Financial Management-Lecture 7

FINANCIAL MANAGEMENT MODULE
DR T. CHINODA
2020
SOURCES OF FUNDS AND COST OF CAPITAL
• The Cost of Capital is the expenses or costs

attached to the sources of capital employed
by a firm.
• The sources can be retained profits, loans
from the bank, shareholders equity and debt.
• A firms cost of capital is a weighted average
cost of capital of the various sources of
capital employed in its capital structure.
Equity capital
Dividend Yield and Capital Gains Yield
• If an investor decides to hold a security for a
certain period of time this return is called the
holding period return (HPR). The HPR consists of
two components, the capital gain and the
dividend.The capital gains yield during the holding
period is measured by :
• Where, P1 is the price at the beginning of the
period,
• P0 is the price at the end of the period.
Example:
You buy a share as part of your portfolio of
investments. You bought the security when the price
per share was 100 cents and after holding it for one
year, the share price is now 130 cents.We can see
that there has been a capital gain of 30cents during
the holding period.
• Then the capital gains yield would be [ ( 130 -
100 ) / 100 ] = 30%.
• The second component of the HPR is the
dividend yield. This return is found by:
• Where, D1 is the dividend that is expected to be

paid during the period.
• For example, If your security paid a dividend of
10 cents per share during the period.
• The dividend yield would then be (10 / 100) =
10%.
• HPR= Dividend Yield + Capital gains Yield=40%
Gordon's Dividend Model
Where, Ke is the cost of equity(RRR).

D1 is the dividend that is expected to be
paid next year.
P0 is the current share price
g is the expected growth rate in dividends.
D1= D0 (1 + g), where D0 is the current

year's dividend.
Example
• A company has just paid a dividend of 120 cents
per share. The currentmarket price of its shares is
1500 cents per share. The dividends have been
growing at 8%per year over the past few years and
it is expected that this growth rate will be
maintainedinto the future. Calculate the cost of
equity on the company'sequity.
Solution
Given that; Ke= (D1 / P0 ) + g ke=1664%
Where, D0 = 120, P0 = 1 500, g = 0.08.
Preferred Capital
• Preference shareholders receive a preferred
dividend which is fixed on the date that theshares
are issued. The dividend is fixed as a percentage
of the nominal value, or par value,of the shares.
• Like in the case of ordinary shares, if there are no
profits, then the preferencedividend will not be
paid. If the preferred dividend has not been paid in
a particular year,then the ordinary dividend cannot
also be paid.
• The cost of preferred equity is therefore
determined by the type of the preferred equity
thatthe firm has in issue.
The Cost of Irredeemable Preferred Equity
• If the preference shares are irredeemable, the
expected dividends are treated as aperpetuity and
the cost of the shares can be found as follows :
Example
A company has in issue 12% preference shares with
a nominal value of $100 and a current market value
of $120. The dividend on the shares has just recently
been paid. Calculate the required rate of return on
the company's preferred equity.
Solution
Note that the share price is already ex-div. as the
dividend has already been paid.
• The annual dividend is $12 ( i.e. 0.12 x $100 ).
• Therefore kp = $12.00 / $120.00 = 10% .
Cost of Redeemable Preferred Equity
Redeemable preferred equity has the further

characteristic that the par value will be paid back to
the shareholder on maturity.
• The cost of redeemable preference shares is the
internal rate of return (IRR) generated by the
internal cash flows of the investment which are the
dividends paid during the life and the redemption
value of shares.
• It’s the discount rate used to discount the dividends
and redemption value. It’s given by the discount
rate that equates the present value of the
redemption value of the share and the dividends to
the value of the asset which is the share.
Example
A company has in issue 15% redeemable preference
shares with a par value of $100 and a market value
of $110. The shares are redeemable at par in 3
years' time and the dividend has been paid on the
shares. Calculate the RRR.
Solution
The annual dividend is 0.15 x $100 = $15, which will
be received for the next 3 years.
After that, the shareholders will receive the nominal
value of $100.
• IRR = A + [(a / a + b)] [(B – A)]
Try 10%:
Year Cash flow x Discount factor = Present value

0 ( 110.00 ) x 1.000 = ( 110.00 )
1-3 15.00x 2.4869 = 37.3065
3 100.00 x 0.7513 = 75.13
NPV = 2.4335
• Since the NPV is positive on the first trial, we must

increase the discount rate so that we get a
negative NPV:
• Try 12%:
Year Cash flow x Discount factor = Present value

0 (110.00) x 1.000 = ( 110.00 )
1-3 15.00 x 2.4018 = 36.0270
• 3 100.00 x 0.7118 = 71.18
• NPV = (2.793 )
• IRR = 10 + [( 2.4335 / 2.4335 + 2.793 ) ] [ ( 12 –

10 ) ] = 10.93%
Cost of Debt capital[Kd]
• Like equity, debt also comes in various forms. It
can be redeemable or irredeemable,convertible or
callable. The calculation of the cost therefore,
depends on the type of debtunder consideration.
• The cost of debt to the company is always an after-
tax cost becauseinterest is allowed as a deduction
from profits for tax purposes. Like in the case of
commonequity, we also use the ex.interest market
price when the debt is traded on a market.
Cost of irredeemable debt.
Irredeemable debt is a debt instrument with no

maturity date. In other words, it is issued inperpetuity.
In this case the cost of the debt is given by :
• Where INT is the annual interest payment,

