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COST
OF
CAPITAL
Learning Objectives
After working through this chapter, you should be able to:
Understand the concept of the weighted average cost of
capital (WACC) (3rd year)
Determine the cost of debt (3rd year)
Determine the cost of preference share capital (3rd year)
(NB: convertible and redeemable preference shares 4th year).
Calculate the cost of equity using the dividend growth
model and the CAPM approach (3rd year)
Understand the practical issues of estimating the CAPM
parameters (3rd year)
Understand how a firms capital structure affects a firms
WACC (3rd year)
Calculate firms weighted average cost of capital (WACC)
(3rd and 4th year)
Understand the use of the WACC in determining a firms
EVA (4th year)
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Why is the Weighted Average Cost of
Capital (WACC) so important?
Evaluation of capital projects
Valuation of companies
Determination of a companys EVA (economic
profit)
Determination of fair value for corporate
reporting purposes
WACC is employed to set pricing decisions for
entities subject to regulatory review
Determination of fair value for financial reporting
purposes 3
WACC Some Principles
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WACC Formula
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Component Costs of Capital:
Cost of Debt
Cost of Debt = Interest rate (1 - tax rate) [Formula 7.1]
Flotation Costs?
Net receipt = Vd (1 - F)
Coupon rate of debenture = 10%
Market rate on date of issue = 11%
Assumption: The debenture is a perpetuity
Vd = (10%/11%) x R100 = R90.91
If flotation (issue) costs are involved, say at 2%
= $90.91(1 - 0.02)
= $89.09
Cash received per debenture = $89.09
Interest at 10% on $100= $10
Cash interest cost (10/89.09) = 11.22%
Effective rate
Kd = 11.22% (1 -0.28) = 8.08%
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Yield to Maturity for
Redeemable Debentures / Bonds
What is the cost of redeemable debentures? The
cost is the yield to maturity.
Assume that the price of a debenture is currently
trading at $93.80. The coupon rate is 10% and the
redemption date is in 5 years time.
Year 0
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Component Costs of Capital
Cost of Equity
Example 7.4
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THE WEIGHTED AVERAGE COST
OF CAPITAL
Calculating the WACC
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Breaks in the WACC
Investment opportunities.
Breaking point for debt, preference shares and ordinary shares are
the limits before the WACC % changes (breaks).
The change occurs from increases in costs of further borrowing
from each of the three components.
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Estimating the Cost Capital of
Divisions
A company may not be operating in just one sector
or industry, but multiple sectors
Each sector may be associated with varying levels
of risk
Due to this, the overall companys cost of capital
should not be used to evaluate projects
A divisional cost of capital is required
Systematic risk of the sector should be used to
determine the cost of capital
Covered in more detail in Chapter 10
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Unlevering and relevering betas
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Cost of Debt & Preference Shares
Use current market rates
Ignore historical and coupon rates
Variable rate financing use long-term rate
Use interest rate spreads for different credit ratings
Probabilities of default implied by rating spreads
What is the current real interest rate? Is it sustainable?
Foreign loans due to interest rate parity, use the
market rate in the local market. (Yet higher liquidity of
bond issues in Europe and NY)
Preference shares non-redeemable = Dividend/Market
Price. If redeemable, use market yield.
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CAPM Some Practical Issues
KEQUITY = Rf + Beta(Rm - Rf)
The Risk-free rate
Treasury Bills or Long-term Bonds?
Matching of rate to the life of the company
Practitioners use the long-term RSA
government bond rate.
Consistent with objective of setting a long-
term cost of equity
Short-term interest rates are volatile, and this
would make the cost of equity very volatile
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More on the Risk-free rate
Long-term bond yields reflect the holding
period returns that match the term of the
underlying investments
Any country risk premium is included in the
risk free rate
PWC Survey = Risk-free rate used is the
long-term government bond rate
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The Market (Equity) Risk Premium
The Market Risk Premium
The difference between the expected rate of
return and the risk-free rate.
How do we measure market premiums?
Historical
Surveys
Dividend growth model for the economy
Market premium
Average market (equity) premium
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Historical Premiums
Most common method for determining risk premium
Extrapolate past premiums into the future
How far back do we go?
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Estimating Betas
Which Index should we use as a Proxy for the
market portfolio?
Levered betas are converted to unlevered betas and
relevered by the firms capital structure
In 2010, the following were some sector betas;
Resources 1.31
Food producers 0.50
Financials 0.71
IT 0.80
Food & Drug retailers 0.42
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More on divisional WACC and beta
Cost of Equity using the
CAPM formula
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Relevering Equity Betas
To determine the equity beta of Co. A, we need to relever
this to reflect Co. As gearing. We can restate Hamadas
formula as;
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Why use a Risk-adjusted Discount Rate?
Why not simply use the firms cost of capital to determine a projects
NPV? What is wrong with using the cost of capital?
High risk projects will be accepted and low risk projects will be
rejected.
Project A should be accepted due its return relative to its risk, yet it is
rejected. Project B should be rejected due to its high risk relative to
its return, yet it is accepted.
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CAPM-parameters.....continued
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