Revision 5 Cost of Capital

Topic List
1. Cost of Capital Exam Question
Reference
a. Meaning
2. Estimating the Cost of Equit
a. Dividend valuation model (DVM)
Calculation Pilot
Dec 09
Jun 11
Q1a
Q2c
Q2a
Weaknesses
. !stimating t"e g#o$t" #ate
%im&le ave#age
'eomet#ic g#o$t"
!a#nings #etention model
c. C(PM
Calculation Dec 0)
Jun 09
Dec 09
Jun 10
Q1c
Q1a
Q2c
Q*a(i)
%+stematic #isk and uns+stematic #isk
(ssum&tions
,imitations Dec 0) Q-c
d. Com&a#ison et$een DVM and C(PM Jun 0) Q1c
!. Cost of "e#t an$ %ther Capital &nstruments
a. .##edeemale det
. /edeemale det (e.g. onds) Jun 09
Dec 09
Jun 10
Dec 10
Jun 11
Q1a
Q2a
Q2a
Q*
Q2a
c. Conve#tile det
d. P#e0e#ence s"a#es Pilot
Dec 10
Q1a
Q*c
e. 1ank det
'. ()CC
110
a. Com&utation + ook value
. Com&utation + ma#ket value Pilot
Jun 0)
Dec 0)
Jun 09
Dec 09
Jun 10
Dec 10
Jun 11
Q1a
Q1a
Q-a
Q1a
Q2c
Q2
Q*c
Q2a
c. W"en is suitale 0o# using in investment a&&#aisal Jun 0) Q1
5. *arginal Cost of Capital
+. Tra$itional ,ie- of Capital .tructure
a. Conce&t Pilot
Jun 09
Jun 11
Q1
Q1c
Q2c
. (ssum&tions
/. *0* ,ie-s on Capital .tructure
a. Wit"out ta2 (193)) Pilot
Jun 09
Jun 11
Q1
Q1c
Q2c
. Wit" ta2 (194-) Pilot
Jun 09
Jun 11
Q1
Q1c
Q2c
c. 5"ei# assum&tions
1. *ar2et &mpactions Jun 09
Jun 11
Q1c
Q2c
3. 4ec2ing %r$er Theor Jun 09
Jun 11
Q1c
Q2c
15. C)4* an$ *0* Com#ine$ 4ro6ect7specific
"iscount Rate
a. W"en to use6
. %te&s 0o# calculating a &#o7ect8s&eci0ic discount #ate Jun 10
Dec 10
Q-c(iii)
Q1c
111
4art ,& Cost of Capital
Jun811 Dec810 Jun810 Dec809 Jun809 Dec80) Jun80) Dec809 Pilot
Topics
&. .ources of 8inance an$ their Relative Costs
1. /isk and #etu#n #elations"i& *a
2. C#edito# "ie#a#c"+ and its connection $it" t"e #elative costs
&&. Estimating the Cost of Equit
-. Dividend g#o$t" model
a. Calculation (:e) 2a 2c -a
. Weaknesses 1c
*. C(PM
a. Calculation *a(i) 2c 1a
. %+stematic #isk and uns+stematic #isk
c. (dvantages and disadvantages
a. Dividend valuation model and C(PM 1c
&&&. Cost of "e#t an$ %ther Capital &nstruments
3. .##edeemale det
4. /edeemale det (e.g. onds) 2a * 2a 2a 1a
9. Conve#tile det
). P#e0e#ence s"a#es *c 1a
9. 1ank det
&,. The %verall Cost of Capital
10. Distinguis" et$een ave#age and ma#ignal cost o0 ca&ital
11. W(CC com&utation
a. 1+ ook value
. 1+ ma#ket value 2a *c 2 2c 1a -a 1a 1a
,. Capital .tructure Theories an$ 4ractical Consi$erations
12. 5#aditional vie$ o0 ca&ital st#uctu#e and its assum&tions 2c 1c 1
1-. M;M vie$s on ca&ital st#uctu#e
a. Wit"out ta2 2c 1c 1
. Wit" ta2 2c 1c 1
c. 5"ei# assum&tions 2c 1c 1
d. Pecking o#de# t"eo#+ 2c 1c *a
,&. &mpact of Cost of Capital on &nvestments
1*. /elations"i& et$een com&an+ value and cost o0 ca&ital 2c
13. Ci#cumstances unde# $"ic" W(CC can e used in
investment a&&#aisal -c 1
14. (&&l+ C(PM in calculating a &#o7ect8s&eci0ic discount #ate 1c -c(iii) -c
112
4art & Cost of Capital
1. The Cost of Capital
1.1 5"e cost o0 ca&ital is t"e rate of return t"at t"e ente#&#ise must &a+ to satisf the
provi$ers of fun$s< and it reflects the ris2iness o0 &#oviding 0unds.
1.2 .n ot"e# $o#ds< it is a -eighte$ average of the cost of equit an$ the cost of $e#t (;
an+ ot"e# sou#ces o0 0inance).
1.- 5"e cost of equit is t"e return of the investors expect to achieve on t"ei# s"a#es.
2. Estimating the Cost of Equit
2.1 "ivi$en$ valuation mo$el
2.1.1 .0 t"e future $ivi$en$ per share is expecte$ to #e constant in amount< t"en t"e cost
o0 e=uit+ $ill e calculated + t"e 0ollo$ing 0o#mula>
0
P
d
k
e

