1. 1 Business Finance - DK 1 Cost of Capital - Definitions Capital structure - the mix of long-term financing sources such as debt, preferred shares, and ordinary shares. Cost of capital - the returns required by the various providers of capital WACC - the weighted average cost of capital is the average of the required rates of return for the various sources of capital weighted according to proportion of capital raised from each source WACC =  w i *k i

2. 1 Business Finance - DK 2 Cost of Capital = Required Rate of Return! 4Easiest way to calculate required rate of return is to compute the value of the series of payments promised to lenders / investors. 4For debt, this is the interest payments + the principal. 4For preferred shares, this is the dividends. 4For ordinary shares, there is no promised payment. Commonly, the only thing shareholders will receive as a group is dividends. But dividends are hard to predict.

3. 1 Business Finance - DK 3 Cost of Debt (Required Rate of Return on Debt) Calculate in one of three ways: u Get interest rate on new debt estimated by lenders. u Observe market interest rates on debt of similar risk. u Use the effective interest rates earned by holders of the company’s existing marketable debt. More on option 3: u calculate the yield to maturity using the following approximation formula: u or calculate the yield to maturity by calculating the IRR on the payment stream Yield to maturity = IRR = Effective rate of return YTM= [annual interest payment + (maturity value - market value)/n] [(maturity value + market value) / 2]

4. 1 Business Finance - DK 4 Cost of Debt (continued) 4Your cash flows are after tax, so your cost of capital also needs to be after tax. 4Since interest expense is tax deductible, the after cost tax of debt is: 4Flotation costs also need to be factored into the calculation. u First calculate yield to maturity without flotation costs u Then calculate an effective interest rate using the expected proceeds as the price Kd = YTM * (1 - tax rate)

5. 1 Business Finance - DK 5 Cost of Preferred Shares (Required Rate of Return on Preferred Shares) 4Preferred shares pay a fixed dividend in perpetuity. 4Obligation to pay rate of return (dividends) is not as contractual as with debt, nor as flexible as with ordinary equity. 4If a company chooses not to pay preferred share: u preferred shareholders often gain voting rights u dividends are cumulative, so missed dividends must be paid before common shareholders receive a dividend u company reputation is damaged 4The effective rate of return for preferred shares is the dividend divided by the price.

6. 1 Business Finance - DK 6 Cost of Ordinary Shares 4As mentioned, if the stream of future dividends was known, then the required return would be the IRR that set the value of that stream equal to the current price of the share. 4But the stream of future dividends is not know with certainty. 4There are three approaches to this problem: u The constant growth dividend valuation model u The earnings yield model u the mean-variance capital asset pricing model (CAPM)

7. 1 Business Finance - DK 7 Constant growth dividend valuation model 4Start with the growth in perpetuity formula l P = D / (k - g) 4Rearrange it to calculate required rate of return l k = ( D / P ) + g 4The model inputs are the current share price, last year’s dividend, and the dividend growth rate (which can be hard to forecast) 4In the P Ltd case dividend growth 1986-1992 averaged 32-33%, but last year growth was 22%. l k = (.11 / 30) +.32 = 32.4% l k = (.11 / 30) +.22 = 22.4%

8. 1 Business Finance - DK 8 Earnings Yield Model 4Earnings yield model uses earnings per share and price per share as the inputs l k = EPS / P 4Not based on cash flow. 4If investors expect the company to have future investment opportunities with positive net present values, then earnings yield is not a good measure of required return. Throw it out!

9. 1 Business Finance - DK 9 Capital Asset Pricing Model 4Focus on market returns for investments of similar risk rather than investor response to a particular security. 4Formula from rate of return is: l k = Rf + Beta ( Rm - Rf) 4Inputs u Rf is quoted rate for treasury bonds u Rm is 6.5% u Beta is from research (or using historical data) for a publicly traded company or use pure play method to estimate for non-trading company

10. 1 Business Finance - DK 10 Cost of Equity - Existing Equity 4On the balance sheet, the equity is often broken into three categories: ordinary shares, paid-in capital in excess of par, and retained earnings. 4These divisions are for accounting purposes - all ordinary equity is money of the shareholders being used by the company. 4Retained earnings do not have an opportunity cost different from the opportunity costs of equity in the other 2 categories or from new equity. 4Use the required return based on the market today. Do not adjust for investors tax rates.

11. 1 Business Finance - DK 11 Cost of Equity - New Equity 4Must take into account flotation costs. l k new = k e / (1 - f) l where f is flotation cost as % of market price

12. 1 Business Finance - DK 12 Weights 4Use of market values of equity and debt to calculate weightings is theoretically best. 4Many companies use book calculations or market calculations for a point in time due to practical considerations.

13. 1 Business Finance - DK 13 More on Weights 4For shares and traded bonds, use market prices. 4For non-traded bonds or other long-term debt, estimate market value based on remaining interest and principal payments discounted at the yield to maturity for securities of similar risk. 4Current maturities of long-term debt should be included in the calculation as would the current portion of capital lease obligations.

14. 1 Business Finance - DK 14 Target Capital Structure 4Book points out the common assumption is that a company is at its optimal debt-equity mix and that any new capital will be raised in the same proportion as existing capital. 4As an insider you can prove or disprove this assumption. 4However, don’t justify a new investment based on the movement towards the optimal capital structure. 4Instead, use weightings from the optimal capital structure with the market rates of return for the various sources of capital.

15. 1 Business Finance - DK 15 In or Out? 4Deferred TaxesOut 4Accounts PayableOut 4Accrued ExpensesOut 4Short-term DebtOut (exception) 4Capital LeasesIn 4ConvertiblesIn

16. 1 Business Finance - DK 16 Marginal Cost of Capital 4The rate of return that must be earned on new investments. 4Must look at the cost to raise additional funds now. 4Marginal cost of capital concept applies not only when raising new funds is required, but also for the use of funds on hand. u Cost of capital is an opportunity cost. The funds on hand could be returned to the providers of capital. Therefore, current market rates of return are still relevant. 4Don’t forget to consider flotation costs.

17. 1 Business Finance - DK 17 Marginal Cost of Capital Schedule 9.5% 10.0% 10.5% 11.0% Amount of Funds £ % Schedule of Project (IRR’s) Marginal cost of capital

18. 1 Business Finance - DK 18 Problem