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The cost of capital concept
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 2
The cost of capital concept
Some investment projects may be funded, for example, by a new
issue of equity and at first glance we might think that the cost of
capital for that investment is the investors required return on the
new share issue.
However, a company usually consists of a collection of projects
and the investors participating in a new share made to finance a
particular project participate in the profit generated by all existing
and future projects of the company, not just the project the new
issue will be used to fund.
This means that the cost of a particular source of finance for an
investment made by the company does not tell the entire cost of
capital story.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 3
The cost of capital concept
The company needs to be able to generate sufficient return to
meet the claims of all providers of finance and still have enough
to cover the required return of ordinary shareholders.
If the company can earn more than the minimum rate of return
on the firms investments that will compensate the suppliers of
capital to the firm, the share price should increase.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 4
The cost of capital concept
Determinants of the cost of capital
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 5
The cost of capital concept
Determinants of the cost of capital
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 6
The cost of capital concept
Determinants of the cost of capital
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 7
The cost of capital concept
Taxation regimes and the cost of capital
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 8
The cost of capital concept
Taxation regimes and the cost of capital
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 9
The cost of capital concept
Taxation regimes and the cost of capital
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 10
Estimating the component costs
Finding the margin cost of funds
Issues costs are the costs associated with bringing an
issue of securities to the market. Also known as
floatation costs for equity issues.
These costs include any underwriting fees and costs for
preparing a prospectus, in addition to costs associated
with the advertising and promotion of the issue.
It may be necessary for the firm to issue new equity
securities at an offer price lower than the current
market price to ensure sufficient funds are raised from
the issue. This discount is also considered a cost.
Issue costs are often stated as a percentage of the issue
price.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 11
The cost of capital concept
Determinants of the cost of capital
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 12
Estimating the component costs
Finding the margin cost of funds
Equation 7.1 shows the relationship between net proceeds and
issue costs.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 13
Estimating the component costs
Calculating net proceeds of an issue
Keating Ltd is planning the issue of 1 million ordinary shares. The
shares will be offered to the market at $5 each. The investment
bank handling the issue has agreed to bear all the costs of the
issue for a fee of 4.6% of total funds raised. What net proceeds per
share can Keating expect and what would be the total net proceeds
from this issue?
NP = 5(1-0.046)
NP = $4.77
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 14
Estimating the component costs
Cost of debt
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 15
Estimating the component costs
Cost of debt
Solving equation 7.2 for rb will give us the before tax cost of
debt, denoted kz,bt.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 16
Estimating the component costs
Cost of debt
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 17
Estimating the component costs
Cost of debt
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 18
Estimating the component costs
= 100 000/(1+kz,bt)3
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 20
Estimating the component costs
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 21
Estimating the component costs
Cost of debt
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 22
Estimating the component costs
Before- tax cost of zero coupon bonds
Using the previous example: A zero coupon bond has a face value
of $100,000 and 3 years to maturity. Interest accrues on the bond
annually. The net proceeds of the bond are $90,000. What is the
cost to the company of this source of finance?
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 23
Estimating the component costs
Before- tax cost of zero coupon bonds
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 24
Estimating the component costs
Before tax cost of coupon bonds
Coupon bonds have more cash flows than zero coupon bonds,
further complicating the estimation of the cost of debt. Thus the
following equation (7.4) is used:
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 25
Estimating the component costs
Before tax cost of coupon bonds
Again, to find the required return or cost of debt, we
need to find the discount rate that makes the PV of the
future cash flows equal to the net proceeds of the
bond. This discount rate is also called the internal
rate of return (IRR).
The most efficient way to do this is by using the IRR
function in a spreadsheet or a financial calculator
Without access to a computer or a financial calculator,
the cost of debt on coupon bonds is approximated
using the trial and error (interpolation) method as
shown in the following example:
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 26
Estimating the component costs
Before tax cost of coupon bonds
A bond has a face value of $100,000 and three years to
maturity. The coupon rate is 5% and coupon are paid
annually. The next coupon is due in 12 months time and the
issue will generate net proceeds of $90,000. what is the cost
to the company of this source of finance?
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 27
Estimating the component costs
Before tax cost of coupon bonds
We can tell from the calculation that a cost of 9% is too high and the
cost of 8% is too low. So we interpolate between these two rates to
get a better estimate of the cost of debt as shown:
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 28
Estimating the component costs
Before tax cost of coupon bonds
The previous use of interpolation method was fairly simple
because there were cash flows for only three periods, however this
becomes difficult with longer terms. As such the following formula
(Equation 7.3) could be applied
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 30
Estimating the component costs
Cost of preference shares
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 31
Cost of Preference Shares
After-tax cost of preference shares
Legolas Ltd is planning the issue of preference shares at
an offer price of $100 per share. Dividend payments of
$5.35 will be made annually. Floatation costs are
estimated at 3.5% of offer price. What is the after-tax
cost of preference shares for Legolas?
where
= 5.35/(100(1-0.035)
=5.35/96.50
= 0.05544 or 5.54%
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 32
Estimating the component costs
Cost of preference shares
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 33
Continued
Before-tax cost of preference shares
Given a corporate tax rate of 30% and the information
about the Legolas Ltd preference shares issue in
previous example, calculate the before-tax cost of
preference shares.