e
k
is t"e cost o0 e=uit+ ca&ital
d is t"e annual dividend &e# s"a#e< sta#ting at +ea# 1 and t"en continuing annuall+ in
&e#&etuit+.
0
P
is t"e e28dividend s"a#e &#ice
2.1.2 .0 t"e future $ivi$en$ per share is expecte$ to gro- constantl< t"e cost o0 e=uit+
can e calculated as 0ollo$s (dividend g#o$t" model)>
g
P
g d
k
e
+
+

0
0
) 1 (
o#
g
P
d
k
e
+
0
1
2.1.- (ea2nesses o0 t"e dividend g#o$t" model
5"e model does not incorporate ris2
8uture $ivi$en$ gro-th rate is not constant in perpetuit
Estimating the future $ivi$en$ gro-th rate is also $ifficult ? "isto#ical
dividend t#ends cannot &#edict t"e 0utu#e g#o$t" #ate accu#atel+
5"e model assumes that #usiness ris2 are constant in 0utu#e &e#iods ? t"e
usiness o&e#ations and t"e economic envi#onment a#e su7ect to constant
c"ange
11-
2.2 Estimating the gro-th rate
2.2.1 9 simple average ? 0ind t"e dividend g#o$t" #ate eac" +ea# and t"en take t"e
ave#age.
2.2.2 1+ geometric gro-th metho$ ? simila# to t"e com&ounding met"od.
@e$est dividend A Bldest dividend C (1 D g)
n
2.2.- 1+ earnings retention mo$el :;or$on<s gro-th mo$el= ? using t"e 0ollo$ing
0o#mula>
g A #
e
W"e#e #
e
A accounting #ate o0 #etu#n o# /BC! o# /B.
A ea#nings #etention #ate
2.! The capital asset pricing mo$el :C)4*=
2.-.1 5"e C(PM can e used to calculate a cost o0 e=uit+ and incorporates ris2.
2.-.2 .t is ased on a comparison of the sstematic ris2 o0 individual investments $it" t"e
#isks o0 all s"a#es in t"e ma#ket.
2.-.- .stematic ris2 :mar2et ris2=>
is t"e ris2 of mar2et -i$e factors suc" as t"e state o0 econom+
affect all companies in the same -a< and it cannot #e $iversifie$ a$a+
2.-.* >on7sstematic ris2 :unsstematic ris2 or #usiness ris2 or unique ris2=>
is t"e ris2 factors t"at $ill impact each firm $ifferentl
goo$ $iversification can almost eliminate unsstematic ris2
2.-.3 %+stematic #isk is measu#ed using #eta factors.
11*
2.-.4 9eta factor is t"e measure of the sstematic ris2 of a securit relative to the
mar2et portfolio (e.g. Eeng %eng .nde2).
2.-.9 9eta ? 1< a 1F c"ange in t"e ma#ket inde2 #etu#n gene#all+ leads to a 1F c"ange in
t"e #etu#n on a s&eci0ic s"a#e.
5 @ 9eta @ 1< a 1F c"ange in t"e ma#ket inde2 #etu#n gene#all+ leads to a less t"an a
1F c"ange in t"e #etu#ns on a s&eci0ic s"a#e.
9eta A 1< a 1F c"ange in t"e ma#ket inde2 #etu#n gene#all+ leads to a g#eate# t"an 1F
on a s&eci0ic com&an+Gs s"a#e.
2.-.) 5"e C(PM 0o#mula>
:R
6
= ? R
f
B C:R
m
7 R
f
=
W"e#e>
/
7
is t"e cost o0 e=uit+ ca&ital
/
0
is t"e #isk80#ee #ate #etu#n
/
m
is t"e #etu#n 0#om t"e ma#ket as a $"ole
H is t"e eta 0acto# o0 t"e individual secu#it+
2.-.9 )ssumptions o0 C(PM
Well8dive#si0ied investo#s
