Transcript Document

2BUS0197 – Financial Management
Cost of Capital and
Returns to Providers
of Finance
Lecture 7
Dr Francesca Gagliardi
Learning outcomes
By the end of the session students should be able to:

Calculate the costs of different sources of finance used
by a company

Calculate the weighted average cost of capital

Understand how to apply the cost of capital in
investment appraisal

Appreciate the reasons for preferring market values to
book values
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Knowledge development

In the past weeks we have looked at short- and longterm financing sources that are available to companies

We have analysed how investment appraisal methods
can be applied to make capital investment decisions

We have also discussed the risk-return trade-off faced
by investors

Today we go a step further and discuss how the level of
risk of different financing sources affects their required
rate of return, hence a company’s cost of capital
3
Why focus on cost of capital?

The cost of capital is the rate of return required on
invested funds

Companies should seek to raise capital by the cheapest
and most efficient methods

Minimisation of the average cost of capital will increase
the net present value of a company’s projects, hence its
market value

To minimise the cost of capital:


Information on the costs associated to the available different
sources of finance is needed
Knowledge of how to combine different sources of finance to
reach an optimal capital structure is required
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Calculating the cost of capital

A company’s cost of capital can be used as:


A discount rate in investment appraisal
A benchmark for company performance

Calculating a company’s cost of capital can be difficult
and time consuming

To calculate the weighted average cost of capital, need
first to find the cost of capital of each source of long-term
finance used by a company
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Ordinary shares

In previous lectures we have seen that equity finance
can be raised either by issuing new ordinary shares or
by using retained earnings

The cost of equity can be calculated using the dividend
growth model as:
where:
Ke  D0(1  g)  g
P0
Ke = cost of equity
D0 = current dividend
g = the expected growth rate of dividends
P0 = the current ex-dividend share price
6
Ordinary shares
 The cost of equity can also be found from the CAPM:
Rj = Rf + βj (Rm - Rf)
where:
Rm = return of the market
Rf = risk-free rate of return
(Rm – Rf) = equity risk premium
βj = beta value of ordinary share

CAPM allows shareholders to determine their required
rate of return, based on the risk-free rate of return plus
an equity risk premium
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Retained earnings

It is a mistake to consider retained earnings as a free
source of finance

Retained earnings have an opportunity cost, which is
equal to the cost of equity


If retained earnings were returned to shareholders they could
have achieved a return equal to the cost of equity through
personal reinvestment
The cost of retained earnings can be found in the same
way as the cost of equity
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Preference shares

Dividend paid on preference shares is usually constant

The cost of preference shares is found by dividing the
preference dividend by the ex dividend market price:
D
Kps 
P
p
0
where:
Kps = cost of preference shares
P0 = current ex dividend preference share price
Dp = preference dividend
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Irredeemable bonds

Like preference shares, bonds involve a constant annual
payment in perpetuity
I
Kid 
P0
Kid = cost of irredeemable bonds
I = annual interest payment
P0 = current ex interest market price

Interest is tax-deductible. The after-tax cost of debt is:
Kid(after-tax) = Kid(1 – CT)
CT = corporation taxation rate
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Example
 10% irredeemable bonds
 Ex interest market price: £72
 Corporation tax: 30%
 Kid (before tax) = 10/72 = 13.9%
 Kid (after tax) = 13.9 x (1 - 0.3) = 9.7%
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Redeemable bonds

Redeemable bonds involve several fixed interest payments plus
redemption value. The after-tax cost of debt is:
P0 
I(1 CT) I(1 CT) I(1 CT)
I(1 CT)  RV


  
2
3
n
(1 Kd) (1 Kd) (1 Kd)
(1 Kd)
I = interest payment
RV = redemption value
Kd = cost of debt capital
n = number of years to maturity
CT = corporation tax rate


The before-tax cost of debt is found by using I instead of I(1-CT)
Kd estimated through linear interpolation or Hawanini-Vora (1992)
model
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Convertible bonds

To calculate the cost of debt need first to determine
whether conversion is likely to occur

Conversion not expected: bond treated as redeemable debt

Conversion expected: cost of capital found by linear
interpolation and a modified version on the redeemable
bond valuation model


Use number of years to conversion (not to redemption)
Use future conversion value (CV) instead of redemption value
P0 
I(1 CT) I(1 CT) I(1 CT)
I(1 CT)  CV


  
2
3
n
(1 Kd) (1 Kd) (1 Kd)
(1 Kd)
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Bank borrowings
 Bank borrowings are not traded and have no market
value that interest can be related to
 The cost of bank borrowings can be proxied by the
average interest paid: interest paid in a period divided by
average borrowings for that period
 Alternatively, the cost of traded debt issued by a
company may be used as a best approximation
 Appropriate adjustments to allow for tax-deducibility of
interest payments are needed
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The relationship between the costs of
different sources of finance

The cost of each finance source is linked to the risk faced by each
supplier of finance

Equity finance: highest level of risk faced by investors, hence most
expensive source of finance

The cost of preference shares is less than the cost of ordinary shares as
the former are less risky and rank higher in the creditor hierarchy

Debt finance: generally no uncertainty on interest payments. Debt
further up the creditor hierarchy. Hence, the cost of debt less is than
the cost of equity

Whether bank debts are cheaper than bonds depends on the
relative costs of obtaining a bank loan and issuing bonds, the
amount of debt and the length of period over which debt is raised
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Calculating the weighted average cost of
capital (WACC)

The costs of individual sources of finance are weighted
according to their relative importance as sources of finance
KeE Kd(1 CT)D
WACC

( D  E)
(D  E )
E = value of equity D = value of debt
Ke = cost of equity
Kd = cost of debt
E/(E+D) is the proportion of equity
D/(E+D) is the proportion of debt
CT = taxation rate

The equation will expand in proportion to the number of
different sources of finance used by a company
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Market value or book value weighting?

