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Cost
INSTINCT BUSINESS SCHOOL
of (IBS)

Capital

NIGEL MAHAMATI
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Capital structure

Accounting equation

ASSETS EQUITY DEBT

 A business is referred as a portfolio of assets used to generate income.

 From the accounting equation stated above it can be seen that the assets of a
business are financed by equity and/or debt.
 Capital structure is the way in which the financing is arranged in a
strategic financial decision.
 It is the responsibility of management to determine the optimal level of debt
relative to equity.
 Golden Rule: The lower the cost of capital the higher the value of the firm, Why?
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Optimal Capital structure

 A company can choose to finance all its assets with equity only or using debt
only.
 Using only one form of finance is not always beneficial to the company.
 The company must therefore determine the optimal capital structure.
 Optimal capital structure: is the debt equity ratio that the company adopts so
that weighted average cost is at its lowest point.
 Two main factors which affect financial policy:
 Risk profile of the company (Business risk or Financial risk)
 Gearing of the company (using relatively more debt in the capital structure)
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Weighted average cost
of capital (WACC)

 WACC is the rate that the company is expected to pay on average to all
its security holders to finance its assets.
 WACC is calculated as: (weighted cost of equity + weighted cost of
preference shares + weighted cost of debt)
Example (Revision)
The following information relates to NISA Ltd,
Equity Preference shares Debt
Market values 10 000 4 000 6 000
Cost of capital 10% 7% 8.5%
Required
Calculated weighted average cost of capital NISA.
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4 steps to calculate WACC

1. Identify all permanent sources of finance (equity, Long-term debt and

preference shares
2. For each source of finance identified calculate the following:
 Market value
 Cost
3. Use market values calculated in step 2 above to determine the weight
to be applied for each source.
4. Calculate WACC using the weight in step 3 multiplied by cost calculated
in step 2.
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Cost of Equity (Ke)

 Equity = Share capital + Retained earnings + Share premium + Other reserves

 Share price used for valuation purposes is equal to the market value of
all equity instruments mentioned above.
 There are three methods used to calculate Ke:
 Dividend growth model
 Capital Asset Pricing Model
 Bond yield premium
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Cost of Equity (Ke) cont.

1. Dividend Growth Model (DGM)

Ke = D1 + g
P0
Where;
D1 = Future dividend (If you are given current year dividend (D0),
D1 = D0 (1 + g)
D1 can also be calculated using EPS and payout ratio if the
dividend policy is known by saying (EPS Dividend cover)
Po = Current market price per share (if new share issue P0 exclude
share issue costs, therefore, P0 ( Share Price – Share issue cost))
g = Expected constant growth rate
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Cost of Equity (Ke) cont.

Dividend Growth Model (DGM)

Example 1

The following information is available for Tosan Ltd:

Current market price: R10

Expected EPS for next year R1.5
Dividend payout ratio 25% of earnings
Expected growth rate 6%

Required
Calculate cost of equity
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Cost of Equity (Ke) cont.

Dividend Growth Model (DGM)

Example 2

The following information is available for Tosan Ltd:

Current market price: R10

Current year dividends R0.28
Expected growth rate 6%

Required
Calculate cost of equity
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Cost of Equity (Ke) cont.

2. Capital Asset Pricing Model (CAPM)

Ke = Rf + β(Rm – Rf)

Where: Rf = The risk-free rate

Rm = Return on a market portfolio
β = Beta of the share
(Rm- Rf ) = Market risk premium

Example
Given that risk-free rate is 6% and market risk premium is 4.5%
Calculate return on market portfolio.
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Cost of Equity

Beta (β)
 Beta is a measure of the volatility of securities (shares) of a company
in comparison to the entire market .

Example 1
In the past, Nagie Ltd’s shares have been relatively volatile compared to the market,
for instance when the JSE share dropped by 22%, Nagie Ltd share price dropped by
37,4%.

Required
Calculate the beta of Nagie Ltd

Beta = % change of company’s share price

% change of market share price
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Cost of Equity

Beta: Using the Hamada formula to unlever and relever Beta

 Hamada formula is used to estimate beta of a company using beta of a
similar company.
 Hamada formula is also used if a company changes its financial leverage.
 BU = BL /[1 + (1 – T) D/E]
 BL = BU × [1 + (1 – T)D/E]

Example 2
Nagie Ltd’s current debt equity ratio is 40%. The beta for a similar company Green
Ltd with a debt equity ratio of 60% is 1.2. Calculate the unlevered beta for Green
Ltd and then calculate the levered beta for Nagie Ltd.
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Cost of Equity

Cost of Equity Comprehensive example

The par value of the shares is R200 each and they were initially issued at a premium of
R5 each. The retained earnings account for CPW Ltd have a closing balance of R130 000
000. The shares are listed on the JSE and CPW Ltd market capitalization is R300 000 000.
In the past, CPW Ltd’s shares have been relatively volatile compared to the market – for
instance, when the FTSE / JSE All share Index dropped by 22% when the financial crisis
first hit between August and December 2008, CPW Ltd share price dropped by 35%.
Since then, CPW Ltd’s share price has displayed a similar sensitivity to movements in the
market.