Pe#0ect ca&ital ma#ket
In#est#icted o##o$ing o# lending at t"e #isk80#ee #ate o0 inte#est
Ini0o#mit+ o0 investo# e2&ectations
(ll 0o#ecasts a#e made in t"e conte2t o0 one time &e#iod onl+
2.-.10 4ro#lems o0 C(PM
"iversification
Inde# t"e C(PM< t"e #etu#n #e=ui#ed 0#om a secu#it+ is relate$ to its
sstematic ris2 rather tan its total ris2
5"e assumption is t"at investors can $iversif all or most of the
unsstematic ris2< ut< in practice< mar2ets are not totall efficient
and investors do not all hol$ full $iversifie$ portfolios
Excess return ? e2&ected #etu#n is di00icult to dete#mine ecause it is 7ust
&#edicted 0#om "isto#ical data
Ris27free rate ? it is not eas+ to dete#mine again ecause inte#est #ates va#+ all
t"e time
Ris2 aversion ? sharehol$ers are ris2 averse< and so $eman$ higher
113
returns in com&ensation 0o# inc#eased level o0 #isk
9eta factors ? it ased on historical $ata and it ma+ e a poor #asis for
future $ecision ma2ing
Dsual circumstances ? e.g. t"e seasonal Jmont"8o08t"e8+ea#G e00ects and Jda+8
o08t"e8$eekG e00ects t"at a&&ea# to in0luence #etu#ns on s"a#es
2.' Comparison #et-een ",* an$ C)4*
2.*.1 DVM>
Estimate t"e future $ivi$en$ an$ gro-th rate a#e ver $ifficult
)ssume the #usiness ris2< and "ence usiness o&e#ations and t"e cost o0
e=uit+< a#e constant in future perio$s
"o not consi$er ris2 ? it s"ould e noted t"at s"a#e &#ice 0all as #isk inc#eases<
indicating t"at inc#easing #isk $ill lead to an inc#easing cost o0 e=uit+
2.*.2 C(PM
Consi$er t"e com&an+Gs level o0 sstematic ris2
'ive #ise to a muc" smaller $egree of uncertaint t"an t"e 0utu#e dividend
g#o$t" in t"e DVM
!. Cost of "e#t
-.1 5"e 0o#mulae o0 t"e cost o0 det 0o# t"e va#ious t+&es o0 det a#e as 0ollo$s>
Tpe of $e#t Cost of $e#t
.##edeemale det $it"out ta2
0
P
i
K
d

.##edeemale det $it" ta2
0
) 1 (
P
T i
K
d

/edeemale det %ame as .//

@on8t#ade det (ank loan) .nte#est #ate C (1 ? 5)
P#e0e#ence s"a#es
0
P
D
K
p

114
-.2 Conve#tile det ? t"e 0ollo$ing te#minolog+ s"ould unde#stand>
(1) 8loor value ? ma#ket value $it"out t"e conve#sion o&tion.
(2) Conversion ratio ? t"is gives t"e nume# o0 o#dina#+ s"a#es into $"ic" a
conve#tile ond ma+ e conve#ted>
Conve#sion #atio A
price Conversion
bond of value par al No ) ( min
(-) Conversion price ? t"is gives t"e &#ice o0 eac" o#dina#+ s"a#e otainale +
e2c"ange a conve#tile ond>
Conve#sion &#ice A
converted be may bond which o shares of No
bond of value par al No
int .
) ( min
(*) Conversion premium ? t"is gives t"e di00e#ence et$een t"e conve#sion &#ice
and t"e ma#ket s"a#e &#ice< it can e e2&#essed as a &e#centage asis o# &e#
s"a#e asis
8rom share price>
Conve#sion &#emium A
F 100

