CHAPTER 11 COST OF CAPITAL 1

Chapter outline Introduction Pooling of funds Cost of capital Weighted average cost of capital (WACC) Using weighted average cost of capital in investment decisions Marginal cost of capital Conclusion

Learning outcomes By the end of this chapter, you should be able to: discuss the importance of cost of capital explain what is meant by pooling of funds identify, calculate and interpret the various costs of capital calculate and interpret the weighted average cost of capital advise on the use of the weighted average cost of capital in investment decisions explain and calculate the marginal cost of capital.

Introduction Costs of capital is the cost to an entity for raising capital Cost = price Capital = finance or funds Cost of capital: price it will cost to raise finance Two categories of capital exist: Debt instruments bonds, loans, overdrafts Equity instruments ordinary shares, preference shares

Pooling of funds Various sources of finance are pooled or grouped together Investments are financed out of this pool of funds Entities aim to establish a long-term target capital structure WACC is the preferred cost, rather than the cost of each individual source

Cost of capital Cost of capital is the cost of raising finance Cut-off rate between worthwhile and unworthwhile investments Includes three components: Cost of ordinary shareholders’ equity Cost of preference shares Cost of debt

Cost of ordinary shareholders’ equity Fairly challenging to calculate as the cost must include the risk undertaken by the shareholders Also known as cost of ordinary shares or cost of equity Cost of equity can be calculated in one of two ways: Dividends Capital Asset Pricing Model (CAPM)

Dividends Use of dividends depends on company’s policy If the entity does not declare dividends, this method cannot be used to calculate cost of ordinary shares Dividend options to calculate cost of equity: Dividend valuation model Dividend growth model

Dividend valuation model Market price of a share is assumed to be present value of future dividends where annual dividend is paid in perpetuity Dividend valuation model formula: Where: Ke = cost of ordinary shares D0 = constant annual dividend (in perpetuity) P0 = ex-dividend market price of ordinary shares

Dividend growth model Market price of share assumed to be present value of future dividends where growing dividend is paid in perpetuity Dividend growth model formula: Where: ke = cost of ordinary shares D0 = current dividend P0 = ex-dividend market price of ordinary share g = expected constant annual growth rate in dividend

Example 11.3

Dividend methods Advantage of the dividend methods Fairly simple to calculate (if a dividend is paid) Disadvantages of dividend methods Neither dividend method can be used if a dividend is not paid Risk not considered The growth model assumes a constant growth rate

CAPM Capital Asset Pricing Model CAPM technique considers risk CAPM formula: Where: ke = cost of ordinary share rf = risk-free rate of return ß = beta coefficient of the share rm = return on the market portfolio rm – rf = market risk premium

Example 11.5

CAPM method Advantages of CAPM Disadvantages of CAPM CAPM incorporates risk, while the dividend methods do not Dividends are not required to estimate the cost of equity Disadvantages of CAPM Requires a beta coefficient and the return on the market portfolio CAPM is only a single-period model

Cost of preference shares Related to the dividend paid on preference shares Preference dividends are not deductible for tax purposes Calculation of cost of preferences shares depends on whether preferences shares are redeemable or not Non-redeemable – use perpetuity principles Redeemable – use annuity principles

Non-redeemable preference shares The cost of non-redeemable preference shares can be calculated as follows: Where: kp = cost of preference shares D = fixed annual dividend (in perpetuity) P0 = ex-dividend market price of preference shares

Example 11.7

Redeemable preference shares The cost of redeemable preference shares can be calculated using annuity principles PV = the current market price of the preference shares FV = the part value of the preference shares at redemption n = the number of periods until the preference shares are redeemed PMT = the fixed gross dividend paid on the par value of the preference share i = the cost of preference shares to be calculated

Example 11.8

Cost of debt Return that the company’s lenders demand on new debt i.e. interest rate that a company must pay on new debt Can be calculated by observing current interest rates in the market Difference between cost of preference shares and cost of debt is that interest on debt is tax- deductible Dividend on preference shares not tax- deductible

