Chapter 14 • The cost of capital

• The dividend growth model

• The capital asset pricing model
The cost of capital (CAPM)
• The cost of debt
• The weighted average cost of
capital

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 Overview

Maximisation of
shareholder wealth

Investment Financing Dividend

decision decision decision

Cost of capital

Cost of debt Cost of equity

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 Syllabus learning outcomes 1

• Describe the relative risk-return relationship and the

relative costs of equity and debt.
• Describe the creditor hierarchy and its connection with
the relative costs of sources of finance.
• Apply the dividend growth model to calculate the cost of
equity and discuss its weaknesses.
• Explain and discuss systematic and unsystematic risk,
and the relationship between portfolio theory and the
capital asset pricing model (CAPM).
• Apply the CAPM to calculate the cost of equity and
describe and explain the assumptions and components
of the CAPM.

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 Syllabus learning outcomes 2

• Explain and discuss the advantages and disadvantages

of the CAPM.
• Calculate the cost of capital of a range of capital
instruments, including: irredeemable debt, redeemable
debt, convertible debt, preference shares, bank debt
• Distinguish between average and marginal cost of
capital.
• Calculate the weighted average cost of capital (WACC)
using book value and market value weightings.

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 Key models and theories

This chapter examines the concept of the cost of capital,

which can be used as a discount rate in evaluating
investment in projects. This is a very important topic in the
exam.
Key models are:
• Cost of equity using the dividend valuation model
• The cost of equity using the capital asset pricing model
• The cost of capital for a range of debt instruments
• WACC: the cost of capital arising from a mix of capital
sources

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 Cost of Capital Introduction
• Within the sources of finance chapter we identified the main sources of long
term finance within a company as: equity (or ordinary shares), preference
shares & debt
• The costs of each source of finance will differ depending on the risk levels
taken on by the investor in that finance i.e. the higher the risk the higher the
expected return, because people expect to be compensated for bearing
additional risk.
• The cost of each source of finance to the company can be equated with the
return which the providers of finance (investors) are demanding on their
investment.
• To calculate the return being demanded, we will assume that in a perfect
market Market value of investment = PV of expected future returns
discounted at the investors required rate of return and therefore:
• Investors’ required rate of return = IRR of investing at current market price and
receiving the future expected returns.

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 The cost of capital – overview 1

The cost of capital is determined by what return the suppliers

of capital demand. This depends on:

Component Explanation
The risk free rate What an investor could get by investing in government
bonds/bills i.e. basic return if there is no risk

+ A premium for Due to a lack of certainty about the firm's prospects

business risk and projects, therefore more risk = more return
required
+ A premium for If a business borrows, the higher the level of gearing
financial risk the higher the risk of bankruptcy. Therefore more
borrowing = more return required
= COST OF The total reward required by investors
CAPITAL

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 The cost of capital – overview 2

Suppliers of equity capital bear most risk:

• Dividends cannot be paid until interest and preference

dividends are paid.
• Even then, dividends are not guaranteed.
• Equity shareholders are the last to be paid if a company
is wound up.
However, equity shareholders will make large capital gains
if the company is successful.
Success = a rise in share price

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 The cost of capital – overview 3

Suppliers of debt capital usually suffer relatively little risk:

• Interest will be paid if at all possible (it is a contractual

obligation) – otherwise the debt holder will call in a
receiver. {Shareholders do not have any rights to dividend payments}
• Interest is often a fixed percentage of the amount
borrowed and returns are stable for the lender.
• Debt is often secured on company assets.
• Creditors are paid before shareholders should the
company be wound up.
However, lenders will not enjoy capital gains if the company
is very successful.

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 The cost of capital – overview 4
• The cost of capital for investors is the return that investors
require from their investment. Companies must be able to
make a sufficient return from their own capital investments to
pay the returns required by their shareholders and holders of
debt capital. The cost of capital for investors therefore
establishes a cost of capital for companies.
• The cost of capital for investors is measured as a pre-tax
cost of capital {Required Return}
• The cost of capital for a company is the return that it must
make on its investments so that it can afford to pay its
investors the returns that they require.
• The cost of debt capital for companies is measured as an
after-tax cost.

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 The cost of capital – overview 5

The relative risk/return relationship of equity and debt is based on

their relative priority for repayment on liquidation—the creditor
hierarchy:
Lowest risk
(1) Creditors with a fixed charge and lowest
cost
(2) Creditors with a floating charge
(3) Unsecured trade creditors
Highest risk
(4) Preference shareholders and highest
(5) Ordinary shareholders cost

In addition debt interest enjoys tax relief, reducing its cost even further to the
borrower.
The risk faced by each class of investor drives the required return of that investor
and the required return drives the firm's cost of each source of finance.