price Market
price market price Converion
8rom #on$ price>
Conve#sion &#emium A Cu##ent ma#ket value ? cu##ent conve#sion value
%r as a percentage #asis>
Conve#sion &#emium A
F 100

value conversion Current

value conversion current value market Current
%r as per share #asisE
converted shares of No
value conversion current value market Current
.

(3) Conversion value ? t"is is t"e value o0 a conve#tile ond i0 it $e#e conve#ted
into o#dina#+ s"a#es at t"e cu##ent s"a#e &#ice>
Conve#sion value A Cu##ent s"a#e &#ice 2 Conve#sion #atio
119
'. The (eighte$ )verage Cost of Capital :()CC=
*.1 Weig"ted ave#age cost o0 ca&ital is t"e average cost of the compan<s finance
(e=uit+< deentu#es< ank loans) -eighte$ accor$ing to the proportion each element
ea#s to t"e total &ool o0 ca&ital.
*.2 ( gene#al 0o#mula 0o# t"e W(CC is as 0ollo$s>
) 1 ( T k
V V
V
k
V V
V
WCC
d
d e
d
e
d e
e

,
_

+
+

,
_

W"e#e k
e
A t"e cost o0 e=uit+
k
d
A t"e cost o0 det
V
e
A t"e mar2et value o0 e=uit+ in t"e 0i#m
V
d
A t"e mar2et value o0 det in t"e 0i#m
*.- W"e#eve# &ossile mar2et value shoul$ #e use$ ecause #oo2 values ased on
historical costs and t"ei# use $ill se#iousl+ un$erstate the impact of the cost of
equit finance. .0 t"e ()CC is un$erestimate$< unprofita#le pro6ects -ill #e
accepte$.
*.* W"en is suitale 0o# using in investment a&&#aisal6
W"en t"e #isk o0 t"e investment &#o7ect is similar to the current ris2s of the
investing compan
K#om t"e &oint o0 vie$ o0 #usiness ris2>
.imilar to t"e usiness #isk o0 e2isting o&e#ations
&f not< a pro6ect specific $iscount rate s"ould e consi$ere$
C)4* shoul$ #e applie$ unde# t"is situation
K#om t"e &oint o0 vie$ o0 financial ris2L
.imilar to t"e 0inancial #isk o0 e2isting o&e#ations
&f not< a$6uste$ present value :)4,= o# t"e C)4*7$erive$ pro6ect
specific cost of capital can e ad7usted to #e0lect t"e 0inancial #isk o0
t"e &#o7ect
%ther factors to conside#
4ro6ect siFe com&a#es $it" t"e siMe o0 t"e com&an+
.0 not similar< ()CC shoul$ not #e applie$.
11)
5. *arginal Cost of Capital :*CC=
3.1 MCC is t"e cost associated $it" raising one a$$itional $ollar of capital.
3.2 .t can e a#gued t"at t"e cu##ent $eig"ted ave#age cost o0 ca&ital s"ould e used to
evaluate &#o7ects. W"e#e a com&an+Gs capital structure changes onl ver slo-l
ove# time< t"e marginal cost of ne- capital s"ould e #oug"l+ equal to t"e -eighte$
average cost of current capital.
3.- W"e#e gearing levels fluctuate significantl< o# t"e finance for ne- pro6ect ca##ies a
significantl $ifferent level o0 #isks to t"at o0 t"e e2isting com&an+< t"e#e is goo$
reason to seek an alte#native marginal cost of capital.
Question 1
:KP Co< a com&an+ listed on a ma7o# stock ma#ket< is looking at its cost o0 ca&ital as it
&#e&a#es to make a id to u+ a #ival unlisted com&an+< @'@. 1ot" com&anies a#e in t"e
same usiness secto#. Kinancial in0o#mation on :KP Co and @'@ is as 0ollo$s>
Bt"e# #elevant 0inancial in0o#mation>
/isk80#ee #ate o0 #etu#n *N0F
(ve#age #etu#n on t"e ma#ket 10N3F
5a2ation #ate -0F
@'@ "as a cost o0 e=uit+ o0 12F &e# +ea# and "as maintained a dividend &a+out #atio o0
