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Cost and Financial Management 1B (CFM11B1)

Unit 6 Cost of Capital


Cost of Capital Part 1
Learning Outcomes

Understand the concept of cost of capital by performing simple calculations

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Assessment Criteria

The concept of required rate of return is correctly defined;


The concept of cost of capital is accurately explained; and
Calculate the cost of the individual sources of the permanent capital structure:
Equity
Preference shares
Debt
The cost of capital concept is clearly understood by accurately performing simple
calculations including the calculation of the weighted average cost of capital
(WACC).

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Introduction

The cost of capital of a company is of critical importance to a financial


manager.

Cost of capital can be regarded as a yardstick in decision-making to ensure


that the objective of company, that is, maximization of shareholder wealth, is
being met.

The purpose of this chapter is to provide a sound understanding of the


concept cost of capital and where it fits into the role of the financial manager.

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Required rate of return
REQUIRED RATE OF RETURN (RRR)
o What investors expect to earn on investments with
equivalent risk

Return = Compensation for taking on a certain degree of risk


Higher risk Higher required return
o Ordinary shares > Preference shares > Debt
(Highest RRR) > (Lower RRR) > (Lowest RRR)

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Cost of capital

What is the cost of capital?


From the point of view of the
company - It is important to know
what the required return of your
providers of capital is!
WHY?

Ensure that you earn enough


on your projects to be able to
pay them their required return

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Cost of capital (2)
Remember! the objective of financial management is to maximize
shareholder wealth
To do this, company must invest in projects and investments that will add
value to the company and ultimately maximize shareholders wealth
Two sources can be used to finance projects and investments: (E) + (D)
= (V or total value of the firm)
Equity (E)
Debt (D)
See example 7.1 P130 131 + additional example in presentation

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Definitions of Cost of Capital P131
1. Rate of return a company must earn on its investments to ensure that the minimum requirements of
the providers of capital are met

2. Breakeven point where the proceeds of a project are exactly enough to pay the providers of capital
OR both equal to each other

3. Collective charge of all the providers of finance for every one Rand invested in the company

4. Opportunity cost of finance


Cash that could have been realized from the best alternative use of funds, which has been given
up to invest in particular project.
Cost of capital is a benchmark = use as benchmark for comparison against the minimum return
that investors could have received on alternative investments

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Class example
Opportunity to invest R2 500 in an asset that will yield
returns one year from today

Have R1 000 cash (equity)


Get a loan for remaining balance (R1 500) (debt)
Interest on loan: 17% p.a.
R1 500 x 17% = R255

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Class example

Alternative use of cash


Invest at 14% interest on savings account
Minimum required return
R1 000 x 14% = R140

Minimum required return on project


Just satisfy return expectations of all capital providers
R255 + R140 = R395

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Class example

Percentage: R395 R2 500 = 15.8%


Required return / cost of capital
Project earns R395
Providers of capital: just satisfied
Wealth maintained
Project earns more than R395
Pay fixed interest to bank
Wealth increased by difference between project earnings
and interest
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Calculation of cost of capital P131 132
Decision making tool used to evaluate future projects, to
ensure that only those projects that will maximize
shareholders wealth are chosen.
o Only projects that maximize shareholder wealth are chosen
(CoC = or > RRR)
o CoC is calculated in the present with the best forecast
information available

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Calculation of cost of capital (2)
Future projects funded by future funds
o Calculate future cost of funding over long term
o Historic cost of funds is irrelevant
o Cost of capital is the cost of obtaining similar funding today
for use in the future
o Ask yourself
What will the cost be of obtaining similar loan today for
future use?

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Calculation of cost of capital (3)
Evaluate capital projects
o Long-term nature
o Funded with long-term funds if not, can create cash
flow shortages
o Identify permanent sources of finance
Sources available for future use in the long term

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Calculation of cost of capital (4)
Calculating cost of capital:

Market value (PV) provided


Future cash flows

Solve for I/Yr (Required Rate of Return or RRR)

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Cost of equity: Ordinary Shares
Various methods available in practice

CFM11B1 we use:
Adjusting the risk-free rate
Equity shareholders arrive at required return by taking basic rate
and adjusting for the risk-profile of the company

Cost of equity = risk free rate + risk premium

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Cost of equity: Ordinary Shares
Cost of equity = risk free rate + risk premium

Risk-free rate
Return on government bonds (example: R208 maturing in
2021)

Any other instrument = Risk

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Cost of equity: Ordinary Shares
Cost of equity = risk free rate + risk premium

