TECHNICAL | IFIN
Get capital-lettered
Kirsty Flint
Cost of capital is one of the key topics on the intermediate level Finance syllabus, so
students need to know the underlying theories as well as how to do the calculations
n any area of business, the return that’s
I generated from performing an activity
needs to exceed the cost of employing
the resources to do that activity. This is no
different for financial management. The
return generated from the activities the
company invests in must exceed the cost of
financing these projects. If that is achieved,
value will be created for the investors.
This is where the cost of capital comes in.
The cost of capital represents the percent-
age annual rate of return required to reward
investors for the level of risk they have
accepted. It is the hurdle rate above which
the company’s projects need to generate a
return in order to satisfy the providers of
that capital.
If the cost of capital is the hurdle rate,
logic says that this should be the discount
rate used when calculating the net present
value (NPV) of potential future projects. If
the project’s cash flows generate a positive
NPV at the weighted-average cost of cap-
ital, the company will have added to its
investors’ wealth.
The cost of capital is therefore important
because it provides the link between the
investment decision (ie, what should the
company invest in?) and the finance deci-
sion (ie, how should the company finance
its investment?). But how do we go about
calculating it? Consider the example in
panel 1, above. The first step is to calculate
the individual costs of capital: the cost of
equity (Ke), the cost of preference shares
(Kp) and the cost of debt (Kd). From the
formula sheet given in the intermediate
level Finance exam, we can see that:
Ke = Do(1 + g) + g
Po
Kp = d
Po
Kd = I(1 – t)
Po
These formulas all start from the same
premise: that the required rate of return is a
function of the investor’s expectations of
future cash flow returns expressed as a
percentage of the current value of their
investment. The cost of equity share capital
18 CIMA Insider September 2003
1 Calculating the cost of capital
A company has the following capital structure:
l 2,000,000 50p ordinary shares
l 1,000,000 6% 100p preference shares
l 5% irredeemable debentures
The ordinary shares are quoted at 124p cum dividend, and the dividend about to be
paid is 13p per share. Dividends are expected to grow by 2 per cent every year.
The preference shares are quoted at 63p and the debentures £72. The preference
dividend and interest has just been paid. Corporation tax is 30 per cent.
is calculated using the dividend valuation
model. The usual assumption made is that
future dividends are expected to grow at a
reasonably constant rate, known as g.
Preference share capital usually pays a
constant dividend each year, so no growth
function is required. For debt, the future
cash flow stream is the interest payments.
As with preference shares, these cash flows
are constant, but, given that a company can
deduct interest payments in determining
taxable profits, it will experience a tax sav-
ing of (1 – tax rate) for each £1 of interest
paid. This so-called tax shield reduces the
cost of debt finance from the perspective of
the company.
In all of these formulas, Po is the ex-
dividend or ex-interest market price today.
If an instrument is quoted cum-dividend or
cum-interest, the price will need adjusting
before it is used in the calculation. So, using
our example:
Ke = Do(1 + g) + g
Po
Do = current dividend = 13p
g = expected future growth rate = 2%
Po = ex-dividend share price
= cum-dividend share price
– current dividend
= 124p – 13p = 111p
Ke = 13(1.02) + 0.02 = 13.9%
111
Kp = d
Po
d = constant dividend per annum
= 6% x £1 = 6p
Po = ex-dividend share price = 63p
£
1,000,000
1,000,000
500,000
(We know this is ex-dividend because the
dividend has just been paid.)
Kp = 6 = 9.5%
63
Kd = I(1 – t)
Po
I = annual interest = 5% x £100
(Debentures have a nominal value of £100.)
= £5
t = tax rate = 30%
Po = ex-interest price = £72 per debenture
(We know £72 is the ex-interest price
because the interest has just been paid.)
Kd = 5(1 – 0.3) = 4.9%
72
We now need to calculate an average cost
of capital for the company. This will tell us
the return that the company’s projects need
to earn to cover the average cost of financing
those activities, assuming that they are
financed out of the “pool of funds”.
The weighted-average cost of capital
(WACC) takes into account the proportion
of funds (and hence the cost) that comes
from each individual source in the pool (see
panel 2, opposite page).
Going back to our example, we have
already calculated that:
Ke = 13.9%
Kp = 9.5%
Kd = 4.9%
Now we need to calculate the values of
equity, debt and preference shares.
Ve = number of ordinary shares x
ex-dividend price per share
= 2,000,000 x 111p
= £2,220,000

Vp = number of preference shares x
ex-dividend price per share
= 1,000,000 x 63p
= £630,000
Vd = nominal value of debt x
ex-interest value ÷ £100
= £500,000 x £72
£100
= £360,000
Therefore the WACC
= [(13.9% x 2,220,000) +
(9.5% x 630,000) +
(4.9% x 360,000)] ÷
(2,220,000 + 630,000 + 360,000)
= 12%
An alternative method of setting this out
in the examination is to use a table (see
panel 3, right).
