1. Cost of Capital and Returns to Providers of Finance
2BUS0197 – Financial Management
Cost of Capital and Returns to Providers of Finance
Lecture 7
Dr Francesca Gagliardi

2. Learning outcomes
By the end of the session students should be able to:
Calculate the costs of different sources of finance used by a company
Calculate the weighted average cost of capital
Understand how to apply the cost of capital in investment appraisal
Appreciate the reasons for preferring market values to book values

3. Knowledge development
In the past weeks we have looked at short- and long-term financing sources that are available to companies
We have analysed how investment appraisal methods can be applied to make capital investment decisions
We have also discussed the risk-return trade-off faced by investors
Today we go a step further and discuss how the level of risk of different financing sources affects their required rate of return, hence a company’s cost of capital

4. Why focus on cost of capital?
The cost of capital is the rate of return required on invested funds
Companies should seek to raise capital by the cheapest and most efficient methods
Minimisation of the average cost of capital will increase the net present value of a company’s projects, hence its market value
To minimise the cost of capital:
Information on the costs associated to the available different sources of finance is needed
Knowledge of how to combine different sources of finance to reach an optimal capital structure is required
All providers of finance require returns.
The required return will reflect the risk of the investment and the returns of alternatives.

5. Calculating the cost of capital
A company’s cost of capital can be used as:
A discount rate in investment appraisal
A benchmark for company performance
Calculating a company’s cost of capital can be difficult and time consuming
To calculate the weighted average cost of capital, need first to find the cost of capital of each source of long-term finance used by a company

6. Ordinary shares
In previous lectures we have seen that equity finance can be raised either by issuing new ordinary shares or by using retained earnings
The cost of equity can be calculated using the dividend growth model as:
where:
Ke = cost of equity
D0 = current dividend
g = the expected growth rate of dividends
P0 = the current ex-dividend share price

7. Ordinary shares The cost of equity can also be found from the CAPM:
Rj = Rf + βj (Rm - Rf)
where:
Rm = return of the market
Rf = risk-free rate of return
(Rm – Rf) = equity risk premium
βj = beta value of ordinary share
CAPM allows shareholders to determine their required rate of return, based on the risk-free rate of return plus an equity risk premium

8. Retained earnings
It is a mistake to consider retained earnings as a free source of finance
Retained earnings have an opportunity cost, which is equal to the cost of equity
If retained earnings were returned to shareholders they could have achieved a return equal to the cost of equity through personal reinvestment
The cost of retained earnings can be found in the same way as the cost of equity

9. Preference shares
Dividend paid on preference shares is usually constant
The cost of preference shares is found by dividing the preference dividend by the ex dividend market price:
where:
Kps = cost of preference shares
P0 = current ex dividend preference share price
Dp = preference dividend
Preference shares are normally irredeemable (i.e. they do not have to be repaid by the company after the term for which the preference shares have been issued). Preference dividends are not tax-deducible because they are a distribution of after tax profits

10. Kid(after-tax) = Kid(1 – CT)
Irredeemable bonds
Like preference shares, bonds involve a constant annual payment in perpetuity
Kid = cost of irredeemable bonds
I = annual interest payment
P0 = current ex interest market price
Interest is tax-deductible. The after-tax cost of debt is:
Kid(after-tax) = Kid(1 – CT)
CT = corporation taxation rate

11. Example 10% irredeemable bonds Ex interest market price: £72
Corporation tax: 30%
Kid (before tax) = 10/72 = 13.9%
Kid (after tax) = 13.9 x ( ) = 9.7%

12. Redeemable bonds
Redeemable bonds involve several fixed interest payments plus redemption value. The after-tax cost of debt is:
I = interest payment
RV = redemption value
Kd = cost of debt capital
n = number of years to maturity
CT = corporation tax rate
The before-tax cost of debt is found by using I instead of I(1-CT)
Kd estimated through linear interpolation or Hawanini-Vora (1992) model

13. Convertible bonds
To calculate the cost of debt need first to determine whether conversion is likely to occur
Conversion not expected: bond treated as redeemable debt
Conversion expected: cost of capital found by linear interpolation and a modified version on the redeemable bond valuation model
Use number of years to conversion (not to redemption)
Use future conversion value (CV) instead of redemption value
An after-tax cost of debt is appropriate only if the company is in a profitable position, i.e. has taxable profits against which to set its interest payments

14. Bank borrowings
Bank borrowings are not traded and have no market value that interest can be related to
The cost of bank borrowings can be proxied by the average interest paid: interest paid in a period divided by average borrowings for that period
Alternatively, the cost of traded debt issued by a company may be used as a best approximation
Appropriate adjustments to allow for tax-deducibility of interest payments are needed

15. The relationship between the costs of different sources of finance
The cost of each finance source is linked to the risk faced by each supplier of finance
Equity finance: highest level of risk faced by investors, hence most expensive source of finance
The cost of preference shares is less than the cost of ordinary shares as the former are less risky and rank higher in the creditor hierarchy
Debt finance: generally no uncertainty on interest payments. Debt further up the creditor hierarchy. Hence, the cost of debt less is than the cost of equity
Whether bank debts are cheaper than bonds depends on the relative costs of obtaining a bank loan and issuing bonds, the amount of debt and the length of period over which debt is raised
Risk of equity finance due to uncertainty on dividend payments and capital gains, and ranking of ordinary shares at the bottom of the creditor hierarchy

