Source of Finance and their Relative Costs F. COST OF CAPITAL

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1 F. COST OF CAPITAL 1. Source of Finance and their Relative Costs 2. Estimating the Cost of Equity 3. Estimating the Cost of Debt and Other Capital Instruments 4. Estimating the Overall Cost of Capital 5. Capital Structure Theories and Practical Considerations 6. Impact of Cost of Capital on Investments What is the cost of capital? The cost of capital is: The cost of funds that a company raises and uses, and the return that investors expect to be paid for putting funds into the company It is the minimum return that a company should make on its own investments, to earn the cash flows out of which investors can be paid their return The cost of capital is an opportunity cost of finance, because it is the minimum return that investors require. What are the elements of cost of capital? Cost of capital = Risk free rate of return + premium for business risk + premium for financial risk What is the Risk free rate of return? The risk free rate of return is the return, which would be required from an investment if it were completely free from risk. (E.g. yield on government security) What is the Premium for business risk? The premium for business risk is an increase in the required rate of return due to the existence of uncertainty about the future and about a firm s business prospects. What is the Premium for financial risk? This relates to the danger of high debt levels (high gearing). The higher the gearing of a company s capital structure, the greater will be the financial risk to ordinary shareholders, and this should be reflected in a higher risk premium and therefore a higher cost of capital. Source of Finance and their Relative Costs The cost of debt is likely to be lower than the cost of equity, because debt is less risky from the debtholders viewpoint. In the event of liquidation, the creditor hierarchy dictates the priority of claims and debt finance is paid off before equity. This makes debt safer investment than equity and hence debt investors demand a lower rate of return than equity investors. Debt interest is also corporation tax deductible making it even cheaper to a tx paying company.

2 What is the dividend growth model? Estimating the Cost of Equity The dividend growth model can be used to estimate a cost of equity, on the assumption that the market value of share is directly related to the expected future dividends from the shares. How can the cost of equity on new issues and retain earnings be calculated? The cost of equity for new issues and retained earnings can be estimated using the dividend valuation model, on the assumption that the market value of shares is directly related to expected future dividends on shares. Ke = D/P0 Where Ke = Cost of Equity, D = annual dividend per share, starting at year 1, P0 = ex- dividend share price Shareholders will normally expect dividends to increase year by year and not to remain constant in perpetuity. The fundamental theory of share values states that the market price of a share is the present value of the discounted future cash flows of revenue from the share, so the market value given an expected constant annual growth in dividends would be: Ke = D0(1+g)/P0 + g How can you estimate the growth rate? There are two methods for estimating the growth rate: Dividend in the 1 st year x (1 + g) n = Dividends in the N th year Gordon s growth approximation: Growth = Portion of profits retained x rate of return on new investments What are the weaknesses of the dividend growth model? The model does not incorporate risk Dividend do not grow smoothly in reality so g is only an approximation No allowance is made for the effects of taxation It assumes there are no issue costs for new shares What is unsystematic or business risk? Unsystematic or business risk can be diversified away it is the risk specific to the company. What is systematic or market risk? Systematic or market risk cannot be diversified away. What is the beta factor? The beta factor measures a share s volatility in terms of market risk.

3 What is the capital asset pricing model? The capital asset pricing model can be used to calculate a cost of equity and incorporates risk. The CAPM is based on a comparison of the systematic risk of individual investments with the risk of all shares in the market. The capital asset pricing model is mainly concerned with how systematic risk is measured, and how systematic risk affects required returns and share prices. Systematic risk is measured using beta factors. The CAPM theory includes the following propositions: Investors in shares require a return in excess of the risk- free rate to compensate them for the systematic risk Investors should not require a premium for unsystematic risk, because this can be diversified away by holding a wide portfolio of investments Investor will require a higher return from shares in those companies where the systematic risk is bigger The expected return on a company s share (Ri): Ri = Capital gain (or loss) + dividend / Price at start of period The expected return on the market portfolio (Rm): Rm = Capital gain (or loss) + dividend / Price at start of period What is the equity risk premium? The market risk or equity risk premium is the difference between the expected rate of return on a market portfolio and the risk- free rate of return over the same period. It is the excess of market returns over those associated with investing in risk- free assets. (Rm Rf) CAPM Statistical analysis of historic returns from a security and from the average market may suggest that a linear relationship can be assumed to exist between the market return of investment and an individual security. The return from a security and the return from the market as a whole will tend to rise or fall together What is the CAPM formula? Ri = Rf + B(Rm Rf) What are the problems with applying the CAPM? Historical returns rather than expected returns are used Determining the risk- free rate can be difficult depending on the terms the interest will change Errors in the statistical analysis used to calculate beta value Beta may also change over time The CAPM is unable to forecast accurately returns for companies with low price/earnings ratios CAPM does not take into account seasonal effects that influence returns on shares

