2. SOURCES OF FUNDS AND COST OF CAPITAL
The cost of capital depends on the nature of the capital used.
It is for this reason that we must start by analyzing the various sources of funds that are used and the way in which these funds are raised. Thus, we study the environment in which the firm raises these funds.

3. Dividend Yield and Capital Gains Yield
If an investor decides to hold a security for a certain period of time this return is called the holding period return (HPR).
The HPR consists of two components, the capital gain and the dividend.The capital gains yield during the holding period is measured by :

5. Where, P1is the price at the beginning of the period,
P0 is the price at the end of the period.
Example:

6. You buy a share as part of your portfolio of investments
You buy a share as part of your portfolio of investments. Youbought the security when the price per share was 100 cents and after holding it for oneyear, the share price is now 130 cents.
We can see that there has been a capital gain of 30cents during the holding period.

7. Then the capital gains yield would be [ ( 130 - 100 ) / 100 ] = 30%.
The second component of the HPR is the dividend yield. This return is found by:

8. Where, D1 is the dividend that is expected to be paid during the period.
For example, that your security paid a dividend of 10 cents per share during theperiod.
The dividend yield would then be (10 / 100) = 10%.

9. The total HPR for you is therefore 40%, that is the dividend yield of 10% plus the capitalgains yield of 30%.
HPR= Dividend Yield + Capital gains Yield

10. We introduce the Gordon's Dividend Growth Model.
We advise you to thoroughly grasp this model as it is not be the last time that you meet it
It is an alternative to another model, known as the Capital Asset Pricing Model (CAPM).

11. Gordon's Dividend Model
Now, you know that when a firm issues shares, they are issued in perpetuity, so when youbuy a share and sell it after holding it for a period, it only exchanges hands between the twoinvestors.
If we assume that size of dividends will grow during the life of a share which isissued in perpetuity, and that this growth rate is constant, and dividends are paid annually,we arrive at Gordon's dividend model.

12. The model states that the return to the shareholder is made up of two parts, the dividendyield, which we have seen to be equal to D1 / P0, and the capital gains yield also shown above.
However,under these assumptions, the capital gains yield will be represented by g, which is the expected growth rate in dividends.

14. Where, Keis the cost of equity(RRR).
D1is the dividend that is expected to be paid next year.
P0is the current share price, ex-dividend.
g is the expected growth rate in dividends.
D1= D0 (1 + g), where D0 is the current year's dividend.

15. Example
A company has just paid a dividend of 120 cents per share. The current market price of its shares is 1500 cents per share. The dividends have been growing at 8%per year over the past few years and it is expected that this growth rate will be maintainedinto the future. Calculate the required rate of return ( the cost of equity ) on the company'sequity.

16. Solution
Given that;
Ke= (D1 / P0 ) + g
Where, D0 = 120, P0 = 1 500, g = 0.08. =
= 16.64%

18. Cost of Retained Earnings vs the Cost of new equity.
Retained earnings represent earnings that belong to the common shareholders but havebeen retained in the business for reinvestment instead of being paid out as dividends.

19. Preferred Capital
Preference shareholders receive a preferred dividend which is fixed on the date that theshares are issued. The dividend is fixed as a percentage of the nominal value, or par value,of the shares.
Like in the case of ordinary shares, if there are no profits, then the preferencedividend will not be paid. If the preferred dividend has not been paid in a particular year,then the ordinary dividend cannot also be paid.

20. Forms of Preference shares 
They can be redeemable, irredeemable, and cumulative.
With redeemable, shares shareholders receive their annual dividend , if it is declared, but at the end of an agreed number of years, the shares are redeemed.

21. The cost of irredeemable preferred equity
If the preference shares are irredeemable, the expected dividends are treated as aperpetuity and the cost of the shares can be found as follows :

23. Example
A company has in issue 12% preference shares with a nominal value of $100 and a currentmarket value of $120. The dividend on the shares has just recently been paid. Calculate therequired rate of return on the company's preferred equity.

24. Example
A company has in issue 12% preference shares with a nominal value of $100 and a currentmarket value of $120. The dividend on the shares has just recently been paid. Calculate therequired rate of return on the company's preferred equity.

25. Practice Question
A company has in issue 18% preference shares with a nominal value of $100 and a current market value of $240. The dividend on the shares is due shortly. Calculate therequired rate of return on the firm's preferred equity.

26. Solution
Note that the share price is already ex-div. as the dividend has already been paid.

27. The annual dividend is $12 ( 0.12 x $100 ).
Therefore kp = $12.00 / $ = 10% .

28. Cost of Debt capital[Kd]
Like equity, debt also comes in various forms. It can be redeemable or irredeemable,convertible or callable. The calculation of the cost therefore, depends on the type of debt under consideration. The cost of debt to the company is always an after-tax cost because interest is allowed as a deduction from profits for tax purposes. Like in the case of commonequity, we also use the ex.interest market price when the debt is traded on a market.

29. Cost of irredeemable debt.
Irredeemable debt is a debt instrument with no maturity date. In other words, it is issued in perpetuity. In this case the cost of the debt is given by :

31. Where INT is the annual interest payment,
T is the tax rate, and
P0is the current marketvalue, ex-interest.

32. Example
A firm has in issue 15% irredeemable debt with a nominal value of $1 000and a current market value of $ The corporate tax rate applicable to the firm is 32%.Calculate therequired rate of return on the debt.

33. Solution
Annual interest = 0.15 x = 150
kd = 150 (1 – 0.32 ) /
= 12.76%.

34. Practice Question
A firm has in issue 18% irredeemable debt with a current market value of $112 and anominal value of $100. The interest on the debt is just about to be paid and the tax rateapplicable to the company is 35%. Calculate the required rate of return.

35. Calculating the WACC
When calculating the Weighted Average Cost of Capital [WACC]we use the following procedure:
Calculate the cost of each component of capital,
Calculate the weight of each component,
Multiply the cost of each component by the respective weight and add the total.
Thus, the WACC is given by the following formula :

36. Thus, the WACC is given by the following formula :
WACC = Wd Kd (1-T) + Wps Kps + We Ke + …..

37. Where , W is the weight of each component
Kd is the cost of debt.
Wd is the weight of debt in the capital structure.
Kps is the cost of preference share capital.
Wps is the weight of preference share capital .
Ke is the cost of common equity.
We is the weight of common equity in the capital structure.

38. The weights that are usually applied are based on the market values,
unless the securities are notquoted on a stock exchange, in which case we may use the book values.

39. Walgreen Pharmacies, has the following capital structures:
ordinary shares at 5 dollars each
% preference share at 4 dollars each
Capital Reserves $
Revenue Reserves $
Retained Earnings $
% debentures at $12 each

40. Additional Information
Ordinary share dividend is expected to grow by 15% p.a. constantly and the current price of $10 and a dividend of $30 have just been issued.
Preference shares are non redeemable and are currently trading at $6. The dividend on the shares has not been paid.
Debentures have a current market value of $15 and interest has just been paid.
Taxation is at 35%.

41. Required
Calculate the weighted average cost of capital (WACC) of Walgreen Pharmacies. Comment on the significance of this measure in financial theory. [10].