Chapter 15:

Cost of Capital

Presented by:
Margarita Kouloumbri
Chapter Map
7
1
The overall
Estimating the approach
cost of equity-
the CAPM
2
Estimating the
cost of equity-the
DVM
6
The impact of Contents
risk

3
Estimating the
cost of preference
5 shares
Estimating the 4
cost of capital Estimating the cost
of debt

Cost of Capital 2
1 The overall approach
 An investor's total required return will depend on
2 specific factors:

The basic return required The prevailing risk

for the risk they take in advancing free rate (rf)
Funds to the firm

Cost of Capital 3
1 The overall approach

Cost of Capital 4
1 The overall approach
The cost of each
source of finance=
the return that TO CALCULATE THE
investors are RETURNS WE WILL
demanding on ASSUME A PERFECT
their investment CAPITAL MARKET:
•MV of the investment= the
PV of the expected future
returns discounted at the
investors’ required return

Cost of Capital 5
2 Estimating the cost of equity- the
Dividend Valuation Model (DVM)
ASSUMPTIONS OF THE DVM:
1. Future income stream is the
 COST OF dividends paid out by the company
EQUITY= 2. Dividends will be paid in perpetuity
3. Dividends will be constant or
The return the
growing at a fixed rate
investors expect to
achieve on their
shares

SHARE PRICE= DIVIDENDS PAID IN

PERPETUITY DICOUNTED AT THE
SHAREHOLDER’S RATE OF RETURN

Cost of Capital 6
2 Estimating the cost of equity- the
Dividend Valuation Model (DVM)
DVM (assuming constant dividends)

THIS IS
THE
COST OF
EQUITY

Cost of Capital 7
2 Estimating the cost of equity- the
Dividend Valuation Model (DVM)
Example 1:
Tom and Jerry Ltd has paid a dividend of 30c for
many years. The company expects to continue paying
dividends at this level in the future. The company’s
share price is $1.50 ex div ( after the latest dividend
payment)
Calculate the cost of equity

Cost of Capital 8
2 Estimating the cost of equity- the
Dividend Valuation Model (DVM)

Solution to example 1:

Cost of Capital 9
2 Estimating the cost of equity- the
Dividend Valuation Model (DVM)
DVM (assuming dividend growth at a fixed rate)

Cost of Capital 10
2 Estimating the cost of equity- the
Dividend Valuation Model (DVM)
Example 2:
Donald Ltd has just paid a dividend of 10c.
Shareholders expect dividends to grow at 5% pa. P
Co’s current share price is $1.05 ex div.
Calculate the cost of equity
Solution to example 2:

Cost of Capital 11
2 Estimating the cost of equity- the
Dividend Valuation Model (DVM)
DVM is based on perpetuity formula, assumes that the
first dividend will be paid in 1 year’s time, and the
correct value for the formula is the EX-DIV ( after the
dividend payment!!!)

Cost of Capital 12
2 Estimating the cost of equity- the
Dividend Valuation Model (DVM)
Example 3:
Mickey Mouse Ltd is about to pay a dividend of 15c.
Shareholders expect dividends to grow at 6%. The
company’s current share price is $1.25-cum div.
Calculate the cost of equity.
Solution to example 3:

Cost of Capital 13
2 Estimating the cost of equity- the
Dividend Valuation Model (DVM)

PAST DIVIDENDS
Estimating
growth (g)
1. Based on past
dividends
(historic trend)
2. The earning
retention
model

Cost of Capital 14
2 Estimating the cost of equity- the
Dividend Valuation Model (DVM)
Example 4:
Minnie Mouse Ltd has paid the following dividends
over the last five years.
20Y0: 10.0c
20Y1: 11.0c
20Y2: 12.5c
20Y3: 13.6c
20Y4: 14.5 c
Calculate the average annual historic growth rate

Cost of Capital 15
2 Estimating the cost of equity- the
Dividend Valuation Model (DVM)
Solution to example 4:

Cost of Capital 16
2 Estimating the cost of equity- the
Dividend Valuation Model (DVM)