4 Estimating the Cost of Debt and Other Capital Instruments What is the cost of debt? The cost of debt is the return an enterprise must pay to its lenders. It is the cost of continuing to use the finance rather than redeem the securities at their current market price. For redeemable debt, the cost is the internal rate of return of cash flows. For irredeemable debt, this is the (post- tax) interest as a percentage of the ex interest market value of the bonds or preferred shares. Also, it is the cost of raising additional fixed interest capital assuming the cost of the additional capital would be equal to the cost of that already issued. Calculate the cost of an irredeemable debt: Kd = i/p0 or Kdnet = i (1- T)/P0 Calculation for half year interest payments: (1 + i/p0 ) ^2 1 Calculate the cost of redeemable debt capital: Kd = IRR L% + NPVL/(NPVL- NPVH) x (H%- L%) The cost of short- term funds such as bank loans and overdrafts is the current interest being charged on such funds. Calculate the cost of convertible debt: The cost of convertible debt depends on whether or not conversion is likely to happen: If the conversion is not expected the bond is treated as redeemable debt using the IRR method If conversion is expected the IRR method is used but the number of years to redemption is replaced by the number of years to conversion and the redemption value is replaced by the conversion value Conversion value = P0 (1+g)^n x # of shares received What is the cost of preference shares? Kp = D/P0 Estimating the Overall Cost of Capital What is the Weighted Average Cost of Capital (WACC)? The weighted average cost of capital is the average cost of the company s finance (equity, bonds, bank loans) weighted according to the proportion each element bears to the total pool of capital. Calculate the WACC: WACC = (Ve/Ve+Vd)Ke + (Vd/Ve+Vd)Kd(1- T) Capital Structure Theories and Practical Considerations

5 The two capital structure theories are: The traditional view that their exist an optimal mix of finance at which WACC is minimised The alternative view of Modigliani and Miller that the overall WACC is not influenced by changes in its capital structure Traditional view: Under the traditional theory of cost of capital, the cost declines initially and then rises as gearing increases. The optimal capital structure will be the point at which WACC is lowest. The traditional view holds that: As the level of gearing increases, the cost of debt remains unchanged up to a certain level of gearing. Beyond this level, the cost of debt will increase The cost of equity rises as the level of gearing increases and financial risk increases The WACC does not remain constant, but rather falls initially as the proportion of debt capital increases, and then begins to increase as the rising cost of equity (and debt) becomes more significant The optimum level of gearing is where the company s weighted average cost of capital is minimised Assumptions under the traditional view: The company pays out all its earnings as dividends The gearing of the company can be changed immediately by issuing debt to repurchase shares or by issuing share to repurchase debt There are no transaction costs for issues The earnings of the company are expected to remain constant in perpetuity Business risk is constant regardless of how the company invests its funds Taxation is ignored Alternative view (Modigliani- Miller): Modigliani and Miller stated that, in the absence of tax, a company s capital structure would have no impact upon its WACC. They proposed that the total market value of a company is determine by its total earnings and the level of operating risk attached to those earnings. Assumptions under the alternative view: A perfect market exists: o Investors have the same information o Investors act rationally There is no tax There is no transaction costs Debt is risk- free Market value of a company: Market value of equity: Ke: Market value per share: Earnings / WACC Market value of a company less market value of debt Earnings less interest / Market value of equity (Earnings less interest / # shares) x (1/Ke)

6 The conclusion of the net operating income approach is that the level of gearing is a matter of indifference to an investor, because it does not affect the market value of the company, nor of an individual share. This is because as the level of gearing rises, so does the cost of equity in such a way as to keep both the WACC and the market value of the shares constant. Modigliani and Miller modified their theory to admit that tax relief on interest payments does lower the WACC. The saving arising from tax relief on debt interest is a tax shield. They claimed that the WACC would continue to fall, up to gearing of 100%. This suggests that companies should have a capital structure made up entirely of debt but this does not happen in practice due to the existence of other market imperfections. What is the Pecking order theory? The pecking order theory is an alternative to the traditional view and it states that firms will prefer retained earnings to any other source of finance, and then will choose debt, and last of all equity. The order of preference being: 1) Retained earnings, 2) Straight debt, 3) Convertible debt, 4) Preference shares, 5) Equity shares. What are the reasons for Pecking order? It is easier to use retained earnings than go to the trouble of obtaining external finance and have to live up to the demands of external finance providers There are no issue costs if retained earnings are used What are the effects of gearing on the Beta values of a company? If a company is geared then its financial risk is therefore higher than the risk of an all- equity company, therefore, the Beta value of the geared company s equity will be higher than the Beta value of a similar ungeared company s equity. What is the formula for un- gearing a beta? Ba = Be x Ve / Ve + Vd (1- T) What is the formula for gearing a beta? Be = Ba x Ve + Vd (1- T) / Ve How could one estimate the beta factor for a company s equity? Another way of estimating a beta factor for a company s equity is to use the beta values of another quoted company that have similar operating characteristics to estimate a beta value for the company under consideration. Instructions: Obtain published beta values for companies in the industry Convert the beta values of other companies in the industry to ungeared betas i.e. using the formula above Convert the ungeared beta value back to a geared beta using the other company s gearing ratio Then use the CAPM to estimate the cost of equity THE END.