ACC412 Management Accounting I Module 4 (B) Cost of Capital By:E. P. Enyi, Ph.D, MBA, ACA, FAAFM, RFS, MFP, FIIA Head, Dept of Accounting, Covenant University, Ota, Nigeria

Cost of Capital Business and economic decisions can only be accurate when all elements of costs and benefits have been correctly considered. Capital like any other variable in business decision has a cost attached to it. It is not free even when provided by the business owner(s). Cost of Capital is defined as the required rate of return necessary to make a capital budgeting project considerable. It is the rate of return on investment that is necessary to maintain the market value of a firm. It is known as hurdle rate, cut-off rate or simply as the minimum required rate of return (RRR).

Components of Cost of Capital Every composition of a firm’s capital has a cost associated with it. For instance, ordinary shares and retained earnings have their own cost to the firm, so also are preferred stock and debts. The cost of debt is the interest rate payable after adjusting for tax. The cost of preference shares is the fixed annual dividend rate. The cost of equity and retained earnings are the opportunity cost of not investing the money elsewhere.

The reason why ordinary shares and retained income carry costs despite their ownership by the firm is that providers of capital have to be compensated for the time and risk in giving away their money. Cost of Debt Cost of debt is the yield or return which lenders expect from their investment. It is tax deductible. The formula is given as follows: K d = r(1-T) Where; K d = Cost of debt; r = pre-tax interest rate T = tax rate

Cost Equity This is the rate of return required by shareholders on stocks of comparable risk. It is a price which the firm must pay to attract capital from shareholders. Because shareholders expect to receive both dividends and capital gains on their investments, the cost of equity includes the expected dividend yield and a percentage of capital appreciation. A simple formula for equity cost is given as: K e = (d/p) + g Where; K e = Cost of Equity d = Dividend yield per share p = Current Market Price of the share g = expected annual dividend growth rate.

Other Methods of Measuring Equity Cost The cost of equity can also be determined by using the Capital Assets Pricing Model (CAPM) introduced by Modigliani and Miller. The CAPM formula is as follows: K e = R f + β(R m – R f ) Where; R f = Risk free rate ( rates of government bonds ) R m = Market Risk Premium β = the beta factor of the firm K e = Cost of equity

Cost of Retained Earnings The cost of retained earnings is the same as the cost of ordinary shares. When a company issues new share capital at a price less than the prevailing market price, the cost of retained earnings will be less than the cost of new equity share issue. E.g. if d=25, p=75 and g=0.07; then K e = K r = (25/75) = 0.4 or 40%. But if p is offered at 50 ( new issue at lower price ) then K e(new issue) =(25/50) = 0.57 or 57% while K r still remains at 40%. (As previously computed) (Here, K r = Cost of retained earnings).

Cost of Preference Shares Preference share is regarded as a debt and, therefore, has no characteristics found in ordinary share holding. It has a fixed dividend rate which must be paid before the ordinary shareholders get their own. Because the dividend is pre-agreed like an interest rate, it has no growth rate. The formula is:K p = d/p (With d and p as previously defined).

Weighted Average Cost of Capital (WACC) The WACC is the firm’s true cost of capital. It is the average or overall cost of capital which has taken all aspects of the costs from all sources of finance into account. The WACC is the firm’s Required Rate of Return (RRR) which must be taken into account when discounting or when making critical investment and financing decisions. It is highly complicated and a bit cumbersome to calculate in real life because of many factors to be taken into consideration such as beta factors, market risk premium etc.

Computing the Weighted Average Cost of Capital (WACC) Three steps are involved in computing the WACC. Step1 – Calculate the capital component costs for each category; Step2 – Assign weights to each component according to its balance sheet value; Step3 – Multiply the weights by computed component costs and sum up to get the WACC.

Illustration Dominion Ventures Ltd., intends to embark on a long term investment in capital assets. The current capital structure of the company is as follows: Ordinary Share Capital N20,000,000 Preference Share Capital 5,000,000 15% Debenture Stock 20,000,000 Retained Earnings 5,000,000 The current rate of corporation tax is 30%. The company’s dividend yield which has maintained a constant growth of 5% per annum is 12kobo per share. The current market price of the company’s share is put at N1.35 while the agreement on the preference dividend is 15kobo on the par value of N1.10 per share. Required: Calculate the Weighted Average Cost of Capital (WACC) for Dominion Ventures Ltd.

SOLUTION Step1: Calculate the cost of components K d = 15(1- 0.3) = 10.5% K e = ((12/135) ) x 100 = 13.89% K p = (15/110) x 100 = 13.64% K r = K e Step2: Assign weights Type of Capital Amount Weight Ordinary Share20,000, (20/50) Preference Share 5,000, (5/50) 15% Debenture20,000, (20/50) Retained Earnings 5,000, (5/50) TOTAL50,000,

Step3: Compute WACC Weighted Capital TypeWeightCost Cost Ordinary Share Preference Share % Debenture Retained Earnings TOTAL i.e. WACC = 12.51%

Class Work Assuming that Dominion Ventures Ltd., decided to issue additional N10million ordinary shares and N5million preferred stock at N1.15 and N1.10 per share respectively before embarking on the new capital project; with all other information as before, compute the company’s cost of capital to be used in the appraisal of the new project.