*3F 0o# seve#al +ea#s. 5"e cu##ent ea#nings &e# s"a#e o0 t"e com&an+ is )0c &e# s"a#e and
its ea#nings "ave g#o$n at an ave#age #ate o0 *N3F &e# +ea# in #ecent +ea#s.
119
5"e e2 div s"a#e &#ice o0 :KP Co is O*N20 &e# s"a#e and it "as an e=uit+ eta o0 1N2. 5"e 9F
onds o0 t"e com&an+ a#e t#ading on an e2 inte#est asis at O9*N9* &e# O100 ond. 5"e
&#icePea#nings #atio o0 :KP Co is eig"t times.
5"e di#ecto#s o0 :KP Co elieve a cas" o00e# 0o# t"e s"a#es o0 @'@ $ould "ave t"e est
c"ance o0 success. .t "as een suggested t"at a cas" o00e# could e 0inanced + det.
Require$E
(a) Calculate t"e $eig"ted ave#age cost o0 ca&ital o0 :KP Co on a ma#ket value $eig"ted
asis. (10 ma#ks)
() Calculate t"e total value o0 t"e ta#get com&an+< @'@< using t"e 0ollo$ing valuation
met"ods>
(i) P#icePea#nings #atio met"od< using t"e &#icePea#nings #atio o0 :KP CoL and
(ii) Dividend g#o$t" model. (4 ma#ks)
(c) Discuss t"e #elations"i& et$een ca&ital st#uctu#e and $eig"ted ave#age cost o0
ca&ital< and comment on t"e suggestion t"at det could e used to 0inance a cas" o00e#
0o# @'@. (9 ma#ks)
(23 ma#ks)
((CC( K9 Kinancial Management June 2009 Q1)
Question 2
5"e 0inance di#ecto# o0 Qendeck &lc is conside#ing "o$ to 0inance a ma7o# ne$ e2&ansion o0
e2isting activities. 5"e investment $ill cost O*0 million and is e2&ected to last 0o# 0ive +ea#s.
5"e com&an+Gs cu##ent ca&ital st#uctu#e is>
O million
Medium8te#m 0loating #ate loans -*
11F deentu#es #edeemale Jul+ 2009 34
.ssued o#dina#+ s"a#es (30 cents &e# value) 13
/ese#ves )2
Bt"e# in0o#mation>
1. 5"e com&an+Gs cu##ent (Jul+ 200*) s"a#e &#ice e28dividend is *9) cents< and
deentu#e &#ice e28inte#est is O109N)0. !ac" deentu#e is #edeemale at its &a# value
120
o0 O100.
2. .ssue costs o0 e2te#nall+ 0inanced e=uit+ a#e e2&ected to e 4N3F o0 t"e total #aised.
5"e#e needs to e a minimum issue o0 O20 million< ot"e#$ise issue costs inc#ease
sustantiall+.
-. .ssue costs o0 ne$ deentu#es a#e estimated to e -N3F.
*. 5"e e=uit+ eta o0 Qendeck is 1N13.
3. 5"e cu##ent dividend &e# s"a#e is -4N* cents and dividends "ave g#o$n +
a&&#o2imatel+ *F &e# +ea# 0o# t"e last t"#ee +ea#s.
4. 5"e #isk 0#ee #ate is -N3F &e# +ea# and t"e ma#ket #etu#n is 11F &e# +ea#.
9. 5"e co#&o#ate ta2 #ate is -0F.
). Qendeck $is"es to maintain its cu##ent ca&ital st#uctu#e.
Require$E
(a) !stimated t"e cost o0 ca&ital o0 t"e ne$ investment>
(i) .0 inte#nal sou#ces o0 e=uit+ a#e used (#etained ea#nings)< and det 0inance is
#aised + a 9N3F 0loating #ate ank loan $it" negligile issue costsL
(ii) .0 e2te#nal sou#ces o0 det (ne$ deentu#es issued at &a# o0 O100) and e=uit+ a#e
used. @e$ e=uit+ ma+ e assumed to e issued at t"e cu##ent ma#ket &#ice.
Comment u&on +ou# 0indings and state clea#l+ an+ assum&tions t"at +ou make.
(11 ma#ks)
() Discuss $"et"e# o# not t"e tec"ni=ues used in &a#t (a) could e a&&lied to unlisted
com&anies. (* ma#ks)
(13 ma#ks)
121
4art && Capital .tructure
+. Tra$itional ,ie- of Capital .tructure an$ its )ssumption
+.1 Tra$ition vie- of capital structure
4.1.1 5"e rate of return require$ + each source of finance $epen$s on its ris2 0#om an
