INTRODUCTION TO FINANCE Instructor: ASAMOAH MICHAEL EFFAH

C OST OF CAPITAL A ND R EQUIRED R ATES OF R ETURN Cost of debt, cost of preference shares and cost of ordinary shares Weighted average cost of capital (WAAC) Marginal cost of capital (MCC) Economic Value Added Investment opportunity schedule 2

C OST OF C APITAL o Cost of capital refers to the cost of funds to the firm which is represented by the return to those who contributed funds to the firm. In other words, cost of capital refers to the cost to a company of providing debt holders or capital provider with the return they expect on their investment 3

C OMPONENTS OF C APITAL Total Capital Debt Preference Shares Ordinary Shares Retained Earnings External Equity 4

C OMPONENT C OSTS Component costs refers to the return to the contributors of each component of capital. Cost of Debt Cost of Preference Shares Cost of Retained Earnings Cost of External Equity 5

C OST OF D EBT, K D The return to contributors of debt which is the interest rate on debt (kd or r). Where there is corporate tax, the appropriate measure of component cost of debt is interest rate on debt, kd, less tax saving, –(k d )*(T), resulting from the treatment of interest as deductible expense for tax purposes. After tax cost of debt denoted by kdT is given by: K dT = k d – (k d )(T) = k d (1 – T ) 6

I LLUSTRATION – C OST OF D EBT Assume that UT Bank has GHS 1,000 par value zero-coupon bonds outstanding. UT bonds are currently trading at GHS 400 with 10 years to maturity. UT is in a 25% tax bracket. What is the cost of debt to UT Bank? Sol: ………………………. 7

C OST OF P REFERENCE S TOCK, K PS The required rate of return on a firm’s preference share. Assuming an infinite period for preference shares, the cost of preference shares, kps, is given by: k ps = D ps / Net Price (Market Value of P.S) = D ps / P 0 8

I LLUSTRATION Makosah Ltd has an issue of preferred stock outstanding that pays GHS 3.20 dividend per share every year in perpetuity. If this issue currently sells for GHS 49.2 per share, what is the required return on this security? Sol: ……………………… 9

C OST OF E QUITY A PPROACHES Dividend Discount Model Dividend Discount Model Capital-Asset Pricing Model Capital-Asset Pricing Model Before-Tax Cost of Debt plus Risk Premium Before-Tax Cost of Debt plus Risk Premium 10

C OST OF R ETAINED E ARNINGS, K S The rate of return required by shareholders on a firm’s existing ordinary share. Retained earnings has an opportunity cost in the sense that if paid out investors could invest that for a return (ks). Therefore when earnings are retained and reinvested, a return of at least ks should be earned. 11

cost of equity capital The cost of equity capital, k e, is the discount rate that equates the present value of all expected future dividends with the current market price of the stock. D 1 D 2 D (1 + k e ) 1 (1 + k e ) 2 (1 + k e ) P 0 =   Dividend Discount Model 12

constant dividend growth assumption The constant dividend growth assumption reduces the model to: k e = ( D 1 / P 0 ) + g Assumes that dividends will grow at the constant rate “g” forever. Constant Growth Model 13

Assume that UT Bank has common stock outstanding with a current market value of GHS per share, current dividend of GHS3 per share, and a dividend growth rate of 8% forever. k e = ( D 1 / P 0 ) + g k e = (GHS3(1.08) / GHS64.80) k e % k e = = 0.13 or 13% Determination of the Cost of Equity Capital 14

The cost of equity capital, k e, is equated to the required rate of return in market equilibrium. The risk-return relationship is described by the Security Market Line (SML). k e = R j = R f + (R m – R f )  j Capital Asset Pricing Model 15

Assume that UT Bank has a company beta of Research by Data Bank suggests that the risk-free rate is 4% and the expected return on the market is 11.4% k e = R f + (R m – R f )  j = 4% + (11.4% – 4%)1.25 k e 13.25% k e = 4% % = 13.25% Determination of the Cost of Equity (CAPM)

