Chapter-17 Cost of Capital

Estimating the cost of equity- the dividend valuation model (DVM)

The cost of equity finance to the company is the return the investors expect to
achieve on their shares.
Assumptions-
DVM states that-
➢ Future income stream is the dividends paid out by the company
➢ Dividends will be paid in perpetuity
➢ Dividends will be constant or growing at a fixed rate
Therefore:
Share price = dividend paid in perpetuity discounted at the shareholder’s rate of
return.
DVM (assuming constant dividends)
The formula for valuing a share is therefore:
P0 = D/re
Where:
P0 → share price now (year 0)
D → constant dividend from year 1 to infinity
re → shareholder’s required return, expressed as a decimal
For a listed company, since the share price and dividend payment are known, the
shareholder’s required return can be found by rearranging the formula:
re = D/P0
DVM (assuming dividend at a fixed rate)
The share valuation formula then becomes:
P0 = D0 * (1+g)/ re-g = D1/re-g
Where:
g → constant rate of growth in dividends, expressed as a decimal
D1 → dividend to be received in one year – i.e. at T1.

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D0*(1+g) → dividend just paid, adjusted for one year’s growth (equivalent to
D1)
Therefore, find the cost of equity the formula can be rearranged to:
re = D0 *(1+g)/ P0 + g = D1 / P0 + g
The ex-div share price- The DVM model is based on the perpetuity formula
which assumes that the first payment will arise in one year’s time. A share price
quoted on this basis is termed as ex-div share price.
The formula for ex-div share price is:
Ex-div share price = Cum div share price – dividend due
Estimating growth- Two ways of estimating the likely growth rate of dividends
are:
➢ Extrapolating based on past dividend patterns
➢ Assuming growth is dependent on the level of earnings retained in the
business
Past dividends- This method assumes that the past pattern of dividends is fair
indicator of the future. The formula of past dividend is:
g = (D0 / Dividend n yrs ago)1/n -1
The earnings retention model (Gordon’s growth model)
Assumption-
➢ The higher the level of retentions in a business, the higher the potential
growth rate.
The formula is therefore:
g = b*re
where:
b → earnings retention rate
re → accounting rate of return on equity
Weakness of DVM- The DVM has a sound basic premise. The weakness occurs
because:

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 ➢ The input data used may be inaccurate- current market price and future
dividend patterns
➢ The growth in earnings is ignored
Estimating the cost of preference shares
Preference shares usually have a constant dividend. The formula is:
Kp = D/P0
Where:
Kp → Cost of preference share
D → the constant annual preference dividend
P0 → ex-div MV of the share
Estimating the cost of debt
Types of debt-
➢ Irredeemable debt- no repayment of principal – interest in perpetuity
➢ Redeemable debt- interest paid until redemption of principal
➢ Convertible debt- may be later converted to equity
Cost of debt and the impact of tax relief- A distinction must be made between
the required return of debt holders/ lenders (Kd) and the company’s cost of debt
[Kd (1-T)]. In equity, the company’s cost is equal to the investor’s required return,
the same is not true of debt. This because of the impact of tax relief.
Consequently, it will use separate terms to distinguish the two figures:
➢ Kd → the required return of the debt holder (pre-tax)
➢ Kd * (1-T) → the cost of the debt to the company (post-tax)
Irredeemable debt
The company does not intend to repay the principal but to pay interest forever.
Assumption:
➢ Market price (MV) = Future expected income stream from the debt
discounted at the investor’s required return.
➢ Expected income stream will be the interest paid in perpetuity
The formula for valuing a loan note is therefore:

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MV = I/Kd
Where:
I → annual interest in $ starting in one year’s time
Kd → debt holder’s required return (pre-tax cost of debt), expressed as a decimal
MV → market price in $ of the loan note
The required return (pre-tax cost of debt) can be found by rearranging the
formula:
Kd = I/MV
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)/MV
Where: T → rate of corporation tax, expressed as a decimal
Redeemable debt
The company will pay interest for a number of years and then repay the principal
Assumptions-
➢ Market price = Future expected income stream from the loan notes
discounted at the investor’s required return (pre-tax cost of debt)
➢ Expected income stream will be interest paid to redemption and the
repayment of the principal.
Debt redeemable at current market price
In this situation, where the debt is redeemable at its current market price, the
position of the investor is the same as a holder of irredeemable debt.
Therefore, where debt is redeemable at its current market price-
Kd = I/MV
And
Kd * (1-T) = I*(1-T)/MV
Convertible Debt- A form of loan note that allows the investor to choose
between taking the redemption proceeds or converting the loan note into a pre-
set number of shares.

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To calculate the cost of convertible debt-
1. Calculate the value of conversion option using available data
2. Compare the conversion option with the cash option. Assume all investors
will choose the option with the higher value.
3. Calculate the IRR of the flows as for redeemable debt
Non-tradeable debt- Bank and other non-tradeable fixed interest loans simply
need to be adjusted for tax relief:
Cost of company = Interest rate * (1-T)
Alternatively, the cost of any normal traded company debt could be used.
Estimating the cost of capital
The need for a weighted average- Each source of finance has been examined in
isolation. However, the practical business situation is that there is a continuous
raising of funds from various sources. These funds are used partly in existing
operations and partly to finance new projects.
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:
➢ Book/nominal values (BVs/NVs) – represents historic cost of finance
➢ Market values (MVs) – represent current opportunity cost of finance
Calculating weights- When using market values to weight the sources of finance,
it should use the following calculations:
Equity = Market value of each share * number of shares in issue
Debt = Total nominal value/$100 * current market value
Calculating the WACC-
The calculation involves a series of steps.
Step 1- Calculate weights for each source of capital.
Step 2- Estimate cost of each source of capital.
Step 3- Multiply proportion of total of each source of capital by cost of that
source of capital.
Step 4- Sum the results of step 3 to give the WACC.