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 Cost of Equity
 Equity finance can be raised either externally by issuing new
ordinary shares or internally by using retained earnings.
• The cost of equity is the required rate of return on investment
of the ordinary shareholders of the company.
• Retained earnings have a cost of capital equal to the cost of
equity. Reason: There is an opportunity cost of the dividend foregone
from retaining profits.
 The following approaches are used to estimate the cost of
equity:
1. The dividend valuation model
2. The dividend growth model aka the Gordon growth model.
3. The Capital Asset Pricing Model (CAPM)

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 The dividend valuation model –No Growth
The dividend growth model: the market value of shares is
equal to the present value of future dividends.

For constant dividends:

P0 = d0 + d0 + d0 … + d0
(1 + ke)1 (1 + ke)2 (1 + ke)3 (1 + ke)n

This is a perpetuity so: Where:

P0 = ex dividend market price
d0 = constant dividend per share
P0 = d0 or ke = d0 ke = cost of equity (the
ke P0 shareholder's discount rate = re)
Ke = Dividend yield.
Ex-div share price = Cum-div share price – dividend due
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 The dividend valuation model with growth

The dividend growth model: the market value of shares is

equal to the present value of future dividends.

The model can be extended to incorporate constant dividend

growth, and the formula given in the exam is:

P0 = d0(1 + g) Where:
(ke – g) P0 = ex dividend market price
or d0 = current dividend
g = anticipated annual dividend
growth rate
Ke = d0(1 + g) + g ke = cost of equity
P0
(Key not given in exam)

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 Question to consider

A company's shares are valued K = d0(1 + g) + g

e
at $4.50 ex div. Dividends grow P0
P0 = ex dividend market price
6% pa. The current dividend is d0 = current dividend
g = annual dividend growth rate
$0.50. ke = cost of equity

What is the cost of equity?

Answer

0.50 (1+0.06) + 0.06 = 17.8%

Ke = 4.50

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 A common error 1

Where:
P0 = d0(1 + g)
(ke – g) P0 = ex dividend market price
d0 = current dividend
or
g = annual dividend growth rate
ke = cost of equity
Ke = d0(1 + g) + g
P0
The formulae use the ex-dividend market value. Share
prices rise as the dividend payment date approaches. When
the dividend is paid (and the share becomes ex-div) the
share price drops by the amount of the dividend.

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 A common error 2
Share price
Price drops by dividend paid

Time

Share goes ex div

 The ex-div market value is the market value of the share, assuming
that the current dividend has just been paid.
 A cum-div market value is one which includes the value of the dividend
just about to be paid.
If you are told that a share price is $5.60 and that a dividend of $0.20 is
about to be paid, then $5.60 is the 'cum div' price. The ex-div price would
be $5.60 – $0.20 = $5.40.
It's the $5.40 you would use to calculate Ke.

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 Question to consider

A company's shares are valued

Ke = d0(1 + g) + g
at $5.80. Dividends grow
P0
5% pa. The current dividend of P0 = ex dividend market price
d0 = current dividend
$0.45 is about to be paid. g = annual dividend growth rate
ke = cost of equity
What is the cost of equity?
Answer
If the dividend is about to be paid, $5.80 must be the cum
div price, and the ex div price will be $5.80 – $0.45 = $5.35

Ke = 0.45 (1 + 0.05) + 0.05 = 13.8%

5.35

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 Estimating g, the dividend growth rate
Note. The relevant growth rate is the future growth rate
anticipated by shareholders. In the absence of specific
information, the future growth rate is assumed to be based on
the past growth rate.
There are two approaches:

(1) Look directly at the historical growth rate

g = {Latest Dividend=Do/Earliest Dividend Dn}1/n – 1
n = number of years of growth
(2) Use the Gordon Growth Model: g = br
where: r = the rate of return earned on reinvestment
b = the proportion of earnings retained

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 Question to consider

A company has paid the Year Dividend

dividends shown in the table. 20X1 0.56
20X2 0.62
What is the estimated dividend 20X3 0.68
growth rate? 20X4 0.75
20X5 0.82

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 Answer

Assume that the dividend Year Dividend

grows from 0.56 to 0.82 × (1 + g) 20X1 0.56
at a constant rate. × (1 + g) 20X2 0.62
There are four growth × (1 + g) 20X3 0.68
opportunities, so × (1 + g)
20X4 0.75
20X5 0.82
0.56 x (1 + g)4 = 0.82
(1 + g)4 = 0.82/0.56 = 1.4643
1 + g = 4√1.4643 = 1.10. Therefore g = 0.1 or 10%

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 Estimating g, the dividend growth rate
The Gordon Growth Model: g = br
where: r = the rate of return earned on reinvestment = ARR
r = Earnings = Profit after Tax
Book value of capital employed Net Assets
b = the proportion of earnings retained {1 – Dividend pay-out ratio}
b = Earnings – dividend = Retained profit
Earnings Profit after Tax
• Assumes that sustained dividend growth can arise only
from earnings growth and that earnings growth depends on
reinvesting earnings to produce additional earnings. {The
higher the level of retentions in a business, the higher the potential
growth rate}

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 Gordon growth model – common error

The Gordon Growth Model: g = br

where: r = the rate of return earned on reinvestment
b = the proportion of earnings retained

Questions often supply the proportion of earnings paid as

dividend, eg 10% of earnings are paid as dividend.
b, the proportion retained is therefore (100 – 10)% = 90% or
0.9.