• T is the tax rate, and
• P0is the current marketvalue, ex-interest.
Example
A firm has in issue 15% irredeemable debt with a
nominal value of $1 000and a current market value of
$799.56. The corporate tax rate applicable to the firm
is 32%.Calculate therequired rate of return on the
debt.
Solution
Annual interest = 0.15 x 1 000 = 150
kd = 150 (1 – 0.32 ) / 799.56
= 12.76%.
Practice Question
A firm has in issue 18% irredeemable debt
with a current market value of $112 and a
nominal value of $100. The interest on the
debt is just about to be paid and the tax rate
applicable to the company is 35%.
Calculate the required rate of return.
Cost of Redeemable Debt
The cost of redeemable debt is calculated in the same
way that we calculated the cost of redeemable preferred
equity. It is the internal rate of return of the expected cash
flows. It is also known as the yield to maturity.
Redeemable debt can be redeemed ,ie the debt holders
will be paid back the principal amount borrowed after an
agreed period of time.
Example
A company has in issue 22% redeemable debt with a
nominal value of $1000 and a market value of $1 158.00.
The interest on the debt has just been paid and the tax
rate applicable to the company is 35%. The debt has
three years to maturity. Calculate the required rate of
return.
Solution
The cash flows will be as follows:
Year Cash flow.

0 (1 158.00) = Current market value ex-interest.
1-3 0.22 x 1 000 x (1 - 0.35) = Annual interest adjusted for
tax.
3 1 000 = Redemption value.
Try 8%
Year Cash flow x PVIF = Present value
0 (1 158.00 ) x 1.000 = (1 158.00)
1-3 143.00 x 2.5771 = 368.5253
3 1 000 x 0.7938 = 793.80
NPV = 4.3253
Try 12%
Year Cash flow x PVIF = Present value

0 (1 158.00 ) x 1.000 = (1 158.00)
1-3 143.00 x 2.4018 = 343.4574
3 1 000 x 0.7118 = 711.80
NPV = (102.74)
• The IRR is therefore = 8 + [ ( 4.3253 / 4.3253 +

102.74 ) ] [ ( 10 – 8 ) ] = 8.08%
Calculating the WACC
• When calculating the Weighted Average Cost of Capital
[WACC]we use the following procedure:
 Calculate the cost of each component of capital,

 Calculate the weight of each component,
 Multiply the cost of each component by the respective
weight and add the total.
• Thus, the WACC is given by the following formula :
• WACC = Wd Kd (1-T) + Wps Kps + We Ke + …..

Where , W is the weight of each component
Kd is the cost of debt.
Wd is the weight of debt in the capital structure.
Kps is the cost of preference share capital.
Wps is the weight of preference share capital .
Ke is the cost of common equity.
We is the weight of common equity in the capital
structure.
Example A firm has the following capital structure on its
Statement of Financial Position :
• Debt 20%, Ordinary equity 60%, Preferred equity 20%
• The tax rate is 35%.
The characteristics of these issues are as follows:
 22% redeemable debt with a nominal value of $1 000 and a
market value of $1 158.00.The interest on the debt has just
been paid. The debt has three years to maturity.
 The firm has paid a dividend of 120 cents per share. The
current market price of itsshares is 1 500 cents per share.
The dividends have been growing at 8% per year overthe
past few years and it is expected that this growth rate will be
maintained into thefuture.
 12% preference shares with a nominal value of $100 and a
current market value of$120. The dividend on the shares
has just recently been paid.
• Calculate the WACC.
• Solution
• The WACC can be found as follows :
• Cost x Weight = Weighted Cost

• Ordinary equity 16.4% x 0.60 = 9.84
• Preferred equity 10% x 0.20 = 2.00
• Debt 8.08% x 0.20 = 1.62
• WACC= 13.46%
• THE END

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FINANCIAL MANAGEMENT MODULE

• The Cost of Capital is the expenses or costs

• Where, D1 is the dividend that is expected to be

Where, Ke is the cost of equity(RRR).

D1= D0 (1 + g), where D0 is the current

Cost of Redeemable Preferred Equity

Redeemable preferred equity has the further

Year Cash flow x Discount factor = Present value

• Since the NPV is positive on the first trial, we must

Year Cash flow x Discount factor = Present value

• IRR = 10 + [( 2.4335 / 2.4335 + 2.793 ) ] [ ( 12 –

Irredeemable debt is a debt instrument with no

• Where INT is the annual interest payment,

Year Cash flow.

Year Cash flow x PVIF = Present value

• The IRR is therefore = 8 + [ ( 4.3253 / 4.3253 +

 Calculate the cost of each component of capital,

• Thus, the WACC is given by the following formula :

• WACC = Wd Kd (1-T) + Wps Kps + We Ke + …..

• Cost x Weight = Weighted Cost

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