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The formula for WACC is:
WACC = [Ve /Ve + Vd ]*ke + [ Vd/ Ve+ Vd]*kd *(1-T)
Where:
Ve and Vd are the market values of equity and debt respectively
Ke is the cost of equity
Kd*(1-T) is the post-tax cost of debt
When to use the weighted average cost of capital
The WACC calculation is based upon the firm’s current costs of equity and debt.
It is appropriate for use in investment appraisal provided:
➢ The historic proportions of debt and equity are not to be charged
➢ The operating risk of the firm will not be changed
➢ The finance is not project-specific, i.e. projects are financed from a pool
of funds
➢ The project is small in relation to the company so any changes are
insignificant
The impact of risk
The DVM and WACC calculations assume that an investor’s current required
return will remain unchanged for future projects. For projects with different risk
profiles, this assumption may not hold true. It needs a way to reflect any
potential increase in risk in our estimate of the cost of finance. When considering
the return investors require, the trade-off with risk is of fundamental
importance. Risk refers not to the possibility of total loss, but to the likelihood of
actual returns varying from those forecasts.
The total return demanded by an investor is actually dependent on two specific
factors:
➢ The prevailing risk-free rate (Rf) of return
➢ The reward investors demand for the risk they take in advancing funds to
the firm
The risk-free rate of return (Rf)
The Rf is the minimum rate required by all investors for an investment whose
returns are certain. The risk is so minimal that government securities are known

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as risk-free and the return they pay (Rf) is s minimum benchmark against which
all other investments can be measured.
Return on risky investments – loan notes
A risk-free investment has a certain return. Although not risk-free, loan notes are
lower risk investments than equities because the return is more predictable. This
is because:
➢ Interest is a legal commitment
➢ Interest will be paid before any dividends
➢ Loans are often secured
If a company issues loan notes, the return needed to attract investors will be:
➢ Higher than the Rf
➢ Lower than the return on equities
Return on risky investments – equities
Equity shareholders are paid only after all other commitments have been met.
They are the last investors to be paid out of company profits. The same pattern
of payment also occurs on the winding up of a company. The order of priority is:
➢ Secured lenders
➢ Legally-protected creditors such as tax authorities
➢ Unsecured creditors
➢ Preference shareholders
➢ Ordinary shareholders
When the earnings are fluctuates, equity shareholders face the greatest risk of
all investors. Since ordinary shares are the most risky investments the company
offer, they are also the most expensive form of finance for the company. The
level of risk faced by the equity investor depends on:
➢ Volatility of company earnings
➢ Extent of other binding financial commitments
The return required by equity investors can be shown as:
Required return = Risk-free return + Risk premium
Estimating the cost of equity- the capital asset pricing model (CAPM)
Reducing risk by combining investments-

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An investor could decide to reduce the overall risk faced by acquiring a second
share with a different risk profile and so obtain a smoother average return.
An investor can reduce risk by diversifying to hold a portfolio of shareholdings,
since shares in different industries will at least to some degree, offer differing
returns profiles over time.
Initial diversification will bring about substantial risk reduction as additional
investments are added to the portfolio. However, not all risk can be diversified
away as it gets harder and harder to find another investment that responds
differently.
Systematic and unsystematic risk
The risk a shareholder faces is in large part due to the volatility of the company’s
earnings. This volatility can occur because of:
➢ Systematic risk – market wide factors such as the state of the economy
➢ Unsystematic risk – company/industry specific factors
The ability of investors to diversify away unsystematic risk by holding portfolios
consisting of a number of different shares is the cornerstone of portfolio theory.
Investors and systematic risk
Rational risk-averse investors would wish to reduce the risk they faced to a
minimum and would:
➢ Arrange their portfolios to maximise risk reduction by holding at least 15-
20 different investments
➢ Effectively eliminate any unsystematic risk
➢ Only need to be compensated for the remaining systematic risk they faced
CAPM
The CAPM shows how the minimum required return on a quoted security
depends on its risk. The required return of a rational risk-averse well-diversified
investor can be found by returning to our original argument:
Required return = Risk-free return + Risk premium
The formula of CAPM is:
E(r)i =Rf + βi (E(rm)-Rf )
Where:

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E(r)i → expected return on investment i
Rf → risk-free rate of return
E(rm) → the expected average return on the market. Simply as Rm
(E(rm)-Rf ) → equity risk premium
βi → systematic risk of investment I compared to the market and therefore
amount of the premium needed.
Understanding Beta-
➢ If an investment is risker than average i.e. the returns are more volatile
than the average market returns then the β > 1.
➢ If an investment is less risky than average i.e. the returns are less volatile
than the average market returns then the β < 1.
➢ If an investment is risk free then β = 0.
The CAPM is based on a number of assumptions:
➢ Well-diversified investors
➢ Perfect capital market
➢ Unrestricted borrowing or lending at the risk-free rate of interest
➢ All forecasts are made in the context of a single period transaction horizon
Using CAPM in project appraisal- The formula of CAPM is therefore:
re = Rf + β (Rm-Rf)
Advantages and disadvantages of CAPM-
Advantages-
➢ Works well in practice
➢ Focuses on systematic risk
➢ Is useful for appraising specific projects
Disadvantages-
➢ Less useful if investors are undiversified
➢ Ignores tax situation of investors
➢ Actual data inputs are estimates and may be hard to obtain