REMEMBER: no retention of earnings (b = 0) means no

growth is possible

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 Question to consider

A company pays out 20% of its earnings as dividends and

earns 12% on amounts reinvested.
What is its estimated dividend growth rate?
Note. The Gordon Growth Model: g = br
where: r = the rate of return earned on reinvestment
b = the proportion of earnings retained

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 Answer

A company pays out 20% of its earnings as dividends and earns 12% on
amounts reinvested.
The Gordon Growth Model: g = br
where: r = the rate of return earned on reinvestment
b = the proportion of earnings retained

r = 12%; b = 80% Note. If dividends = 100% of earnings,

there can be no growth

g = 0.12 × 0.80 = 0.096 or 9.6%

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 Earnings retention model

A company is just about to pay an ordinary dividend of 9

cents per share and the current share price is $2.45.
The accounting rate of return on equity is 10% and the
dividend payout ratio is 25% and both of these figures are
expected to remain at this level for the foreseeable future.
Calculate the cost of equity for the company
g = b × re
g = 0.75 × 0.1 = 0.075 or 7.5%
Ex div share price = $2.45 – $0.09 = $2.36
Ke = [D0 (1 + g)/P0] + g
Ke = [$0.09 × 1.075/$2.36] + 0.075 = 0.116 or 11.6%

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 Weaknesses of the dividend growth model
1. The model does not explicitly incorporate risk i.e. risk that
actual dividends will no be the same as expected dividends.
2. Dividends are either constant or are growing at a constant
rate i.e. it is difficult to estimate and it isn’t constant
3. All investors have the same expectations and therefore the
same required rate of return i.e. share prices are constant,
therefore Ke is constant
4. The model fails to take capital gains into account.
5. It does not produce meaningful results where no dividend is
paid (if d is zero, ke is 0).
6. Perfect capital market assumptions e.g. no transaction
costs, all investors have same information etc.
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 PORTFOLIO THEORY

• Portfolio theory suggests that the total risk of a portfolio of

investments can be reduced by diversifying the
investments held in the portfolio, e.g. by investing capital
in a number of different shares rather than buying shares
in only one or two companies
• Portfolio theory is concerned with total risk, which is the
sum of systematic risk and unsystematic risk. The capital
asset pricing model assumes that investors hold
diversified portfolios, and so is concerned with systematic
risk alone

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 Unsystematic and systematic risk 1
Total risk divides into:
 Unsystematic risk (also known as unique/specific risk):the risk
which is unique to each company's shares or industry. can be
potentially eliminated by shareholders building a diversified
portfolio
 Unsystematic risk can be diversified away. Studies suggest
that if an investor has around 30 diversified stocks, the random
good news in one is cancelled by the random bad news in
another.
 Systematic/Market/unavoidable risk:the risk which affects the
market as a whole rather than a specific company's shares,
e.g. economic news about one particular country can affect all
stock markets. Systematic risk cannot be diversified away – all
shares are affected.
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 The capital asset pricing model (CAPM) 2

• CAPM asserts that different companies have different

costs of equity because they have different risks.
• Higher risk higher return
• If risk is measured then it should be possible to predict
the return that shareholders should require.
• The capital asset pricing model addresses the causes of
the cost of equity and is an alternative approach to
calculating ke.

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 Unsystematic and systematic risk 2

Total risk
(variability
of returns)
Unsystematic
risk

Systematic
risk No of
different
Around 30 – 50 shares in
portfolio
CAPM deals only with systematic risk, so to use this model, investors
must have a well-diversified portfolio.
Systematic risk is measured by β (beta factors).
Beta factor is the measure of the systematic risk of a security relative
to the average market portfolio

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 CAPM – risk and return 1

The following measurements can be made:

• Investing in a risk free investment will earn the risk free
rate of return (eg the rate on government bonds), Rf
• Investing in all shares in the market will earn the market
rate of return, Rm
• The market return will be enough to reward investors for
the systematic risk of the market. By definition, this is
given a β value of 1
• The returns from specific investments will be logically
related to Rf and Rm by their β values

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 CAPM – risk and return 3

Return

Rm

Rf

β
1

• If β>1: share is relatively volatile and risky. i.e. this means that the share is more
sensitive than the market. Therefore, if the market in general rises by 10% then the
returns from this share are likely to be more than 10%.high β and high return.
• If β<1, a share is relatively stable and has lower risk i.e. the share is less sensitive than
the market and is likely to rise and fall in value less than the market in generalwill have a
lower β and lower return.

