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Lecture 9: Cost of Capital

Lecture 9: Cost of Capital. At the end of this session you should be able to: define what is cost of capital; Explain the calculation of cost of capital: equity and debt calculate the weighted average cost of capital Discuss the arguments for and against WACC. Cost of Capital. Definition

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Lecture 9: Cost of Capital

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  1. Lecture 9: Cost of Capital At the end of this session you should be able to: • define what is cost of capital; • Explain the calculation of cost of capital: equity and debt • calculate the weighted average cost of capital • Discuss the arguments for and against WACC

  2. Cost of Capital • Definition • is concerned with what a firm has to pay for the capital it uses to finance new investments. • In other words, it is a return required by investors.

  3. Factors influencing the cost of capital • General economic conditions determines the supply and demand of capital within the economy. • Risk: Firm’s operating and financial decision. Higher the risk the higher investor required rate of return • Capital structure: a significant increase in a firms gearing, by raising additional debt finance, may cause equity shareholders to demand increased returns.

  4. Market Value of Share • Points to Note: • Return on investment is associated with the value of share. • E.g. if company A is paying high dividend it share prices will rise. • Therefore cost of capital can be estimated by means of dividend valuation model.

  5. Market value of share Example 9.1 C Ltd- pays a dividend of £10/share discount rate is 10%. What is the share price? Solution 9.1 Price per share = Dividend per share interest rate = 10/0.10 = 100

  6. Market value of share Formula: Ke = D0/p Where: D0 = annual dividend P = current market price Ke = cost of equity capital

  7. Cost of Capital - Example 9.2 IT plc has ordinary shares in issue which have a current market value of £2.20. Annual dividend to be paid is 40p. What is the cost of capital? Solution Ke =Do / P 0.4/2.2 =18.2%

  8. Cost of Capital - Example 9.3 AT & T has in issue 5 million £1.00 par value irredeemable 6% preference shares. Find the cost of the shares if their current market value is £0.96. Solution Kp = £0.06/0.96 = 6.25%

  9. Cost of Capital - Example 9.4 Weatherall Ltd has in issue 8% bonds with a par value of £100. If the market value of a bond is currently £90 and the rate of corporation tax is 30%. What is the cost of the bond? Solution Kd = (I/BV) x (1-T) 8/90 x (1-0.3) = 6.22%

  10. Gordon’s growth model If dividend is assumed to grow annually at a constant rate we can use the dividend growth model to calculate the value of the company as follows: P0 = Do (1+g) = D1 ( r - g) (r-g) where: • Po = value of share at time zero • D1 = expected dividend per share one year from now • r = required rate of return on the share • g = constant growth rate

  11. Cost of Equity capital Example 9.5 A Ltd shares is selling at £1.50. Dividend for next year is 20p/share. Future dividend is expected to growth at a constant rate of 3%. What is the cost of capital? Solution Ke = (D1 /Po) + g Ke = 0.20/1.50 + 0.03 = 16.3%

  12. Weighted Average Cost of Capital (WACC) • WACC : • is a discount rate • which combines the capital costs of all of the various types of capital • Thus it may include the costs of equity capital, debt capital, and any other capital claims outstanding.

  13. Weighted Average Cost of Capital • The WACC: • is convenient measure to use, because it captures in a single discount rate all returns necessary to service the company’s capital claims. • It is a firm’s overall cost of capital. This is also used as a discount rate in investment appraisal.

  14. Formula

  15. Weighted Average Cost of Capital Example 9.6 The Sky plc currently has 5 million shares in issue and the market price is quoted at £3.00. The company also has 50,000 £100 par value bonds issued in the market and which are currently trading at £98, with a current yield of 10%. The cost of equity is 12%. Corporation tax is £30%. Calculate WACC

  16. Weighted Average Cost of Capital Solution 9.6 step 1: calculate the market value of debt &equity and the weightings/proportions of equity &debt Market value Weight Equity (5m x £3.00) = £15.0 0.75 Debt (50,000 x £98) = £4.9 0.25 £19.9 1.00

  17. Weighted Average Cost of Capital Solution 9.6 step 2: calculate the WACC using the formula above 0.25 (10%) X (1-0.3) + 0.75(12%) = 1.75% + 9% = 10.75%

  18. WACC Please study the consolidating question on page 70.

  19. Problems with WACC • Certain securities have no market value since not traded on regular basis (unlisted companies). • Which source of finance to include and which not to include (long term or short term). • It assumes same level of risk

  20. Estimating the value of g Method 1: the earnings retention model g = r x b Where: r = return on equity b = earnings retention rate. Assumption The higher the level of retentions in a business, the higher the potential growth rate.

  21. Estimating the value of g

  22. Exercise 9.1 Under what circumstances should CAPM be used instead of WACC?

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