Cost of Capital SU9 - Overview

Cost of Capital - SU9 Overview
 Introduction
Each provider of funds requires a return on its investment, which to the company is a
cost. For shareholders, it translates into the cost of capital. For debt providers it
translates into cost of debt. The combination of the various sources of funds within
the entity’s capital structure is known as the Weighted Average Cost of Capital
(WACC). Study unit 8 referred to theories for optimal capital structures where WACC
is at its lowest, which would translate in value creation for all providers of funds.
 Weighted average cost of capital (WACC)
The reasons (or uses) of calculating WACC are as follows:
1. Evaluation of capital projects;

2. Valuation of companies;
3. Determination of a company’s EVA or economic profit;
4. To frame pricing decisions for industries subject to regulatory review (such as
Eskom)
5. Determination of fair value for corporate reporting purposes (IFRS).
 WACC - principles and formulas
Page 7-4 delves into some principles that are relevant to WACC. It can be summarised as
follows:
 Use a weighted average of the costs of the different sources of finance.

 Use marginal costs.
 Include the effects of corporate tax.
 Use nominal rates.
 Use market values or a target capital structure.
Refer to formula 7.1 in Correia for the formula to calculate WACC.
 Pooling of funds
In order to determine the appropriate discount rate for evaluating projects, the
concept of pooling of funds must be explained. In practice it is unlikely that every
individual project (or investment opportunity) will be financed in proportion to the
capital structure weightings.
Refer to the graph on page 7-5 and the explanation of the concept of maintaining a
target capital structure by either issuing new debt of issuing new equity. It may lead
to the notion that a specific project is funded by either equity or debt and must be
evaluated using either the cost of equity or the cost of debt. This would lead to
incorrect investment decisions.
To illustrate this, reflect on the following Correia example:

Example:
 Cost of Equity = 14% and cost of debt = 8%

 Capital structure = 50% debt and 50% equity
 Project A offers a return of 10% and the company can use debt to finance the
project. Later, project B offers a return of 12% but firm now needs to use
equity financing at a cost of 14%.
 We evaluate projects by using the firm’s WACC.
If cost of each projects source of finance has to be used, then project A will be
accepted and project B will be rejected, because it does not render a return of 14%,
even though the project would produce a return higher than project A!
If, however, the WACC from the table from the previous section is used (Table 7.1),
Project A will be rejected (below the WACC of 11%), but project B will be accepted.
 Component cost of capital
Capital consists of the following three main elements:
 Debt;
 Preference shares; and
 Shareholders' equity.
NB: WACC only considers sources of finance that form part of the LONGTERM
CAPITAL STRUCTURE of the company. For example, bank overdrafts can be used
as a source of finance for short term working capital financing, and therefore would
not form part of the calculation of WACC.
 1. Debt
Cost of debt is calculated using the following formula:
Kd = I x (1 - t)
Important to note from this formula is the consideration of the tax shield (1 - t). I can
be calculated using one of two methods:
1. If debt is non-redeemable, then the cost will be incurred into perpetuity. I can
therefore be calculated using the TVM principles of a Perpetuity:
Interest payment = Face value x coupon rate
1. If debt is redeemable, all the elements of a normal PV calculation are present

and it would be possible to calculate I using a financial calculator.
In order for you to achieve step 2 of the process of calculating WACC, it may be
required to calculate the market value of debt.
Market value of debt
For non-redeemable debt:
For redeemable debt you will use the TVM principles and calculate PV using your
financial calculator.
 2. Preference shares
Preference shares have similar qualities that debt and therefore the cost as well as
the market value of preference shares are calculated the exact same way as the
different categories of debt, i.e. redeemable (using TVM’s PV calc) or non-
redeemable (using the principles of a perpetuity).
The difference however comes with the principle of flotation costs. In practice,
issuing new preference shares and ordinary shares has a cost attached to it when it
goes to the primary market. To take this into account, the value of the share is
adjusted by the effects of flotation costs.
In the exam you can expect one of two ways in which flotation costs could come up:
1. A specified cost is given

o In this case, you simply deduct the cost per share, from the market
value of the share
2. A specified % is given
o In this case, you have to ensure that you calculate the cost per share
using the % given multiplied by the MARKET VALUE of the share, by
default.
The principle of flotation costs can only be mastered by working through prior exam
papers and questions from the text book.
 3. Equity
The cost of equity can be calculated using one of two methods:
1. Dividend yield and growth model

2. Capital Asset Pricing Model
Dividend growth
This model looks at the market value of equity being the present value (PV) of
dividends that grow at a constant rate. The value of ordinary shares can therefore be
calculated using the following formula:
Where D1 refers to the next year’s expected dividend and g the expected growth of
the company. The textbook refers to Ve as P0 on page 7-14.
D1 can be calculated by one of two methods:
 Growing the current year’s dividend by the expected growth rate (1 + g).
 Multiplying the dividend pay-out % (will be given) to the expected earnings per
share (EPS).
Cost of equity (Ke) can be calculated using the same formula but ensuring that Ke is
the outstanding element:
The effect of flotation cost can also be brought into this equation in a similar fashion
than with preference shares:
Capital Asset Pricing Model (CAPM)
The CAPM model and the bond yield + models works from the premise of a lower
risk instrument’s required return to be adjusted with a premium to derive a cost of
equity.
CAPM is as follows:
Ke= Rf + Beta(Rm - Rf)
Remember CAPM assumes that there are no flotation costs (transaction costs).
 Weighting components of capital structure
From study unit 7, it was clear that a number of entities do actually have a target
capital structure which is a goal or aim for in the long term, and the optimal capital
structure may be within an acceptable range.
In the exam the order of approach you need to follow to weigh each component in
the calculation of WACC is as follows:
1. Target capital structure
( this will be given to you in some or other form)
2. Market values
(in the absence of a target structure, you must use MVs)
3. Book values
(in the unlikely event that no target is given and no market values can be calculated,
the only course to follow is to use the book values as provided in financial
statements. Avoid using this method!)

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Cost of Capital - SU9 Overview

 Weighted average cost of capital (WACC)

The reasons (or uses) of calculating WACC are as follows:

1. Evaluation of capital projects;

 WACC - principles and formulas

 Use a weighted average of the costs of the different sources of finance.

Refer to formula 7.1 in Correia for the formula to calculate WACC.

To illustrate this, reflect on the following Correia example:

 Cost of Equity = 14% and cost of debt = 8%

 Component cost of capital

Capital consists of the following three main elements:

Cost of debt is calculated using the following formula:

Interest payment = Face value x coupon rate

1. If debt is redeemable, all the elements of a normal PV calculation are present

Market value of debt

For non-redeemable debt:

1. A specified cost is given

The cost of equity can be calculated using one of two methods:

1. Dividend yield and growth model

D1 can be calculated by one of two methods:

Capital Asset Pricing Model (CAPM)

 Weighting components of capital structure

1. Target capital structure

( this will be given to you in some or other form)

(in the absence of a target structure, you must use MVs)

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