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 CAPM – risk and return 2

Return

Rm

Rf

β
1
As systematic risk (β) increases, so does the required
return
The equation of the line is:
Required return = Rf + β(Rm – Rf)

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 CAPM – risk and return 4

Required return = Rf + β(Rm – Rf)

Where Rf = risk free rate, Rm = return from the market, β is

the measure of the investment's (or project's) systematic
risk.

It is suggested that you remember this rather than use the

formula provided in the exam.

(Rm – Rf) is known as the 'equity risk premium' or 'market

premium'.

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 Question to consider

A company has a β of 1.3. The risk free rate is 6% and the

market return is 15%.
What return should the share produce ie what is the ke?
Required return (ke)= Rf + β(Rm – Rf)
Answer
A company has a β of 1.3. The risk free rate is 6% and the
market return is 15%.
Required return (ke ) = Rf + β(Rm – Rf)
Required return (ke) = 6 + 1.3(15 – 6) = 17.7%

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 What comes first – risk or return?

• If a share's return is below that required, the share will be

unpopular and market forces will drive down its price, so
increasing the % return until the required return is
obtained.
• If a share's return is above that required, the share will be
popular and market forces will drive up its price, so
decreasing the % return until the required return is
obtained.
• Similarly, under the dividend growth model, a company
cannot reduce its cost of equity by cutting its dividend. All
that would happen is that the share price would fall until
the required cost of equity is restored.

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 Question to consider

A company has a β of 1.3. The risk free rate is 5% and the

equity risk premium is 11%.
The company has just paid a dividend of $0.40 and
dividends are expected to grow at 3% pa.
What is the market price of a share?

Required return = Rf + β(Rm – R) Ke = d0(1 + g) + g

P0
P0 = ex dividend market price
d0 = current dividend
g = annual dividend growth rate
ke = cost of equity

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 Answer

A company has a β of 1.3; risk free rate = 5%; equity risk premium is 11%.The
company has just paid a dividend of $ 0.40 and dividends are expected to grow
at 3% pa.

Required return = Rf + β(Rm – R) = 5 + 1.3(11) = 19.3%

P0 = d0(1 + g) = $0.40 (1 + 0.03) = $2.53

Ke – g 0.193 – 0.03

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 Dividend growth model and CAPM

The following data relates to the ordinary shares of Stilton.

Current market price, 31 December 20X1 250c
Dividend per share, 20X1 3c
Expected growth rate in dividends and earnings 10% pa
Average market return 8%
Risk-free rate of return 5%
Beta factor of Stilton equity shares 1.40
(a) What is the estimated cost of equity using the dividend
growth model?
(b) What is the estimated cost of equity using the capital
asset pricing model?

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 CAPM – practical problems

• Determining the return from the market. Expected, rather

than historical, returns should be used, although
historical returns are often used in practice.
• Determining the risk-free rate. A risk-free investment
might be a government security. Gilts have different rates
depending on maturities.
• Errors in the statistical analysis used to calculate β
values. Betas may also change over time.
• Shares with low P/E ratios make statistical analysis or
returns difficult.

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 ASSUMPTIONS OF CAPM

• assumes that all the company's shareholders hold well-

diversified portfolios and therefore need only consider
systematic risk.
• Assumes the stock market is a perfect capital market i.e.
no taxes, no transaction costs and info is available to all
investors
• CAPM is a one period model, while most investment
projects tend to be over a number of years

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 Cost of Preference Shares
• The required rate of return on investment of the preferred
shareholders of the company.
• Cost of preference shares: Easy – simply like the cost of
equity with no dividend growth.
Kp = D D = Constant annual preference div
P0 P0 = ex div market price of a share
Note. The dividend on, say, 8%, $0.50 preference shares is:
Dividend rate × par value = 8% × 0.50 = $0.04/share
Bishop Co has 100,000 18% preference shares in issue with
a nominal value of $0.50 each. The current ex div market
value is $1.75. Calculate the cost of the preference shares.
Kp = ($0.50 × 18%)/$1.75 = 0.051 or 5.1%
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 Cost of Debt 1
The required rate of return on investment of the lenders of a
company.
The following debt terminology is applied
 The terms loan notes, bonds, loan stock and marketable
debt are used interchangeably. Gilts are debts issued by
the government.
 Debt is always quoted in $100 nominal blocks.
 Nominal value is also known as par or face value. In the
exam the nominal value of one bond is usually $100.
 Market value (MV) is normally quoted as the MV of a block
of $100 nominal value.*

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 Cost of Debt 2

 Interest paid on the debt is stated as a percentage of

nominal value, called the coupon rate.
Annual interest = coupon rate × nominal value
For example, 10% bonds quoted at $95 means that a $100
block is selling for $95 and annual interest is $10 per $100
block.
 Ex-interest (after interest payment) and cum-interest
(before interest payment).
 Interest can be either fixed or floating (variable). All
questions are likely to give fixed rate debt.