Book values are historical and are obtained from a
company’s accounts

Book values rarely reflect the current required rate of
return of providers of finance

Example: an ordinary share with a nominal value of 25p has
a market value of £1.76


Book values will underestimate the impact of the cost of
equity on the average cost of capital, hence unprofitable
projects will be accepted
Market values reflect current requirements and can be
obtained from financial press and databases
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Class activity





Source of finance
Equity
Preference shares
Irredeemable debt
Redeemable debt
Bank loans
Cost
Market value (£000)
Ke = 16.9%
633.6
Kp = 13.4%
33.5
Kid = 9.7%
68.4
Krd = 8.7%
76.0
Kbl = 8.8%
60.0
871.5
Note: the relative costs of the different sources reflect
their relative risks, i.e. the risk-return hierarchy of
financial securities
Required: in groups of four calculate the WACC
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Solution
WACC
(16.9%633.6) (13.4%33.5) (9.7%68.4) (8.7%76.0) (8.8%60.0)
WACC
871.5
13009.42
871.5
14.9%
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Average and marginal cost of capital

So far we have looked at how to calculate the cost
of capital on an average basis by using book values
or market values

The cost of capital can also be calculated on a
marginal basis, as the cost of the next increment of
capital raised
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Average and marginal cost of capital
Cost (%)
MC
0
AC
Quantity of capital
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Average or marginal cost of capital?
 The marginal cost of capital should be preferred but it is
difficult to allocate particular funding to a specific project
 WACC can be used if the following are satisfied:
 The business risk of an investment project is similar to the
business risk of a company’s current operations
 Incremental finance is raised in proportions that preserve
the existing capital structure
 The required return of existing finance sources is not
affected by a new investment project
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Practical problems with WACC

Calculating the cost of particular sources of finance may
not be straightforward

Ordinary shares of private companies


Market value of bonds


Solution: use the cost of equity for a listed company, with
similar characteristics and add a premium to reflect the
higher risk of the private company
Solution: find the market value of a bond issued by another
company, with similar maturity, risk and interest rate, and use
this market value as a proxy
The accuracy of the calculated cost of capital depends
on the reliability of the models used
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Practical problems with WACC

Which sources of finance should be included in the WACC
calculation?

Finance sources used to fund the long-term investments of a
company should be included in the calculation of WACC


What about a bank overdraft used on an ongoing basis?
The difficulty of finding the market value of securities impacts
on the weightings applied

Both market and book values are used in practice

Debt finance raised in foreign currencies needs to be
converted

WACC is not constant: changes in the market value of
securities and in macroeconomic conditions affect a
company’s average cost of capital
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WACC in the real world

Companies pay attention to the value of WACC

In recent years WACC received attention also from
national regulatory bodies to determine what is
considered to be a ‘fair’ level of profit

Several companies claimed that the cost of capital calculated by
the regulatory body underestimated their true cost of capital
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Gearing

The term refers to the amount of debt finance a company
uses relative to its equity finance

Gearing ratios assess financial risk:

Debt/equity ratio: long-term debt / shareholders’ funds

Capital gearing: long-term debt / capital employed (i.e. D+E)

Market values preferred to book values

The nature of the industry in which a company operates
is a major factor in determining what the market
considers to be an appropriate level of gearing

Typically, the lower the business risk the higher the
gearing
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Implications of high gearing

Increased volatility of equity returns arises with high
gearing since interest must be paid before paying returns
to shareholders

Increased risk of bankruptcy also occurs

Stock exchange credibility falls as investors learn about
company’s financial position

Short-termism moves managers’ focus away from
maximisation of shareholder wealth
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Summary
Today we looked at:

How to calculate the cost of different sources of finance

How to calculate the WACC

Average vs. marginal cost of capital

Main issues arising from WACC
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Readings
Textbook

Watson, D., Head, A. (2009). Corporate Finance. Principles & Practice, 5th
Ed., FT Prentice Hall – Chapter 9
Research papers

Miller, R. A. (2009), The Weighted Average Cost of Capital is not Quite
Right, The Quarterly Review of Economics and Finance, Vol. 49, 3, pp. 128138

Bade, B. (2009), Comment on “The Weighted Average Cost of Capital is not
Quite Right”, The Quarterly Review of Economics and Finance, Vol. 49, 4,
pp. 1476-1480

McGowan, C.B., Tessema, A., Collier, H.W. (2004), A Comparison of the
Weighted Average Cost of Capital for Multinational Corporations: The Case
of the Automobile Industry Versus the Soft Drink Industry, The Journal of
Current Research in Global Business, Vol. 6, 9, pp.82-88
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Your tutorial activity for next week
During the seminar you will be expected to work on:


Q1 p.298; Q3 p.299 (5th ed)
Q1 p.278; Q3 p.279 (4th ed)
To prepare for the seminar you should answer the following
practice questions:
 Q3,4,5,9 p.295-6 (5th ed)
 Q3,4,5,10 p.274-5 (4th ed)
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