1. CHAPTER 11
COST OF CAPITAL 1

2. 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

3. 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.

4. 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

5. 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

6. 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

7. 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)

8. 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

9. 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

10. 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

11. Example 11.3

12. 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

13. 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

14. Example 11.5

15. 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

16. 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

17. 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

18. Example 11.7

19. 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

20. Example 11.8

21. 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

22. 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

23. Example 11.9

24. 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

25. Example 11.10

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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.

34. 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.

35. 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.

36. 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.

37. 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.