Non-redeemable debt Use perpetuity principles The cost of non-redeemable debt can be calculated as follows: Where: kd = after-tax cost of debt i = fixed annual interest in perpetuity t = rate of company tax (%) P0 = ex-interest market price of debt

Example 11.9

Redeemable debt Use annuity principles The cost of redeemable debt can be calculated as follows: PV = the current market price of the debt FV = the par value of the dept at redemption, adjusted n = the number of periods until the debt is redeemed PMT = the fixed net interest paid on the par value of the debt i = the cost of debt to be calculated

Example 11.10

Weighted average cost of capital Overall return that an entity must generate on existing assets to maintain value of ordinary shares, preference shares and debt WACC determined because each cost of capital component has different cost Different costs due to different levels of risk Debt cheapest source of finance – lowest cost of capital Preference shares 2nd cheapest – rank ahead of ordinary shares on liquidation Ordinary shares most expensive – ultimate owners of company and bear most risk

WACC Calculate cost of each source of finance weighted by proportion of finance used Market values for each component should be used, but book values are often used instead Market values provide more accurate measure of entity’s value

Calculating WACC Step 1: Calculate the after-tax component cost of each category of capital Step 2: Determine the relevant weighting of each component Step 3: Determine the contribution of each component and then add each contribution together to obtain the WACC

Formula for calculating WACC Where: ke = cost of ordinary shares kp = cost of preference shares kd = after-tax cost of debt Ve = value of ordinary shares Vp = value of preference shares Vd = value of debt

Assumptions of WACC WACC assumes when entity raises finances it is added to a pool of funds WACC can be used as discount rate when calculating NPV for new investments WACC assumes capital structure of company is constant – to ensure capital structure is constant, use target capital structure New investments do not have a significantly different risk profile to entity’s existing investments All cash flows are constant perpetuities

Using WACC in investment decisions An entity should only invest in a project if the return will exceed the WACC New investments must be financed by new sources of finance and WACC includes these costs WACC reflects entity’s long-term future capital structure as well as cost of capital Appropriate discount rate to use for investment decisions unless more appropriate discount rate New investments might have risk characteristics which are different from business’s current investments – risk might be higher or lower

Marginal cost of capital Marginal cost of capital is defined as the cost of raising the next rand of capital If an entity is considering a large investment project that would significantly affect its current capital structure then WACC may not be appropriate The most appropriate cost of capital to use in this case would probably be the marginal cost of capital

Conclusion The cost of capital is the rate of return that an entity’s providers of capital require on the funds they have provided. Cost of capital relating to an investment depends on the risk of that investment. Cost of capital depends primarily on the use of funds and not the source. When a suitable project is identified, the investment in the project is financed from a pool funds rather than by a specific form of finance.

Conclusion (cont.) Cost of capital consists of: Ordinary shares Preference shares Debt The cost of ordinary shares can be calculated by either making use of dividends or the Capital Asset Pricing Model. The dividend method used to calculate the cost of ordinary shares depends on whether a constant dividend is paid, necessitating the use of the dividend valuation method, or whether a constant growing dividend is paid, necessitating the use of the dividend growth model.

Conclusion (cont.) If dividends paid are not constant, then a constant average annual growth rate can be calculated for use in the dividend growth model. The CAPM method of estimating the cost of ordinary shares specifically incorporates risk into the calculation. The beta coefficient is a measure of the change in the price of an individual security compared with the change in the return on the overall market or a market index.

Conclusion (cont.) The dividend paid on preference shares is not deductible for tax purposes, whereas the interest paid on debt is tax-deductible. The calculation of the cost of preference shares and debt depends on whether these sources of finance are redeemable or non-redeemable. The WACC is the overall cost of capital of an entity based on the cost of each source of finance weighted on a suitable proportional basis, such as market value or book value.

Conclusion (cont.) Determining WACC is critically important because WACC is often used as the discount rate when evaluating suitable investment opportunities. Investments that result in a positive net present value using the WACC as the discount rate should be accepted, as these investments should generate long- term wealth for the ordinary shareholder. The marginal cost of capital is the incremental cost of the capital structure before and after the introduction of new capital.