1. CALCULATING THE COST OF CAPITAL Focus Topic 2: Study unit 4 Defining the cost of capital and sources of capital Cost of debt Cost of preference shares Cost of ordinary shares and the relation to retained earnings Cost of new issues

2. CALCULATING THE COST OF CAPITAL Defining the cost of capital and sources of capital Rate of return that a firm must earn on the projects in which it invests to maintain its market value Assumptions  Business risk unchanged  Financial risk unchanged  After tax basis

3. CALCULATING THE COST OF CAPITAL Expected average future costs over the long run Target capital structure (Chapter 12) Page 500 example of accepting wrong project Debt and capital cost? Weighting of proportion

4. CALCULATING THE COST OF CAPITAL Specific sources of capital Long term debt Preference shares Ordinary shares Retained earnings After tax cost of obtaining the capital Not what it is on the balance sheet

5. CALCULATING THE COST OF CAPITAL Symbols – page 29 studyguide Cost of capital comprises  Pure rate of interest – Ri  Business risk premium – Bp  Financial risk premium – Fp  K = Ri + Bp + Fp Cost of long term debt Goal - After tax cost Assume it’s done through bonds

6. CALCULATING THE COST OF CAPITAL Cost of long term debt Net proceeds Floatation costs Before tax cost – Kd  Cost quotation – YTM  Calculation – Calculator example  Approximation – harder – formula – page 504  = (I+ (Par value –Nd)/n)/(Nd + par value)/2 Guess which one I prefer

7. CALCULATING THE COST OF CAPITAL Cost of long term debt After tax cost Kd *(1 – tax rate) Ki=Kd * (1-t) Why? Debenture formula on page 30

8. CALCULATING THE COST OF CAPITAL Cost of Preference Shares Stated dividends – main interest of preference shareholders Don’t share in excess profits (usually) Perpetuity formula Kp=D/n D is the dividend, n the rate  Can rearrange the formula  They could ask you the rate Rate usually higher than after tax rate on debt No tax deduction on preference share dividends

9. CALCULATING THE COST OF CAPITAL Cost of ordinary shares Return required by investors in the marketplace  Retained earnings  New issues Cost of common stock Constant growth model valuation – one method Formula Rearranging, solving for the rate ‘g’ – dividends growth rate

10. CALCULATING THE COST OF CAPITAL Cost of ordinary shares CAPM model – another method Rf+ B(Km-Rf) Cost of retained earnings Same as new share issue of ordinary shares

11. CALCULATING THE COST OF CAPITAL Cost of new ordinary share issue Same as existing shares BUT need to include floatation costs – increases the cost Forced to underprice Therefore would refer back to the existing two models  CGV  CAPM

12. CALCULATING THE COST OF CAPITAL Studyguide examples Certain nuances