16. Calculating the weighted average cost of capital (WACC)
The costs of individual sources of finance are weighted according to their relative importance as sources of finance
E = value of equity D = value of debt
Ke = cost of equity Kd = cost of debt
E/(E+D) is the proportion of equity
D/(E+D) is the proportion of debt
CT = taxation rate
The equation will expand in proportion to the number of different sources of finance used by a company

17. Market value or book value weighting?
Book values are historical and are obtained from a company’s accounts
Book values rarely reflect the current required rate of return of providers of finance
Example: an ordinary share with a nominal value of 25p has a market value of £1.76
Book values will underestimate the impact of the cost of equity on the average cost of capital, hence unprofitable projects will be accepted
Market values reflect current requirements and can be obtained from financial press and databases

18. Class activity Source of finance Cost Market value (£000)
Equity Ke = 16.9%
Preference shares Kp = 13.4%
Irredeemable debt Kid = 9.7%
Redeemable debt Krd = 8.7%
Bank loans Kbl = 8.8%
871.5
Note: the relative costs of the different sources reflect their relative risks, i.e. the risk-return hierarchy of financial securities
Required: in groups of four calculate the WACC

19. Solution

20. Average and marginal cost of capital
So far we have looked at how to calculate the cost of capital on an average basis by using book values or market values
The cost of capital can also be calculated on a marginal basis, as the cost of the next increment of capital raised

21. Average and marginal cost of capitalAC MC
Quantity of capital

22. Average or marginal cost of capital?
The marginal cost of capital should be preferred but it is difficult to allocate particular funding to a specific project
WACC can be used if the following are satisfied:
The business risk of an investment project is similar to the business risk of a company’s current operations
Incremental finance is raised in proportions that preserve the existing capital structure
The required return of existing finance sources is not affected by a new investment project

23. Practical problems with WACC
Calculating the cost of particular sources of finance may not be straightforward
Ordinary shares of private companies
Solution: use the cost of equity for a listed company, with similar characteristics and add a premium to reflect the higher risk of the private company
Market value of bonds
Solution: find the market value of a bond issued by another company, with similar maturity, risk and interest rate, and use this market value as a proxy
The accuracy of the calculated cost of capital depends on the reliability of the models used

24. Practical problems with WACC
Which sources of finance should be included in the WACC calculation?
Finance sources used to fund the long-term investments of a company should be included in the calculation of WACC
What about a bank overdraft used on an ongoing basis?
The difficulty of finding the market value of securities impacts on the weightings applied
Both market and book values are used in practice
Debt finance raised in foreign currencies needs to be converted
WACC is not constant: changes in the market value of securities and in macroeconomic conditions affect a company’s average cost of capital

25. WACC in the real world Companies pay attention to the value of WACC
In recent years WACC received attention also from national regulatory bodies to determine what is considered to be a ‘fair’ level of profit
Several companies claimed that the cost of capital calculated by the regulatory body underestimated their true cost of capital

26. Gearing
The term refers to the amount of debt finance a company uses relative to its equity finance
Gearing ratios assess financial risk:
Debt/equity ratio: long-term debt / shareholders’ funds
Capital gearing: long-term debt / capital employed (i.e. D+E)
Market values preferred to book values
The nature of the industry in which a company operates is a major factor in determining what the market considers to be an appropriate level of gearing
Typically, the lower the business risk the higher the gearing

27. Implications of high gearing
Increased volatility of equity returns arises with high gearing since interest must be paid before paying returns to shareholders
Increased risk of bankruptcy also occurs
Stock exchange credibility falls as investors learn about company’s financial position
Short-termism moves managers’ focus away from maximisation of shareholder wealth

28. Summary Today we looked at:
How to calculate the cost of different sources of finance
How to calculate the WACC
Average vs. marginal cost of capital
Main issues arising from WACC

29. Readings Textbook Research papers
Watson, D., Head, A. (2009). Corporate Finance. Principles & Practice, 5th Ed., FT Prentice Hall – Chapter 9
Research papers
Miller, R. A. (2009), The Weighted Average Cost of Capital is not Quite Right, The Quarterly Review of Economics and Finance, Vol. 49, 3, pp
Bade, B. (2009), Comment on “The Weighted Average Cost of Capital is not Quite Right”, The Quarterly Review of Economics and Finance, Vol. 49, 4, pp
McGowan, C.B., Tessema, A., Collier, H.W. (2004), A Comparison of the Weighted Average Cost of Capital for Multinational Corporations: The Case of the Automobile Industry Versus the Soft Drink Industry, The Journal of Current Research in Global Business, Vol. 6, 9, pp.82-88

30. Your tutorial activity for next week
During the seminar you will be expected to work on:
Q1 p.298; Q3 p.299 (5th ed)
Q1 p.278; Q3 p.279 (4th ed)
To prepare for the seminar you should answer the following practice questions:
Q3,4,5,9 p (5th ed)
Q3,4,5,10 p (4th ed)