 = x 𝛽𝑎
𝑉𝑒 investment. (Re- gearing Beta)
4. Use βe to calculate Ke using CAPM 𝑉𝑒 + 𝑉𝑑(1 − 𝑇)
5. Calculate WACC
𝛽𝑒 = x 𝛽𝑎
𝑉𝑒
5. Use βe to calculate Ke using CAPM
6. Calculate WACC

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 Example

Techno, an all equity agro-chemical firm, is about to invest in a diversification in the consumer
pharmaceutical industry. Its current equity beta is 0.8, whilst the average equity β of pharmaceutical
firms is 1.3. Gearing in the pharmaceutical industry averages 40% debt, 60% equity. Corporate debt is
available at 5%.
Rm = 14%, Rf = 4%, corporation tax rate = 30%.
Required:

What would be a suitable discount rate for the new investment if Techno were to finance the new
project with 30% debt and 70% equity?

SOLUTION

Pharmaceutical Industry 𝛽𝑒 = 1.3

60
𝛽𝑎 = 60+40(1-30%) 𝑋 1.3 = 0.89
70+30(1-30%)
𝛽𝑒 = 𝑋 0.89 = 1.16
70

Ke = 4% + 1.16 (14% - 4%) = 15.6%

5. WACC
Source Propotion X Cost WACC
Equity 70% X 15.6% 10.92%
Debt 30% X 5% (1-30%) 1.05%
WACC 11.97%

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