C OST OF EXTERNAL EQUITY, K E The cost of external equity is the required return on new equity stock (ordinary shares). It is based on cost of retained earnings but modified to include floatation costs. Using the DCF approach, ke is given by the following formula: K e = [D 1 / (Net Price)] + g = D 1 / P 0 (1 – F) + g 17

The cost of equity capital, k e, is the sum of the before-tax cost of debt and a risk premium in expected return for common stock over debt. k e = k d + Risk Premium* * Risk premium is not the same as CAPM risk premium Before-Tax Cost of Debt Plus Risk Premium

Assume that UT Bank typically adds a 2.75% premium to the before-tax cost of debt. k e = k d + Risk Premium = 9% % k e 11.75% k e = 11.75% Determination of the Cost of Equity (k d + R.P.)

W EIGHTED AVERAGE COST OF CAPITAL (WACC) The actual capital that a company will use to finance projects will normally come from a variety of sources: Equity, Preference Shares, Debenture, other long term loans. Each of these will probably have a different cost structure. As a general rule a company should regard projects as being financed from a general pool of capital as mentioned above. Consequently, Cost of funds or weighted average cost of capital is the average of the different cost of capital weighted according to their relative contribution to the pool of capital. 20

W EIGHTED AVERAGE COST OF CAPITAL WACC refers to the weighted average of the component costs of debt, preference shares, and ordinary shares. Meaning of WACC Where w d, w ps, w e are the proportion of total capital in debts’ preference shares, and ordinary shares. Where D, P, E are cedi amounts of debts, preference shares, and ordinary shareholders fund. V is total capital or value of firm. Formula for WACC 21

A PPROPRIATE DISCOUNT RATE FOR PROJECTS If a project is to be financed with both debt and equity then the WACC is the appropriate discount rate to use in evaluating the project’s viability. 22

P RACTICAL D IFFICULTIES WITH WACC Ascertainment of cost of equity as there are two alternatives, ie, Dividend model and CAPM, each with potential drawbacks Ascertainment of the cost of debt. Problem of ascertaining market value of debt and equity, especially non-listed securities The problem of not including short term debt in the calculation of WACC 23

M ARGINAL C OST OF C APITAL (MCC) The cost of the last cedi of new capital that the firm raises. The weighted average cost of last cedi of new capital raised. The MCC rises as more and more capital is raised during a period. 24

E CONOMIC V ALUE A DDED  A measure of business performance.  It is another way of measuring that firms are earning returns on their invested capital that exceed their cost of capital.  Specific measure developed by Stern Stewart and Company in late 1980s. 25

E CONOMIC V ALUE A DDED EVA = NOPAT – [Cost of Capital x Capital Employed]  Since a cost is charged for equity capital also, a positive EVA generally indicates shareholder value is being created.  Based on Economic NOT Accounting Profit.  NOPAT – net operating profit after tax is a company’s potential after-tax profit if it was all- equity-financed or “unlevered.” 26

D ETERMINING P ROJECT -S PECIFIC R EQUIRED R ATES OF R ETURN Use of CAPM in Project Selection: Initially assume all-equity financing. Determine project beta. Calculate the expected return. Adjust for capital structure of firm. Compare cost to IRR of project. 27

D ETERMINING P ROJECT -S PECIFIC R EQUIRED R ATE OF R ETURN 1. Calculate the required return for Project k (all- equity financed). R k = R f + (R m – R f )  k 2. Adjust for capital structure of the firm (financing weights). Weighted Average Required Return = [k i ][% of Debt] + [R k ][% of Equity] 28

Assume a computer networking project is being considered with an IRR of 19%. Examination of firms in the networking industry allows us to estimate an all-equity beta of 1.5. Our firm is financed with 70% Equity and 30% Debt at k i =6%. The expected return on the market is 11.2% and the risk-free rate is 4%. Project-Specific Required Rate of Return Example 29

k e = R f + (R m – R f )  j = 4% + (11.2% – 4%)1.5 k e 14.8% k e = 4% % = 14.8% WACC WACC = 0.30(6%) (14.8%) 12.16% = 1.8% %= 12.16% IRR 19%WACC 12.16% IRR = 19% > WACC = 12.16% Do You Accept the Project? 30