= 5.35/(1-0.30)
96.50
=7.64/96.50
= 0.0792 or 7.92%
The before-tax value of Legolass dividend consists of the cash
payment of $5.35 plus imputation credits of $2.29, giving a before tax
value of $7.64. the before tax cost of preference shares is 7.92%.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 34
Estimating the component costs
Cost of ordinary equity
The cost of ordinary equity is the level of return that must
be generated in order to meet the required return of the
ordinary shareholders.
The ultimate purpose of company earnings is to be paid as
dividends or to be reinvested in the company on the
shareholders behalf.
Retained earnings represent the accumulated profit of the
company that has not been paid out to shareholders as
dividends.
Retained earnings are not a free source of funds for new
projects.
Retained earnings belong to the ordinary shareholders and
the ordinary shareholders expect to get their required return
on this source of funds.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 35
Estimating the component costs
Cost of ordinary equity
After tax Cost of retained earnings
The cost of retained earnings is the required return of ordinary
shareholders on shares that have already been issued.
Assuming that the constant growth assumption is applicable to
the company in question, we can rearrange the constant growth
model to obtain the cost of retained earnings As in equation 7.8:
where: Dt = D0 (1 + g)t
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 36
Cost of Ordinary equity cost of retained earnings
After-tax cost of retained earnings
The ordinary shares of Legolas Ltd are currently
trading at $4.72. A dividend of 50c was recently paid and
the next dividend is due a year from now. The
estimated growth rate is 4% per annum. What is the
after-tax cost of retained earnings for Legolas?
;where: Dt = D0 (1 + g)t
= 0.50(1+0.04)/4.72 +0.04
= 0.52/4.72 + 0.04
= 0.150169 or 15.02%
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 37
Estimating the component costs
Cost of ordinary equity
Before tax Cost of retained earnings
The before-tax cost of retained earnings for a company that
pays a fully franked dividend uses the grossed up dividend
amount. Equation 7.9 gives this cost:
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 38
Continued
Before-tax cost of retained earnings
If the corporate tax rate is 30% and Legolas pays fully
franked dividends, what is the before-tax cost of
retained earnings?
= 0.50(1+0.04)/(1-0.30) + 0.04
4.72
= 0.52/0.7 + 0.04
4.72
= 0.1974 or 19.74%
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 39
Estimating the component costs
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 40
Cost of new share issues
= 0.50(1+0.04) + 0.04
4.70(1-0.03)
= 0.52/4.56 + 0.04
= 0.15404 or 15.4%
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 41
Estimating the component costs
Cost of ordinary equity
Cost of new share issues
To obtain the before-tax cost of a new issue we gross up the
dividend to reflect the 100% franking credits. The equation
for the before-tax cost of a new issue is (7.11):
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 42
continued
Before-tax cost of new share issue
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 43
Estimating the component costs
Cost of ordinary equity
Cost of new share issues
We can use the CAPM as an alternative to the dividend
discount model to calculate the cost of ordinary shares.
The after-tax cost of ordinary shares is given by equation
7.12:
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 44
CAPM and the after-tax costs of ordinary shares
= 0.055+1.6(0.05)
= 0.135 or 13.5%
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 45
Estimating the component costs
Cost of ordinary equity
Cost of new share issues
While the CAPM does not require forecasts of
dividends or assumptions about a dividend growth
rate, it does need a forecast of the equity risk premium,
E(RM)-Rf, a measure of the risk-free rate, Rf, and a
measure of systematic risk, , of the firm.
Another complication with applying the CAPM to
calculate the cost of ordinary shares is that the model
does not incorporate floatation costs.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 46
The weighted-average cost of capital
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 47
The weighted-average cost of capital
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 48
The weighted-average cost of capital
Example
The financial manager of Exa-Life has identified the amount of
funds attributable to each component of the cost of capital and the
amount derived from each source of funds as follows:
Source of Funds Component Amount of
costs(kx) Financing
Term loans 0.067 2 000 000
Bonds 0.081 20 000 000
Preference Shares 0.085 10 000 000
Ordinary Shares 0.125 50 000 000
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 49
The weighted-average cost of capital
Example contd
Source of Funds Amount of Proportion of total funding (Wx)
Financing
Term loans 2 000 000 2 000 000/82 000 000 = 0.0244
Bonds 20 000 000 20 000 000/82 000 000 = 0.244
Preference Shares 10 000 000 10 000 000/82 000 000 = 0.122
Ordinary Shares 50 000 000 50 000 000/82 000 000 = 0.61
82 000 000 1.00
WACC 0.108
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 50
The weighted-average cost of capital
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 51
The weighted-average cost of capital
Alternatives for weighting
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 52
The weighted-average cost of capital
Alternatives for weighting
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 53
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