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 Irredeemable securities
If securities are irredeemable, the company does not intend
to repay the principal but to pay interest for ever. In this
case the present value of a perpetuity equation may be used
Example
$100 is the nominal value. If the market value of the debenture is $90 per cent,
then the company pays $9 pa to raise $90.
Cost of debt = 9/90 = 10% per year
The post-tax cost of debt to the company is found by adjusting the
formula to take account of the tax relief on the interest
Kd(1-T) = i(1 – T) ÷ Ext Interest MV
The MV of the loan notes is set by the investor, who does not get tax
relief, and is therefore based on the interest before tax {Pre-tax cost of
debt/required return by debt by debt providers}
Kd = i ÷ Ext Interest MV

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 Cost of irredeemable debt

A company has irredeemable loan notes in issue trading at

$95 cum interest. The coupon rate is 5% and the rate of
corporation tax is 30%.
Calculate the pre-tax and post-tax cost of debt.
Answer
Ex interest MV = $95 – ($100 × 5%) = $90
Kd = I/MV
Pre-tax Kd = $5/$90 = 0.056 or 5.6%

Kd(1 – T) = I (1 – T)/MV
Post-tax Kd(1 – T) = ($5 × 0.7)/$90 = 0.039 or 3.9%

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 Question to consider: Irredeemable debt with tax

Bishop Co has in issue 6% irredeemable debentures quoted

at $105 (ex-interest). The corporation tax rate is 30%.
Calculate the return required by the debt providers and the
cost of debt to Bishop Co.
Answer
Kd = I/MV
Kd = ($100 × 6%)/$105 = 0.057 or 5.7%

Kd(1 – T) = I (1 – T)/MV
Kd(1 – T) = ($6 × 0.7)/$105 = 0.04 or 4%
NB: Investor return (yield) kd > ‘kd(1 – T)’ cost of debt.

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 The cost of debt – Redeemable
Debt is raised, interest is paid at the coupon rate for several
years, then the debt redeemed, often at a premium.
 Redeemable debt: cost = internal rate of return of the cash
flows involved {aka redemption yield or Yield to Maturity}
• Looking at the return from an investor's point of view, interest
payments are included gross. {Pre-tax cost of debt}
• Looking at the cost to the company, interest payments are
included net of corporation tax. {Post-tax cost of debt}
• If interest payments are being made every six months, then
when the IRR of the bonds' cash flows is calculated, it should
be done on the basis of each time period being six months
Effective annual cost = (1 + semi-annual cost)2 -1

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 Question to consider: Cost of redeemable debt

A company has $2 million 7% debentures in issue. They are

redeemable in five years at a premium of 30%. Current
market value = $120 percent.
Corporation tax = 25%
What is the pre tax and post-tax cost of the debentures?

Hint: set up a series of cash flows relating to issuing $100

par value debt at the current market value, paying interest
and getting tax relief, then redeeming the debt.

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 Answer: Pre tax cost of redeemable debt

A company has $2 million 7% debentures in issue, redeemable in five years at a

premium of 30%. Current market value = $120 per cent. Corporation tax = 25%

Time/flow $ 10% factor DCF 5% factor DCF

0: Issue 100 at MV (120) 1 (120.00) 1 (120.00)

1 – 5: interest before tax 7 3.791 26.54 4.329 30.30

5: redeemed 130 0.621 80.73 0.784 112.22

(12.73) 22.52

IRR = 5 + 22.52 (10 – 5) = 8%

22.52 + 12.73

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 Answer: Post tax cost of redeemable debt

A company has $2 million 7% debentures in issue, redeemable in five years at a

premium of 30%. Current market value = $120 per cent. Corporation tax = 25%

Time/flow $ 10% factor DCF 5% factor DCF

0: Issue 100 at MV (120) 1 (120.00) 1 (120.00)

1 – 5: interest after tax 7 × 75% 3.791 19.90 4.329 22.73

5: redeemed 130 0.621 80.73 0.784 101.92

(19.37) 4.65

IRR = 5 + 4.65 (10 – 5) = 6%

4.65 + 19.37

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 Question to consider: semi-annual cost

A company has in issue 6% bonds, the interest on which is

paid on 30 June and 31 December each year. The bonds
are redeemable at par on 31 December 20X9. It is now 1
January 20X7 and the bonds are quoted at $96 per $100
nominal value.
Required:
Calculate the effective annual cost of debt to the
company. Ignore corporation tax

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 Answer: Semi annual cost of redeemable debt

Six interest payments are due and each interest payment will be just half of the
coupon rate, $3 each 6 months.

Time/flow $ 3% factor DCF 5% factor DCF

0: Issue 100 at MV (96) 1 (96.00) 1 (96.00)

1 – 6: interest before tax 3 5.417 16.25 5.076 15.23

6: redeemed 100 0.837 83.70 0.746 74.60

3.95 (6.17)

IRR = 3 + 3.95 (5 – 3) = 3.78%

3.95 + 6.17
The effective annual cost of debt is 1.03782 – 1 = 7.7%

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 The cost of convertibles 1

Convertibles start life as debentures, but the holder has an

option to convert them into equity shares.
• They allow investors to 'wait and see':
• Start with safe, well-secured debentures (but debentures
have no growth prospects).
• If the company does well, convert to equity and enjoy the
chance of capital growth.
• The option is very attractive to investors, so coupon rate
should be lower than for simple debentures.