THE EARNINGS RETENTION MODEL

(GORDON’S GROWTH MODEL)
Assumption: The higher the level of retentions in a
business the higher the potential growth rate

Cost of Capital 17
2 Estimating the cost of equity- the
Dividend Valuation Model (DVM)
EXAMPLE 5

Cost of Capital 18
2 Estimating the cost of equity- the
Dividend Valuation Model (DVM)

Solution to example 5:

Cost of Capital 19
2 Estimating the cost of equity- the
Dividend Valuation Model (DVM)
Example 6:
Pluto is about to pay a dividend of 16c a share. The
share price is 200c. The accounting rate of return on
equity is 12.5% and 20% of earnings are paid out as
dividends.
Calculate the cost of equity for Pluto Ltd.

Cost of Capital 20
2 Estimating the cost of equity- the
Dividend Valuation Model (DVM)

Solution to example 6:

Cost of Capital 21
2 Estimating the cost of equity- the
Dividend Valuation Model (DVM)

Cost of Capital 22
3 Estimating the cost of preference
shares

Cost of Capital 23
3 Estimating the cost of preference
shares
Example 7:
Goofy has 50,000 8% preferences shares in issue,
nominal value $1. The current ex div MV is $1.20/
share.
What is the cost of the preference shares?
Solution to example 7:

Cost of Capital 24
4 Estimating the cost of debt

Debt is tax
deductible for
the debt holder
(i.e. the receiver
of the debt)

Cost of Capital 25
4 Estimating the cost of debt
Key
points to
remember

Cost of Capital 26
4 Estimating the cost of debt

Cost of Capital 27
4 Estimating the cost of debt

Cost of Capital 28
4 Estimating the cost of debt
Example 8:
Scroutz has in issue 10% irredeemable debt
quoted at $80 ex interest.
What is the return required by debt providers?
Solution to example 8:

Cost of Capital 29
4 Estimating the cost of debt
Example 9:
Tweedy has irredeemable loan notes currently
trading at $40 ex interest. The coupon rate is
5% and the rate of corporation tax is 30%.
What is the cost of the debt to the company?
Solution to example 9:

Cost of Capital 30
4 Estimating the cost of debt

Cost of Capital 31
4 Estimating the cost of debt

So for redeemable debt I

have to use the TABLE!!!!!
(CASH FLOWS, DF, PV
etc)
THE KEY IS TO
CALCULATE THE IRR!!

Cost of Capital 32
4 Estimating the cost of debt
Example 10:
Winnie the Pooh Ltd has in issue redeemable
debt with 5 years to redemption. Coupon Rate
is 12%. Redemption is at par. The current
market value of the debt is $107.59. What is
the cost of debt to the company?

Cost of Capital 33
4 Estimating the cost of debt
Solution to example 10:

Cost of Capital 34
4 Estimating the cost of debt
Example 11:
Nemo Ltd has in issue 10% loan notes with a
current MV of $98. The loan notes are due to
be redeemed at par in 5 years time.
If corporation tax is 30% what is the
company’s cost of debt?

Cost of Capital 35
4 Estimating the cost of debt
Solution to example 11:

Cost of Capital 36
4 Estimating the cost of debt
Debt Redeemable at current market price

The position of the investor is the same as a holder

of irredeemable debt

Cost of Capital 37
4 Estimating the cost of debt

Convertible Debt

Cost of Capital 38
4 Estimating the cost of debt

Cost of Capital 39
4 Estimating the cost of debt
Example 12

Cost of Capital 40
4 Estimating the cost of debt

Solution to example 12

Cost of Capital 41
4 Estimating the cost of debt
Non tradeable debt:
JUST ADJUST FOR THE TAX RELIEF!!

