F9 Financial Management

2 Section F: Cost of Capital Designed to give you the knowledge and application of: F1. Sources of finance and their short-term finance F2. Estimating the cost of equity F4. Estimating the overall cost of capital F6. Impact of cost of capital on investments

3  Distinguish between average and marginal cost of capital. [2]  Calculate the weighted average cost of capital (WACC) using book value and market value weightings. [2] Learning Outcomes F4. Estimating the overall cost of capital

4 Average and marginal cost of capital  The weighted average cost of new, or incremental, capital is known as the marginal cost of capital.  By definition, the marginal cost of capital is the cost of raising an additional unit of capital.  When capital is raised in lump sum in practice, the marginal cost of capital in finance is referred to as the cost of raising the new funds. Marginal cost of capital Average cost of capital  Weighted average cost of capital (WACC) is an average representing the expected return on all of a company’s sources of capital.  Each source of capital, such as stocks, bonds and other debt is weighted in the calculation according to its prominence in the company’s capital structure.  The WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk.

5 V e V d WACC = K e K d (1 – T) V e + V d V e + V d Where, K e = Cost of equity K d = Cost of debt V e = Market value of equity V d = Market value of debt T = Corporate taxation  They are consistent with the objective of trying to maximise the value of the firm to its share holders.  They reflect the current required rate of return by stakeholders  They are based on the historical costs  They rarely reflect the current required return of providers of finance Calculating WACC Cost of individual sources of finance for existing capital structure Market value weighting Book value weighting Calculate weighted average cost of capital (WACC) using book value and market value weightings

6  The composite or overall cost of capital is the weighted average of the cost of various sources of funds, weights being the proportion of each sources of funds in the capital structure.  Following are the steps involved to calculate the weighted average cost of capital Weighted average cost of capital Multiply the cost of each source by its proportion in the capital structure Add the weighted component costs to get the firm’s weighted average cost of capital Calculate the cost of the specific source i.e. equity, preference and debt (consider tax effect) Refer to Example (page 382)

7 Recap  Distinguish between average and marginal cost of capital. [2]  Calculate the weighted average cost of capital (WACC) using book value and market value weightings. [2]