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 The cost of convertibles 2
Convertible debentures/loan stock allow the investor to
choose between taking cash at redemption or converting
the debentures into a pre-determined number of shares.

Step 1 Calculate the value of the conversion option using

available data.

Step 2 Compare the conversion option with the cash option

(redemption option). Assume all investors will choose the
option with the higher value.

Step 3 Calculate the IRR of the flows as for redeemable

debentures.

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 Question to consider: Cost of convertibles

A company has issued 10% convertible bonds which are due

to be redeemed in four years at a 5% premium. They are
currently quoted at $80 per $100 nominal. $100 nominal can
be converted into 25 shares in four years.
The share price is currently $4.00 and is expected to grow at
a rate of 4% pa.
Assume a 30% rate of tax.
Calculate the cost of the convertible debt.
Hint: first decide which of conversion or redemption is likely
to happen. Then, basing calculations on $100 nominal, use
that result to work out IRR of the cash flows = cost of the
convertibles.

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 Answer: Cost of convertibles 1

A company has issued 10% convertible bonds which are due to be redeemed in
four years at a 5% premium. They are currently quoted at $80 per $100 nominal.
$100 bonds can be converted into 25 shares in four years.
The share price is currently $4.00 and is expected to grow at a rate of 4% pa.
Assume a 30% rate of tax.

Step 1: will conversion of redemption take place?

Redemption = 100 × 105% = $105

Conversion = 25 × 4 × (1.04)4 = $117

Therefore, conversion is assumed.

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 Answer: Cost of convertibles 2

A company has issued 10% convertible bonds which are due to be redeemed in
four years at a 5% premium. They are currently quoted at $80 per $100 nominal.
$100 bonds can be converted into 25 shares in four years.
The share price is currently $4.00 and is expected to grow at a rate of 4% pa.
Assume a 30% rate of tax.

Time/flow $ 10% factor DCF 20% factor DCF

0: Issue (80) 1 (80.00) 1 (80.00)
100 at MV
1 – 4: 10 × 70% 3.170 22.19 2.589 18.12
interest
after tax
5: 117 0.683 79.91 0.482 56.39
converted
22.10 (5.49)

BPP LEARNING MEDIA

 Answer: Cost of convertibles 3

A company has issued 10% convertible bonds which are due to be redeemed in
four years at a 5% premium. They are currently quoted at $80 per $100 nominal.
$100 bonds can be converted into 25 shares in four years.
The share price is currently $4.00 and is expected to grow at a rate of 4% pa.
Assume a 30% rate of tax.

NPV at 10% = 22.10; NPV at 20% = –5.49

IRR = 10 + 22.10 × (20 – 10) = 18%

22.10 + 5.49

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 Cost of variable rate debt (floating rate debt)
A substantial proportion of the debt of companies is not traded e.g. bank
loans.
 The pre-tax cost of variable rate debt (also called floating rate debt),
such as the cost of a bank loan, is the current interest rate payable on
the debt.
 The after-tax cost of variable rate debt is the pre-tax cost multiplied
by a factor (1 – t), where t is the rate of tax on company profits
 As bank loans are not traded, their book value must be taken as a
proxy for market value when including them in the weighted average
cost of capital (WACC).
For example, suppose that a company is currently paying interest at
7.5% on its bank loan of $10 million, and the rate of tax on company
profits is 30%. The pre-tax cost of the debt is 7.5% and the after-tax cost
is 7.5 (1 – 0.30) = 5.25%.

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 The weighted average cost of capital (WACC)

• We have covered how to work out the cost of various

types of capital: equity, debt etc
• Most business have a mix of capital. It makes no sense
to 'mark' cash as it comes in and trace its use.
• Cash goes into a pool and investment projects must be
able to pay the suppliers for the overall pool of finance.

Equity Debt Preferences Shares Convertibles

Capital

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 The weighted average cost of capital (WACC)

The overall cost of finance is known as the weighted

average cost of capital (WACC).

• WACC = cost of each element of finance weighted by the

proportion the market value of each element bears to
the total market value of the pool of capital.
• WACC is usually the rate that is used to work out the
NPV of projects as it represents the investors overall
required rate of return.