investo# &oint o0 vie$< $it" equit eing seen as t"e most ris2 and $e#t seen as t"e
least ris2.
4.1.2 ()CC $ould t"e#e0o#e e expecte$ to $ecrease as equit is replace$ # $e#t< since
$e#t is cheaper t"an e=uit+.
4.1.- (s t"e level o0 gearing increases< t"e cost of $e#t remains unchange$ up to a
certain level o0 gea#ing.
4.1.* B#dina#+ sharehol$ers are relativel in$ifferent to t"e a$$ition of small amounts
of $e#t in te#ms o0 inc#easing 0inancial #isk and so t"e ()CC falls as a compan
gears up.
4.1.3 (s gea#ing u& continues< t"e cost of equit increases to inclu$e a financial ris2
premium and t"e ()CC reaches a minimum value< at $"ic" &oint its mar2et
value -ill #e maximiFe$.
4.1.4 9eon$ this minimum point< t"e ()CC increases $ue to the effect of increasing
financial ris2 on the cost of equit and< at "ig" level o0 gea#ing< $ue to the effect of
increasing #an2ruptc ris2 on #oth the cost of equit an$ the cost of $e#t.
4.1.9 Com&an+ s"ould gea# u& until it #eac"es o&timal &oint and t"en #aise a mi2 o0 0inance
122
to maintain t"is level o0 gea#ing. Eo$eve#< there is no metho$< apart from trial an$
error< availa#le to locate the optimal point.
+.2 )ssumptions of tra$ition vie-
4.2.1 (ssum&tions>
5"e com&an+ pas out all its earnings as $ivi$en$s.
5"e gearing o0 t"e com&an+ can #e change$ imme$iatel + issuing det to
#e&u#c"ase s"a#es< o# + issuing s"a#es to #e&u#c"ase det. 5"e#e a#e no
t#ansaction costs 0o# issues.
5"e ea#nings o0 t"e com&an+ a#e expecte$ to remain constant in perpetuit
and all investo#s s"a#e t"e same e2&ectations aout t"ese 0utu#e ea#nings.
9usiness ris2 is also constant< #ega#dless o0 "o$ t"e com&an+ invests its
0unds.
Taxation< 0o# t"e timing eing< is ignore$.
/. *0* :1351= ,ie- of ()CC
9.1 .n t"ei# 193) t"eo#+< M;M demonst#ated t"at t"e ()CC remaine$ constant as a
compan geare$ up.
9.2 5"e assum&tions a#e t"at>
( perfect capital mar2et exists< in $"ic" investors have the same
information< u&on $"ic" t"e+ act rationall< to arrive at the same
expectations a#out future earnings an$ ris2.
5"e#e a#e no tax or transactions costs.
"e#t is ris27free an$ freel availa#le at t"e same cost to investo#s and
com&anies alike.
9.- 5"e+ claimed t"at t"e increase in the cost of equit $ue to financial ris2 e2actl+
offset # the $ecrease in the ()CC cause$ # the lo-er #efore7tax cost of $e#t.
9.* %ince in a perfect capital mar2et< t"e possi#ilit of #an2ruptc ris2 $oes not arise<
t"e ()CC is constant at all gearing levels and t"e mar2et value of the compan is
also constant.
9.3 5"e#e0o#e< t"e mar2et value o0 a com&an+ $epen$s on its #usiness ris2 alone< and
not on its financial ris2.
9.4 W(CC cannot #educe to a minimum.
12-
1. *0* :13+!= -ith Tax
).1 W"en corporate tax -as a$mitte$ into t"e anal+sis o0 M;M< t"e interest paments
on $e#t re$uce$ tax lia#ilit< $"ic" means t"at t"e ()CC fell as gearing
increase$< $ue to the tax shiel$ given to &#o0its.
).2 5"e#e0o#e< a com&an+ can re$uce its ()CC to a minimum + ta2ing on as much
$e#t as possi#le.
12*
3. *ar2et &mperfections
