Cost of Capital and Returns to Providersof Finance

Lecture 7

Dr Francesca Gagliardi

2BUS0197 – Financial Management

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 long-term 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

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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 required4

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 = cost of equity

D0 = current dividend

g = the expected growth rate of dividends

P0 = the current ex-dividend share price

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gP

DK0

0 )g1(e

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:

where:

Kps = cost of preference shares

P0 = current ex dividend preference share price

Dp = preference dividend

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K DP

psp

0

Irredeemable bonds

Like preference shares, bonds involve a constant annual payment in perpetuity

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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0idPIK

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:

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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)K1(

RV)C1(I

)K1(

)C1(I

)K1(

)C1(I

)K1(

)C1(IP

dn

T

d3

T

d2

T

d

T0

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

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)K1(

CV)C1(I

)K1(

)C1(I

)K1(

)C1(I

)K1(

)C1(IP

dn

T

d3

T

d2

T

d

T0

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

E = value of equity D = value of debt

Ke = cost of equity Kd = cost of debtE/(E+D) is the proportion of equityD/(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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)ED(D)C1(K

)ED(EKWACC Tde

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 Cost Market value (£000) Equity Ke = 16.9% 633.6 Preference shares Kp = 13.4% 33.5 Irredeemable debt Kid = 9.7% 68.4 Redeemable debt Krd = 8.7% 76.0 Bank loans Kbl = 8.8% 60.0

871.5Note: 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

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5.871WACC )0.60%8.8()0.76%7.8()4.68%7.9()5.33%4.13()6.633%9.16(

%9.145.871

WACC 42.13009

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

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MCAC

Cost (%)

Quantity of capital0

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 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

Market value of bonds 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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ReadingsTextbook

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. 128-138

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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