Cost to the company=

Interest Rate X (1-T)

Cost of Capital 42
5 Estimating the cost of capital
(WACC)
 What is WACC?( Weighed Average Cost of
capital)….
 It is….. the average Cost of the Company’s finance
(equity, debentures, convertibles etc) weighed
according to the proportion each of this efficient
bears to the total pool of capital.
 Why is it important?
 It represents the discount rate used in investment
appraisals
 It has an inverse relationship with MV of the company
i.e. the lower the WACC the higher the MV of the
company
Cost of Capital 43
5 Estimating the cost of capital
(WACC)

Cost of Capital 44
5 Estimating the cost of capital
(WACC)
 Choice of weights:
 BOOK VALUES: represent historic cost of finance
 MARKET VALUES: represent current opportunity
cost of finance=> PREFERABLE USE MVs!!!
 Calculating Weights:
 Equity: Market Values of each share x number of
shares in issue
 Debt: Total nominal Value x Current Market Value
100
WACC= MVe x ke + MVd x kd
Total MV of the company
Cost of Capital 45
5 Estimating the cost of capital
(WACC)
Procedure for calculating WACC:
 Step 1: Identify each source of capital (i.e debentures,
shares, convertibles, bank loans)
 Step 2: Calculate the weights for each source of
capital
 Step 3:Estimate the cost for each source of capital (ke,
kd, kc)
 Step 4: Multiply the proportion of each source of
capital by cost of that source of capital.
 Step 5: Sum up the results of Steps 1-4 to give the
WACC

Cost of Capital 46
5 Estimating the cost of capital
(WACC)
Example 13:
Pokémon Ltd has $1 million loan notes in issue,
quoted at $50 per $100 of nominal value; 625,000
preference shares of $1 each quoted at 40c and 5
million ordinary $1 shares quoted at 25c. The
cost of capital of these securities is 9%, 12% and
18% respectively. This capital structure is to be
maintained.
Calculate the WACC

Cost of Capital 47
5 Estimating the cost of capital
(WACC)

Solution to example 13:

Cost of Capital 48
5 Estimating the cost of capital
(WACC)
Example 14:
Lion King Ltd has 10 million ordinary shares in issue,
with a current price of 155 cum div. The annual
dividend of 9c has just been proposed. The company
earns and accounting rate of return ROE of 10% and
pays out 40% of the return as dividends. The
company also has 13% redeemable loan notes with a
nominal value of $7m trading at $105. They are due
to be redeemed at par in 5 years time. This capital
structure is to be maintained.
Calculate the WACC if Tax is 33%
Cost of Capital 49
5 Estimating the cost of capital
(WACC)

Solution to example 14:

Cost of Capital 50
5 Estimating the cost of capital
(WACC)
Solution to example 14:

Cost of Capital 51
5 Estimating the cost of capital
(WACC)
WHEN TO USE THE WACC AS A
DISCOUNT RATE IN INVESTMENT
APPRAISAL???
•If the historic proportions of debt and
equity will remain unchanged
•If the operating risk of the firm will
remain unchanged
•If the finance is not project specific i.e.
projects are financed from a pool of funds
•If the project is small in relation to the
company so any changes are insignificant

Cost of Capital 52
6 The impact of risk

 DVM and WACC assume that an investor’s

current required return will remain unchanged
for future projects.
 BUT projects have different risk profiles
this assumption may not hold
The higher the
 Consider the risk- return trade off: risk the higher
the return
RISK: IS THE LIKELIHOOD OF
ACTUAL RETURN VARYING FROM
THOSE FORECAST

Cost of Capital 53
6 The impact of risk

Cost of Capital 54
6 The impact of risk

The choice between D and C is less clear- cut!!! It will

depend on the investor’s attitude towards risk!!!

Cost of Capital 55
6 The impact of risk
Return on loan notes
Risk free rate  More risky than the
 It is the minimum rate Government bill or gilts
required by investors for but less risky than equities
an investment whose because return is more
returns are certain predictable so… it is higher
 In Qs will be given as: than Rf but lower than
 The return on Treasury bills return on equities
or  Why? Because interest is a
 The returns on government legal commitment, interest
gilts will be paid before
dividends, loan are secured
Cost of Capital 56
 6 The impact of risk

Return on equities
 Equity shareholders are paid after Required Return of
all the other commitments of the equity holders=
company are met Rf return+ Risk premium
 Company’s earnings fluctuate so
equityholders’s earnings are more
risky and the most expensive form
of finance for the company

Cost of Capital 57
7 Estimating the cost of equity-
CAPM

How can an investor reduce the risk of his investment?