Capital

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 Choice of weights

• To find an average cost, the various sources of finance must be weighted

according to the amount of each held by the company.
• The weights for the sources of finance could be:
1. book values (BVs) – represents historic cost of finance
2. market values (MVs) – represent current opportunity cost of finance.
Wherever possible MVs should be used
NB:Note that when using BVs, reserves such as share premium and retained
profits are included in the BV of equity, in addition to the nominal value of share
capital.
• When using market values to weight the sources of finance, you should use
the following calculations:
Equity = Market value of each share × number of shares in issue
Debt = Total nominal value × current market value
100

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 Question to consider: WACC
A company has the following capital structure:

Equity: 1 million shares valued at $2.30 each. Cost of equity

= 18%
Debt: 0.5 million 6% debentures valued at $90 per $100
nominal. Post-tax cost of debt = 6%
Preference shares: 0.5 million $0.50 10% shares valued at
$0.40 each. Cost of preference capital = 12.5%
What is the WACC? hint
Calculate weights for each source of capital.
Estimate the cost of each source of capital.
Multiply proportion of total of each source by its cost and sum the results, using the formula

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 Answer: WACC

Equity: 1million shares valued at $2.30 each. Cost of equity = 18%

Debt: 0.5 million 6% debentures valued at $90%. Post-tax cost of debt = 6%
Preference shares: 0.5 million $0.50 10% shares valued at $0.40 each. Cost
of preference capital = 12.5%
Capital Detail Market value ($m)
Equity 1m × $2.30 2.30
Debentures 0.5m × 90% 0.45
Preference shares 0.5m × 0.40 0.20
Total market value 2.95

WACC = (18% × 2.3/2.95) + (6% × 0.45/2.95) + (12.5% ×

0.2/2.95)
= 15.8%
Note. Looks about right: should be between the cost of the
highest and lowest component

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 ACCA formula for WACC

The FM formula sheet gives the following formula for WACC:

Ve Ve
WACC = ke + kd (1– T)
Ve + Vd Ve + Vd
This is of limited use:
• Applies only when there are two types of capital in the
mix.
• Kd(1 – T) gives the post-tax debt cost only when Kd is the
pre-tax cost for irredeemable debt: it does not work for
redeemable debt.
• Symbols are not defined.
Use the approach shown in these slides to adapt for the
sources of finance in the specific question.
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 Comprehensive lecture example

A company has the following capital structure:

Equity: 2 million shares valued at $3.30 each. Current

dividend of $0.06 about to be paid. Dividends for
each of the last two years were $0.051 and $0.0415
(earliest)
Debt: 0.5 million 8% loan notes valued at $112 percent.
Redeemable in four years' time at a premium of
20%. Corporation tax is 30%.
What is the WACC?

BPP LEARNING MEDIA

 Answer to comprehensive lecture example 1

Equity: 2 million shares valued at $3.30 each. Current dividend of $0.06 about to
be paid. The last two years' dividends were $0.051 and $0.0415
Debt: 0.5 million 8% loan notes valued at $112 per cent. Redeemable in four
years at a 20% premium. Corporation tax = 30%

Cost of equity
Ke = d0(1 + g) + g
g: 0.0415 × (1 + g)2 = 0.06; 1+g = P0
√0.06/0.0415 = 1.20; g = 0.2 ( or 20%) P0 = ex dividend market price
d0 = current dividend
P0 (ex div) = 3.30 – 0.06 = 3.24 g = annual dividend growth rate
ke = cost of equity

Ke = 0.06(1 + 0.2) + 0.2 = 22.2%

3.24

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 Answer to comprehensive lecture example 2

Equity: 2 million shares valued at $3.30 each. Current dividend of $0.06

about to be paid. The last two years' dividends were $0.051 and $0.0415
Debt: 0.5 million 8% loan notes valued at $112 per cent. Redeemable in four
years at a 20% premium. Corporation tax = 30%

Cost of debt
Time/flow $ 10% factor DCF 5% factor DCF
0: Issue 100 at MV (112) 1 (112.00) 1 (112.00)

1 – 4: interest after 8 × 70% 3.170 17.75 3.546 19.86

tax
4: redeemed 120 0.683 81.96 0.823 98.76
(12.29) 6.62
Kd = 5 + 6.62 × (10 – 5) = 6.75
6.62 + 12.29

BPP LEARNING MEDIA

 Answer to comprehensive lecture example 3

Equity: 2 million shares valued at $3.30 each. Current dividend of $0.06 about to
be paid. The last two years' dividends were $0.051 and $0.0415
Debt: 0.5 million 8% loan notes valued at $112 per cent. Redeemable in four
years at a 20% premium. Corporation tax = 30%

Cost of equity = 22.2%; Cost of debt = 6.75%

MV equity (ex div) = 2m × $3.24 = $6.48 million
MV debt = 0.5m × $112% = $0.56m
Total MV = 6.48 + 0.56 = $7.04m

WACC = (22.2% × 6.48/7.04) + (6.75% × 0.56/7.04) = 21%

BPP LEARNING MEDIA

 Past exam question Practice: WACC

Rupab Co has in issue five million shares with a market value of

$3.81 per share. The equity beta of the company is 1.2. The yield
on short-term government debt is 4.5% per year and the equity risk
premium is approximately 5% per year.
The debt finance of Rupab Co consists of bank loan with a total
book value of $2 million. These bank loan pay annual interest
before tax of 7%. The par value and market value of bank loan is
$100.
Rupab Co pays taxation one year in arrears at an annual rate of
25%.