9.1 .n t"e #eal $o#ld< mar2et imperfections associate$ -ith high levels of gearing< t"e
tax shiel$ o00e#ed + inte#est &a+ments is more than offset # the effects of
#an2ruptc ris2 an$ agenc costs. .t $ould limit the extent to -hich a compan
can gear up.
9.2 &n practice< it a&&ea#s t"at com&anies can re$uce their ()CC # increasing
gearing< $"ile avoiding t"e 0inancial dist#ess t"at can a#ise at "ig" levels o0 gea#ing.
9.- B0 cou#se it ma+ e di00icult to dete#mine $"et"e# it "as #eac"ed a ca&ital st#uctu#e
giving a minimum W(CC.
15. 4ec2ing %r$er Theor
10.1 Com&anies choose the source of finance $"ic"< 0o# one #eason o# anot"e#< is easiest
for them to access. 5"e o#de# o0 &#e0e#ence $ill e>
/etained ea#nings
%t#aig"t det
Conve#tile det
P#e0e#ence s"a#es
!=uit+ s"a#es
10.2 5"e vie$ suggests that companies ma not in practice see2 to minimiFe their
()CC.
Question !
5"e 0inance di#ecto# o0 (Q/ Co "as "ea#d t"at t"e ma#ket value o0 t"e com&an+ $ill
inc#ease i0 t"e $eig"ted ave#age cost o0 ca&ital o0 t"e com&an+ is dec#eased. 5"e com&an+<
$"ic" is listed on a stock e2c"ange< "as 100 million s"a#es in issue and t"e cu##ent e2 div
o#dina#+ s"a#e &#ice is O2N30 &e# s"a#e. (Q/ Co also "as in issue onds $it" a ook value o0
O40 million and t"ei# cu##ent e2 inte#est ma#ket &#ice is O10* &e# O100 ond. 5"e cu##ent
a0te#8ta2 cost o0 det o0 (Q/ Co is 9F and t"e ta2 #ate is -0F.
5"e #ecent dividends &e# s"a#e o0 t"e com&an+ a#e as 0ollo$s.
Gear 255+ 255/ 2551 2553 2515
Dividend &e# s"a#e (cents) 19.-) 20.20 20.*1 21.02 21.)0
5"e 0inance di#ecto# &#o&oses to dec#ease t"e $eig"ted ave#age cost o0 ca&ital o0 (Q/ Co<
123
and "ence inc#ease its ma#ket value< + issuing O*0 million o0 onds at t"ei# &a# value o0
O100 &e# ond. 5"ese onds $ould &a+ annual inte#est o0 )F e0o#e ta2 and $ould e
#edeemed at a 3F &#emium to &a# a0te# 10 +ea#s.
Require$E
(a) Calculate t"e ma#ket value a0te#8ta2 $eig"ted ave#age cost o0 ca&ital o0 (Q/ Co in
t"e 0ollo$ing ci#cumstances>
(i) e0o#e t"e ne$ issue o0 onds takes &laceL
(ii) a0te# t"e ne$ issue o0 onds takes &lace.
Comment on +ou# 0indings. (12 ma#ks)
() .denti0+ and discuss #ie0l+ t"e 0acto#s t"at in0luence t"e ma#ket value o0 t#aded
onds. (3 ma#ks)
(c) Discuss t"e di#ecto#Gs vie$ t"at issuing t#aded onds $ill dec#ease t"e $eig"ted
ave#age cost o0 ca&ital o0 (Q/ Co and t"e#e+ inc#ease t"e ma#ket value o0 t"e
com&an+. () ma#ks)
(23 ma#ks)
((CC( K9 Kinancial Management June 2011 Q2)
11. C)4* an$ *0* Com#ine$ 4ro6ect7specific "iscount Rate
11.1 W"e#e t"e #usiness ris2 of an investment pro6ect is $ifferent from the #usiness
ris2 of the existing operations o0 t"e investing com&an+< it is not appropriate to use
the ()CC as the $iscount rate in investment a&&#aisal.
11.2 %te&s o0 C(PM and M;M comined>
%te& 1> 5o fin$ a prox compan $"ose #usiness ris2 is similar to t"at o0 t"e
propose$ investment.
%te& 2> 5o ungear the equit #eta of the prox compan. 5"is removes the effect
of the financial ris2 o0 t"e &#o2+ com&an+ on t"e value o0 its e=uit+ eta. .t
is usual to assume t"at t"e #eta of $e#t is Fero and "ence t"e ungea#ing
0o#mula is as 0ollo$s>
( ) ( )
1
]
1