By acquiring a second
investment with a different
risk profile => smoothes
the average return
Reducing Risk in this way
is called
DIVERSIFICATION

Cost of Capital 58
7 Estimating the cost of equity-
CAPM

Cost of Capital 59
7 Estimating the cost of equity-
CAPM

Cost of Capital 60
7 Estimating the cost of equity-
CAPM
 Systematic Risk: Created by market wide factors
as the state of the economy, will affect all the
companies in the same way=> IT CAN’T BE
ELIMINATED
 Non systematic Risk: Company/industry specific
factors=> IT CAN BE ELIMINATED
THROUGH DIVERSIFICATION

Cost of Capital 61
7 Estimating the cost of equity-
CAPM
Example 15:
The following factors have impacted the volatility of earnings
of Shrek Co, a manufacturer of chocolate biscuits and cereals:
1. Increase in interest rates

2. Increase in the price of coca beans

3. Legislation changing the rules on tax relief for investments

in non-current assets
4. Growth in the economy of the country where Shrek Co is
based
5. Government adv ice on the importance of eating breakfast

6. Industrial unrest in Shrek Co’s main factory

Are they example of systematic or unsystematic risk?

Cost of Capital 62
7 Estimating the cost of equity-
CAPM
 CAPM= Capital Asset Pricing Model shows how
the minimum required return on a quoted security
depends on its risk
Key
 Assumptions: points to
 Well diversified investors remember
 Perfect Capital Market
 Unrestricted borrowing or lending at the risk-free rate of
interest
 Uniformity of investor expectations
 All forecasts are made in the context of one time period
only
Cost of Capital 63
7 Estimating the cost of equity-
CAPM
CAPM formula
Required Return= rf+b( Rm-Rf)

I cant stand
any more
formulas!!!!

Cost of Capital 64
7 Estimating the cost of equity-
CAPM

So what is beta β??

IT IS THE
SYSTEMATIC RISK
ON THE
INVESTMENT
COMPARED TO
MARKET=> AMOUNT
OF THE PREMIUM
NEEDED

Cost of Capital 65
7 Estimating the cost of equity-
CAPM
 The market has a
beta= 1
Using CAPM as a
discount rate in
 If an investment is
riskier than the investment
average then its appraisal
beta>1 (aggressive) • When the project
 If an investment is will be equity
less risky than the financed
market its beta <1
(defensive) • When the
 If an investment is operating risk of
risk free then its the firm will
beta=0 remain unchanged
Cost of Capital 66
7 Estimating the cost of equity-
CAPM

Example 16:
The current average market return being paid on
risky investment is 12% compared with 5% on
treasury bills. Little Mermaid has a beta of
1.2.What is the cost of equity of Little Mermaid?
Solution to example 16:

Cost of Capital 67
7 Estimating the cost of equity-
CAPM

Example 17:
Popeye is currently paying a return of 9% on
equity investment. If the return on gilts is
currently 5.5% and the average return on the
market is 10.5%. What is the beta of the company
and what does this tell us about the volatility of
the company’s returns compared to those of the
market?

Cost of Capital 68
7 Estimating the cost of equity-
CAPM
Solution to example 17:

Cost of Capital 69
7 Estimating the cost of equity-
CAPM

Advantages of CAPM
•Works well in
practice
•Focuses on
systematic risk
•Is useful for
appraising specific
projects

Cost of Capital 70
7 Estimating the cost of equity-
CAPM

Disadvantages of CAPM
•Less useful if investors
are undiversified
•Ignores tax situation
of investors
•Actual data inputs are
estimate- hard to obtain

Cost of Capital 71
How is this Chapter Tested?
 You will surely get one question on the exam on
chapters 14&15
 All the assumption, advantages and disadvantages of
the models are important
 Calculation of WACC and explanation of CAPM, cost
of equity and different types of debt
 June 08 Q1, June 09 Q1, Dec 09 Q2, Dec 08 Q3, Dec
07 Q1, June 2010 Q2, Dec 2010 Q4,June 2011 Q2, Dec
2011 Q3

Cost of Capital 72
Cost of capital

Thank you !