Required
Calculate cost of equity.
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Cost of Equity

3. Bond yield plus a risk premium method

 The company determines the cost of equity by using the bond yield or
interest rate and then add a risk premium.
 The risk premium is an estimate determined by management
normally in the range of 2% to 6%.

Example

PQ Ltd assume that the firm’s bond yield is 9% and the firm adds an equity risk
premium of 5% to determine the cost of equity. Calculate the cost of equity for
PQ Ltd.
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Cost of debt
(Preference shares)

Cost is the
market related
interest rate of a COST OF DEBT
similar
instrument

Non-Redeemable
Redeemable
 Use time value of  Payment is infinite
money principles for  PV = Payment
normal annuities.
Interest
Market value is the
present value Market
Cost of
calculated using value preference
market interest rate
shares
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Cost of debt
(Preference shares)

Preference shares example

Wips Ltd issued 10 000 12% non-redeemable preference shares with a par value of
R100 per share. On 31 December 2018 (year end), the ex-div market value is R120
and cum-div market value is R135.
Required
a. Calculate total market value of preference shares.
b. Calculate the cost of preference shares.
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Cost of Debt
loans and other instrument with similar features

 Debt refers to all long term interest bearing loans.

 Cost of debt is the market related interest rate.
 Market value of debt is the present value of the debt instrument calculated using
the market interest rate.
 A question must provide you with either cost of debt or market value, there is no
way you may be required to calculate both.
 In terms of s24J interest rate is deductible for tax purpose. Therefore, the cost of
debt is after taking into account the tax shield effect.
 Kd = Market related interest rate × (1 – marginal tax rate)
 To calculate present value for an instrument which qualifies for section 24J
deduction remember to effect the tax shield on interest expense calculated using
the yield to maturity method.
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Cost of Debt
loans and other instrument with similar features

Example
The books of Ph Ltd reflects a closing balance of R10 000 000 for a finance lease
liability correctly calculated using the lease implicitly rate of 12%. The finance lease
is for a delivery vehicle used by Ph. If Ph obtained a similar lease the current market
related cost would be 11%. The remaining lease period is 4years.
You may assume that the lease liability is going to be settled with 4 equal annual
payments in arrears and further assume that future value is zero.
Required
Calculate the market value of the finance lease and the cost of finance lease to be
included in WACC calculation.
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Convertible instruments

 What is the likelihood of conversion?

If convertible at shareholders’ option, do a calculation to see if ordinary
shares’ value on maturity is more than redemption value.
 What is the marginal cost for the WACC?
The cost for WACC is the future form, so if it will be converted to equity, the
cost for WACC will be cost of equity.
 What is the Market Value for WACC?
For the purposes of calculating the MV today of such an instrument, FV =
EQUITY value, I/YR = Marginal Cost of similar preference share (NB!), solve for
PV
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Convertible instruments

Example
Riverlake Ltd issued 14% R1OO par value preference shares convertible at the option of the
preference share holder into one ordinary share for every four preference shares. The total
number of preference originally issued amount to 100 000. If the preference shares are not
converted, they will remain in existence as non-redeemable preference shares. Similar
preference shares are currently trading at a market rate of 15% and are expected to do so for
the foreseeable future. Analysts’ projections indicate that they expect Riverlake ordinary
shares to be trading at R230 per share on the date the conversion date can be exercised. The
floatation costs for issuing new preference shares amounts to R2 per share.
Required
a) Determine the value of preference shares and ordinary shares on the conversion date
b) Based on your calculations above determine the likelihood of conversion by preference
shareholders.
c) Calculate the market value and cost of preference shares for the current year.
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Incorporating the effect of tax
Section 24J of the income tax act

Example 1 (Unisa 2018 Test 2)

Greatz Ltd obtained a loan from SABAS bank on 1 January 2018 for an original
amount of R65 000 000. The period of loan is five years and the loan is repayable, in
arrears, in equal annual installments of R 18 588 784, comprising capital and
interest. The period of the loan The market related pre-tax cost of similar a loan is
approximately 4.5% above the prime interest rate. The loan qualifies as an
instrument and is deductible for taxation purposes in terms of Section 24J of the
Income Tax Act.
Current prime interest rate: 10.25%
Required
Calculate the market value of the loan held by Greatz Ltd on 31 December 2018.
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Incorporating the effect of tax
Section 24J of the income tax act

Example 2 (UJ 2018 Cost of capital question bank)

KFP issued 1 800 000 debentures at par value of R50 with a coupon rate of 12%
payable annually in arrears. The debentures are redeemable in 2 equal annual
installments starting in 10 years time. The current trading price per debenture is
R34.18 ex-interest.

Required
Calculate the market value of debentures and the after tax cost of debentures (IRR).
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