Required: Calculate the after-tax weighted average cost of capital

of Rupab Co. (6 marks)

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 Past exam question Practice: WACC

Cost of equity = 4.5 + (1.2 × 5) = 10.5%

The bonds are trading at par so the before-tax cost of debt is
the same as the interest rate on the bonds, 7%.
After-tax cost of debt = 7 × (1 – 0.25) = 5.25%

Market value of equity = 5m × 3.81 = $19.05 million

Market value of debt is equal to its par value of $2 million
Sum of market values of equity and debt = 19.05 + 2 =
$21.05 million
WACC = (10.5% × 19.05/21.05) + (5.25% × 2/21.05) =
10.0%

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 Q3 June 2013
AMH Co $'000 Ex div MV ordinary shares = $4.70
Ordinary shares ($0.5) 4,000 per share; ordinary dividend of 36.3
18,000
cents per share has just been paid.
Reserves
Recent dividends (cents)
22,000
Long-term liabilities 2008 30.9 2009 32.2
4% Preference shares ($1) 3,000 2010 33.6 2011 35.0
7% Bonds redeemable
after six years 3,000 Ex div MV preference shares (not
Long-term bank loan 1,000 redeemable) = 40 cents per share.
The bank loan rate = 4%
7,000
29,000

The 7% bonds premium have an ex interest market value of

$104.50 per bond and are redeemable at a 5% premium.
Tax = 30%. Required: Calculate AMH Co's WACC.
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 Q3 June 2013 1

Cost of equity
The geometric average dividend growth rate in recent
years:
4 (36.3 / 30.9)
– 1 = 1.041 – 1 = 0.041 or 4.1% per year
Using the dividend growth model:
Ke = 0.041 + [(36.3 × 1.041)/470] = 0.041 + 0.080 =
0.121 or 12.1%

Cost of preference shares

As the preference shares are not redeemable:
Kp = (0.04 × 100)/40 = 0.1 or 10%
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 Q3 June 2013 2

Cost of debt of bonds

The annual after-tax interest payment is 7 × 0.7 = $4.9 per bond.
Using IRR (linear interpolation):
Year Cash flow 5% DF PV ($) 4% DF PV ($)
0 Market price (104.50) 1.000 (104.50) 1.000 (104.50)
1–6 Interest 4.9 5.076 24.87 5.242 25.69
6 Redemption 105.00 0.746 78.33 0.790 82.95
( 1.30 ) 4.14

After-tax cost of debt = 4 + [(4.14/(4.14 + 1.30)) × (5 – 4)] = 4 + 0.76 =

4.8%

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 Q3 June 2013 3

Cost of debt of bank loan

Assumed to be irredeemable the after-tax cost of debt of the bank loan
will be its after-tax interest rate, ie 4% × 0.7 = 2.8% per year.
Market values
Number of ordinary shares = 4,000,000/$0·5 = 8 million shares
$000
Equity: 8m × 4.70 = 37,600
Preference shares: 3m × 0.4 = 1,200
Redeemable bonds: 3m × 104.5/100 = 3,135
Bank loan (book value used) 1,000
Total value of AMH Co 42,935
WACC calculation
[(12.1% × 37,600) + (10% × 1,200) + (4.8% × 3,135) + (2.8% ×
1,000)]/42,935 = 11.3%

BPP LEARNING MEDIA

 Recent exam questions
Nature of question Exam details
Describe the risk-return relationship Section A (published)
and the relative costs of equity and Dec 2014 (2 marks)
debt Section C
Q219 Dinla March/June 2016 (3 marks)
Cost of equity – apply and discuss the Section A
techniques for calculating the cost of Dec 2016 (2 marks)
equity Section C
Q217 Tinep Dec 2014 (9 marks)
Q219 Dinla March/June 2016 (1 mark)
Q220 Tufa Sep/Dec 2017 (3 marks)
Mock exam 3 Q31 Gadner Dec 2016 (2 marks)
Estimating the cost of debt and the Section C
weighted average cost of capital Mock exam 2 Q32 Froste Specimen exam, part (a) (4
marks)
Q217 Tinep Dec 2014 (9 marks)
Q219 Dinla March/June 2016 (7 marks)
Q220 Tufa Sep/Dec 2017 (11 marks)
Mock exam 3 Q31 Gadner Dec 2016 (9 marks)
Q220 Tufa Sept/Dec 2017 (11 marks)

Note. These topics are very integrated. A typical question asks for the costs of
individual capital components to be calculated then combined into the WACC.
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 Overview

Maximisation of
shareholder wealth

Investment Financing Dividend

decision decision decision

Cost of capital

Cost of debt Cost of equity

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