+
1
]
1

d
d e
d
e
d e
e
a
T V V
T V
T V V
V

) 1 (
) 1 (
) 1 (
W"e#e
a

is t"e asset o# ungea#ed eta

e

is t"e e=uit+ o# gea#ed eta

124
d

is t"e eta 0acto# o0 det in t"e gea#ed com&an+

W"en
d

A 0<
) 1 ( T V V
V
d e
e
g a
+

5"e asset eta (
a

) reflects onl the #usiness ris2 o0 t"e ne$ usiness

a#ea.
%te& -> 5o regear the asset #eta into an equit #eta t"at reflect the financial ris2
o0 t"e investing com&an+. /ea##anging t"e ungea#ing 0o#mula used ea#lie#
gives>
e
d e
a e
V
T V V ) 1 ( +

%te& *> 5"is regeare$ equit #eta can e inserte$ in the C)4* equation to give a
pro6ect7specific cost of equit 0o# t"e &#o&osed investment if it is finance$
entirel # equit>
:
e
A /
0
D H(/
m
8 /
0
)
%te& 3> .0 $e#t finance forms part of the financing 0o# t"e &#o&osed investment< a
pro6ect7specific ()CC can #e calculate$.
129
)$$itional Examination .tle Questions
Question '
5"e 0ollo$ing 0inancial in0o#mation #e0e#s to @@ Co>
Current statement of financial position
@@ Co "as 7ust &aid a dividend o0 44 cents &e# s"a#e and "as a cost o0 e=uit+ o0 12F. 5"e
dividends o0 t"e com&an+ "ave g#o$n in #ecent +ea#s + an ave#age #ate o0 -F &e# +ea#. 5"e
o#dina#+ s"a#es o0 t"e com&an+ "ave a &a# value o0 30 cents &e# s"a#e and an e2 div ma#ket
value o0 O)N-0 &e# s"a#e.
12)
5"e long8te#m o##o$ings o0 @@ Co consist o0 9F onds t"at a#e #edeemale in si2 +ea#sG
time at t"ei# &a# value o0 O100 &e# ond. 5"e cu##ent e2 inte#est ma#ket &#ice o0 t"e onds is
O10-N30.
5"e &#e0e#ence s"a#es o0 @@ Co "ave a nominal value o0 30 cents &e# s"a#e and &a+ an annual
dividend o0 )F. 5"e e2 div ma#ket value o0 t"e &#e0e#ence s"a#es is 49 cents &e# s"a#e.
@@ Co &a+ &#o0it ta2 at an annual #ate o0 23F &e# +ea#
Require$E
(a) Calculate t"e e=uit+ value o0 @@ Co using t"e 0ollo$ing usiness valuation met"ods>
(i) t"e dividend g#o$t" modelL
(ii) net asset value. (3 ma#ks)
() Calculate t"e a0te#8ta2 cost o0 det o0 @@ Co. (* ma#ks)
(c) Calculate t"e $eig"ted ave#age a0te#8ta2 cost o0 ca&ital o0 @@ Co. (4 ma#ks)
(d) Discuss t"e 0acto#s to e conside#ed in 0o#mulating t"e dividend &olic+ o0 a stock8
e2c"ange listed com&an+. (10 ma#ks)
(23 ma#ks)
((CC( K9 Kinancial Management Deceme# 2010 Q*)
129