Cost of Capital Note

8/4/2019 Cost of Capital Note

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COST OF CAPITAL

COST OF CAPITAL:

Cost of capital is the minimum return that a coy should make on its investment toearn the cash-flow out of which provider of fund can be paid their return. The cost of

capital is therefore the rate of return that the business must pay to satisfy the

investors.

ELEMENTS OF COST OF CAPITAL:

The cost of capital has 3 elements:

The Risk Free Rate Of Return: This is the minimum in return that would be required

from an investment if it were to be completely free from risk and that is why it isknown as the risk free rate of return, example is the return on government bond.

Premium For Business Risk: This is an increase in the required rate of return due

to the uncertainty about the future and about a firms business prospects. As a result

of uncertainty and risk, the return expected by investor is higher than the risk free

return.

Premium For Financial Risk: This relates to the danger of high debt level (High

Gearing).The higher the company Gearing, the greater will be financial risk to

Ordinary Shareholders, and this should be reflected in higher risk premium andtherefore a higher cost of capital.

COST OF ORDINARY SHARE CAPITAL

The cost of ordinary share capital is the minimum return expected by the providers of

Equity Capital within the business. Fund from Equity Shareholder are obtained at via

new issues of shares or from retained earnings. Both of which has a cost. The cost

of Ordinary Share capital can be calculated using the following Models:

1.DIVIDEND VALUATION MODEL:

Is a model that is used to estimate the cost of Equity on the assumption of the

market value of shares is directly related to the expected future dividend on the

shares

If the expected future dividend per-share is constant, then the ex-dividend share

price will be calculated:


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FORMULAR:

Po = d + d + d +.........=(1+Ke) (1+Ke)

2 (1+Ke)

3

By substitution ke= d/po

Where the dividend is expected to increase year by year and not remain constant in

perpetuity, the market price of the share is the present value of the discounted future

cash-flow of revenue from the share.

FORMULAR:

Po = dO (1+g) + do (1+g)2 +............

(1+Ke) (1+Ke)2

By substitution also Po = dO (1+g) = d1(Ke-g) (Ke-g)

And both Ke and g are expressed as proportionsWhere: Po is the current market price (ex div)

Do is the current net dividendKe is the cost of Equity capitalg is the expected annual growth in divided payment proportions

WEAKNESS OF DIVIDEND GROWTH AND ODD

It assumes there are issues cost for new shares.

It does not make allowance for the efficiency of tax.

It does not incorporate risk.

Capital gain is not accounted for by D.G.M. (Director General Manager).

Dividend growth calculation is only in approximation

2. THE CAPITAL ASSET PRICING MODEL (CAPM)

Is a model that is used to calculate the cost of equity and which incorporates risk

This model is based on comparison of the systematic risk of individual investment

with the risks of all shares in the market (trying to compare the risk of a company to

the risk on the market).

Systematic Risk: Market risks are unavoidable and non diversifiable risk that is

general to the market as a whole.


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Unsystematic Risk: Otherwise known as Business risk are avoidable non

diversifiable risk the applies to a single investment or class of investment an can be

reduced or eliminated by diversification.

Beta Factor: Is the measure of the systematic risk of a security relative to the

market portfolio. BF measures shares validity in terms of market risk. If a share price

were to rise or fall at double the market rate, it would have a beta of 2. Conversely, if

the share moves at half the market rate, the beta factor would be 0.5.

CAPM IN INVESTMENT APPRAISAL

CAPM can also be used to calculate projects specific cost of capital. The required

project is based on the expected market return, risk free return and the Beta factor of

the project.

LIMITATION OF CAPM IN INVESTMENT

The need to determine the risk free rate of return may vary with term of

lending

The need to determine the excess return [Rm-Rf] r(isk premium)

It is hard to estimate return on project market return and probabilities under

different economic environment

GEARED AND UNGEARED BETA

When an investment has a different business and financial Risk from the existingbusiness the GEARED BETA may be used to obtain an appropriate rate of return

using the formula below

Ba = Ve *Be + Ve BdVe+Vd (1-T) Ve+Vd (1-T)

Where Ba= is the asset or Geared betaBe= is the Equity or Geared beta

Bd= is the Beta factor of debt capital in the companyVe= is market value of Equity in the GearedVd= is the market value of debt in the Geared CompanyT is the tax rate.

Debt is assumed to be risk free and its beta Bd is taken to be zero which reduces theformula to


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COST OF DEBT

This represent the return that must be paid the lenders .these debt can either be

redeemable or irredeemable debt.i.e the cost of continuing to use the finance that

redeemed security at their current market price

IRREDEEMABLE DEBT CAPITAL this is interest paid in perpetuity to lender of debt

capital and its determine as

Kd= i or i [1-T]Po Po

Where kd = cost of irredeemable debtI = interest

Po = ex-interest current price of debt

REDEEMABLE COST OF DEBT: The cost of redeemable debt is calculated byconsidering all the interest payable and the capital sum be paid on redemption.

IRR=LR+ NPVLR (HR-LR)%NPVLR+NPVHR)

Where LR = the lower rate of returnHR = the higher rate of return

NPVLR = the NPV obtained using the lower rate

NPVHR = the NPV obtained using the lower rate

CONVERTIBLE DEBT: This represent debt which convey on the holder the right toconvert into other security usually equity at a specific time. The cost of convertibledebt will depend on whether the conversion is likely to happen or not.If conversion is expected the IRR method for calculating the cost of redeemable debtis used, but:

The years to redemption is replaced by the year conversion.

The redemption value is replaced by conversion value.

P0 (1+g)n

RWhere

Po = is the current price of or the share ex-divg = is the expected annual growth in share priceR = no of shares to be received on conversionN = no of years to conversion.

*If Conversion is not expected, the conversion value is ignored and the bond is to

rated as redeemable debt.


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THE WEIGHTED AVERAGE COST OF CAPITAL:

This is the average cost of companys finance weighted according to the proportion

each element bears to the total pool of capital. It is calculated by weighting the cost

of the individual sources of finance according to their relative importance and the

source of finance.

In most cases it will be difficult to associate a particular project with a particular

source of finance because a companys fund is viewed as a pool of resources.

Money is withdrawn from the pool to invest in new projects, and added to the pool as

new finance is raised. it is therefore it will be appropriate to use an average cost of

capital as the discounted rate. WACC is calculated as

WACC = WACC == Ve *Ke + Ve Kd(1-T)

Ve+Vd Ve+Vd

Ve= the market value of Equity

Vd = the market value of Debt

Ke= the cost of Equity Capital

Kd= the cost of Debt

T= is the rate of company tax

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Cost of Capital Note