1. Market specific risk factors


o State of world economy
o State of national economy
o Political instability in country
o Market sentiment on JSE

2. Company specific risk factors


o High business risk and/or
o Financial risk
o Labour unrest and strikes
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Cost of equity: Ordinary shares
Assess risk factors determine risk premium add to risk-free
rate

Example 7.2 P133

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Cost of equity: Example
Lions Limited has 10 000 shares at a par value of R10 each.
The return on R208 government bonds is 10.79% at present.
Due to the recent war in the Middle East the risk in global markets is perceived
as high and a premium of 8% is considered appropriate.
The company has a fairly low business risk and financial risk. A further
premium of 5% is considered appropriate.

Required:
Calculate the cost of equity.

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Cost of equity: Example solution
The cost of equity capital is:
Risk-free % + Risk premium %
10.79% + (8% + 5%)
23.79%

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Cost of preference shares
TVM calculation
Identify future cash flows
PMT = Dividends paid (% of par value x number of shares)
Identify current market value and redeemable value
PV =no of shares at current market value
FV = no of shares at par value
Solve for I/Y

See Example 7.2 (cont.) P134

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Cost of preference shares: Example

Lions Limited also has 20 000 preference shares at a par value of


R2 each in issue
The preference dividend of 10% is paid annually
The shares are redeemable in 4 years time at par
Shares are trading at R1.50 today

Required:
Calculate the cost of preference shares

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Cost of preference shares: Example solution
P/Y 1
FV -40 000 (20 000 x R2)
PMT -4 000 (20 000 x R2 x 10%)
N 4
PV 30 000 (20 000 x R1.50)
I/Y ? 19.58%
Required return on similar instruments issued today
NB! 10% dividend is historic rate, not cost of capital
RRR of preference shares (19.58%) is lower than RRR of ordinary shares
(23.79%) because lower risk!

FV and PMT must have a negative sign.


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Cost of debt
Similar to calculating the cost of preference shares, except
Effect of taxation
Interest paid on debt can be deducted from taxable income
(finance costs)
Saving in tax
Lower after-tax cost to the company
After tax cost of debt = Cost of debt x (1 tax %)
Preference dividends and ordinary dividends are not deductible
for tax
See Example 7.2 (cont.) P134 135

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Cost of debt: Example
Lions Limited has a loan of R60 000 on their balance sheet
This is the price at which the loan can be fully repaid today
The loan is repayable in 4 installments of R20 000 each, at the end
of each year
The tax rate is 30%.

Required:
Calculate the cost of debt

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Cost of debt: Example solution

P/Y 1
PV 60 000
PMT -20 000
FV 0
N 4
I/Y 12.59%

Cost of debt = 12.59 x (1 - 0.3)


After tax cost of debt = 8.81%

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Weighted average cost of capital (WACC)

WACC in four steps:


1. Calculating the average after-tax cost of each source of financing
2. Determine the weighting of each source of financing
3. Multiply the weight and cost of each source of financing to calculate the
contribution of each source of financing to the weighted average cost of
capital
4. The sum of these contributions is the weighted average cost of capital =
WACC

See Example 7.3 (cont.) P136 137

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Cost of Capital Part 2
Decision making
Which Cost of Capital (Capital source) to use?

Calculate cost of each individual source of permanent capital

Which cost must be used to ensure that shareholder wealth


is maximized?
Do we choose between the individual sources of capital?

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Weighted Average Cost of Capital (WACC)

Which of these rates should be used to ensure maximised


shareholder wealth?
Ordinary equity
Preference shares
Debt

Look at company's capital structure


Mix between debt and equity, thus D + E!
Selection of most appropriate capital structure (Optimum Capital
Structure)

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Optimum Capital Structure
Company will have optimal/target capital structure (This is given to
you in CFM1B)
Debt : Equity mix at which shareholder wealth is maximized
CFM11B1:
Assume company is operating at optimal capital structure
Reflected by book value of sources on statement of financial position
Usually best to use market values but read question!

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Optimum Capital Structure

Will always aim to maintain the optimal capital structure


over the long term
New capital cannot always be raised in optimal
proportion
Deviations will take place in short term
Optimal capital structure over long term by using
different sources at different times.

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Example 7.3 WACC
Example 7.3 P137 - Yankee Limited has a target capital
structure of 50 : 50 (50% debt + 50% equity)
They are considering an investment in Project A with a return
of 16%
To fund this they will use a 12% after tax loan

The project will yield a return in excess of the required return


ACCEPT!
Reason: Return exceeds the required return of the lender

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WACC
Project B comes up with a 20% return
To bring target capital structure back they will issue
ordinary shares at a cost of 22%
REJECT!
Reason: Return not sufficient to meet the requirements
of the shareholders

Summary
Accept Project A (16% return)
Reject Project B (20% return)

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WACC
How is it possible that a project yielding 20% return is rejected in
favour of a project yielding 16%?
WRONG DECISION
Measuring projects against individual sources of capital will lead
to incorrect decisions

Over the long-term the pool of funds will be used in proportion


to the capital structure
Investments must be measured against the cost of the entire
pool of funds
Calculate weighted average cost of capital.

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WACC
Weighted cost of capital for Yankee Limited is 17%
(50% 12%) + (50% 22%) = 17 %

The correct way to choose projects:


Project A
16% return < 17% required return
REJECT
Project B
20% return > 17% required return
ACCEPT
Measure a project against the weighted average cost of capital
Include the cost of both debt and equity in proportion to their weight in the total capital
structure

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WEIGHTED AVERAGE COST OF CAPITAL

WACC
Ordinary Preference
Debt
Equity Shares

Weighted Average Cost of Capital (WACC)


Pooling of funds to determine the rate on investments to satisfy ALL providers of capital
Overall return company must generate on existing assets to maintain value of:
Ordinary shares (highest risk = highest cost of capital)
Preference shares (2nd lowest risk = 2nd cheapest cost of capital)
Debt (lowest risk = lowest cost of capital)

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WEIGHTED AVERAGE COST OF CAPITAL

Calculate the after-tax component cost of each category


Step of capital.
1:

Step Determine the relevant weighting of each component.


2:
Determine the contribution of each component and
Step then add each contribution together to obtain the
WACC.
3:

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WEIGHTED AVERAGE COST OF CAPITAL

After-
tax Value Weighting Contribution
Component
cost (R) (%) (%)
(%)
Ordinary shares K V V/V total K x V/V total
Preference shares Kp Vp Vp/V total Kp x Vp/V total
Debt Kd Vd Vd/V total Kd x Vd/V total
V total 100% WACC

Step
Step 2: Step 3:
1:
Example 1: Cats Limited
The information in the table below has been provided to you with regards to
Cats Ltd.

Required:
Calculate the weighted average cost of capital.

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Example 1: Cats Limited

Step 2:

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Cats Limited (3)

Step 3:

Step 3:

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Example 1: Cats Limited
Cats Limited needs to earn at least 16.56% on its investments to
satisfy all the providers of capital proportionately to their interest
in the project.
WACC = 16.56%

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Example 2: Dogs Limited
Dogs Limited has a capital structure as follows:
Equity: 100 000 shares valued at R5 per share. Equity
shareholders require 18% return for similar shares.
12% Preference shares: 200 000 of R2. The preference
shareholders require 12% return on similar investments.
Debt: R100 000 at a fixed interest of 9% before tax. (tax is 28%)

Required:
Calculate Dogs Limiteds weighted average cost of capital

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Example 2: Dogs Limited

Step
# 9% -28% tax = 6.48% after tax 1:

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Example 2: Dogs Limited

# 9% -28% tax = 6.48% after tax


Step 2: Step 3:

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Example 2: Dogs Limited
Dogs Limited needs to earn at least 14.45% on its investments to
satisfy all the providers of capital proportionately to their interest
in the project.
WACC = 14.45%

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Class question 1: Rabbit Limited
Rabbit Limited has a capital structure as follows:
Equity: 1 000 000 shares trading at R 1.54 per share. Equity
shareholders require 22% return for similar shares.
12% Preference shares: 200 000 of R2. The required rate of
return is 16%.
Debt: R300 000 at a fixed interest of 11% before tax. (tax is 28%)

Required
Calculate Rabbit Limiteds weighted average cost of capital

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Class question 2: Pony Limited
Pony Limited has a capital structure as follows:
Equity: Equity shareholders require 20% return for similar shares.
14% Preference shares. The required rate of return is 13%.
Debt: fixed interest of 11% before tax. (tax is 28%)
The capital structure of the company is 50% equity, 20% pref
shares and 30% debt.

Required
Calculate Pony Limiteds weighted average cost of capital.

NOTE: You do not have to have a rand value for capital if you have
the individual weighting.

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Homework

Do question 1 pg 139 of textbook

Do question 2 pg 139 to 140 of textbook

Tutorial questions

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