As discussed, the WACC represents the
average cost of financing, assuming that the
activities of the company are financed out of
the pool of funds. The other two assump-
tions made when the WACC is used as the
discount rate in project appraisal are that:
l the business risk of the company will not
change if the project is accepted;
l the financial risk – ie, the gearing – of the
company will not change.
Redeemable debt
In the original example, the 5 per cent
debentures were irredeemable. Suppose
instead that they were redeemable in three
years at par – ie, nominal value. If the debt
is redeemable, the formula Kd = I(1 – t) ÷ Po
cannot be used, because this would
measure only the cost of the debt in terms
of the interest paid. It would ignore any
gain or loss on redemption. The correct way
2 The pool of funds
Value = Ve + Vp + Vd
Cost = WACC
= VeKe + VpKp + VdKd
Ve + Vp + Vd
TECHNICAL | IFIN
3 Tabular calculation of WACC
Source K V VxK
Equity 13.9% 2,220,000 308,580
Preference shares 9.5% 630,000 59,850
Debt 4.9% 360,000 17,640
3,210,000 386,070
(Ve + Vp + Vd) (VeKe + VpKp + VdKd)
WACC = VeKe + VpKp + VdKd
Ve + Vp + Vd
= 386,070
3,210,000
= 12%
to calculate the cost of redeemable debt is by Calculating g
using an internal rate of return (IRR) The example gives an expected future
approach – ie, the discount rate that sets growth rate of 2 per cent. This could be the
NPV at zero. The cost of debt will be the IRR case in an examination question, but you
of the after-tax cash flows associated with may instead be asked to estimate g. This can
the debt instrument. be done in two ways:
For our modified example, these cash l using the formula g = rb, where r is the
flows will be as follows: return on investment for the firm and b is
Time Cash flow the proportion of funds retained;
Today Ex-interest price as an outflow l using historic growth to estimate future
(t0) = – £72 expected growth.
Years 1-3 Net interest as an inflow
(t1 – t3) = I(1 – t) = 5(1 – 0.30) = £3.50 Capital asset pricing model (CAPM)
Year 3 Redemption value as an inflow The formulas used so far to estimate Ke, Kp
(t3) = £100 and Kd have all been based on the dividend
To calculate the IRR, discount the cash valuation model. A key problem in using the
flows at two different discount rates and this model to calculate the cost of equity is
linearly interpolate between the two points that there’s no obvious way to modify this
using the following formula: cost to reflect different business risk profiles.
IRR = R1 + NPV1(R2 – R1) Costs of capital calculated using this model
NPV1 – NPV2 reflects the company “as it is”. This discount
See panel 4 on the next page to view the final rate will be inappropriate for appraising
calculation of IRR for this example. projects with different business risk profiles
from those of the existing activities.
The CAPM provides a solution. It allows
the calculation of risk-adjusted discount
rates for use in project appraisal. It works on
the simple idea that investors will require
at least the risk-free rate of return when
investing in a project. They will also require
a premium to compensate them for the
Equity Debt particular risk of the investment.
Value = Ve Value = Vd Since the investors’ required rate of
Cost = Ke Cost = Kd return is exactly the same as the cost of
equity to the company, CAPM can be used to
calculate the cost of equity.
Where CAPM is special is in the nature of
Preference the risk considered. There are two types of
shares risk to take into account. The first is unsys-
Value = Vp tematic and is a function of factors specific
Cost = Kp to the company or the industry in which it
operates. By definition, shareholders will be
able to diversify away much of this risk by
spreading their funds among a wide range
of securities from different industries. The
September 2003 CIMA Insider 19
TECHNICAL | IFIN/IMPM
second element of risk, systematic, is caused
by general economic factors. These affect all
companies in the same way to a greater or
lesser extent and therefore cannot be
removed by diversification. In an efficient
market, shareholders are assumed to be well
diversified and will therefore only require a
return for systematic risk.
Different companies can be more or less
subject to these general economic factors
and therefore be more or less systematically
risky. The measure of a company’s system-
atic risk is the beta factor (ß). These factors
are published quarterly for all quoted com-
panies by London Business School’s risk
measurement service. The beta factor,
together with an estimate of the risk-free
rate of return and the market portfolio
return, allow an estimate of the cost of
equity to be made as follows:
ke = rf + ß(rm – rf ) where
rf = the risk-free rate of return
ß = the beta factor for the company
rm = the market portfolio return
Suppose a company has a beta factor of
1.2, and the risk-free rate of return and
the market portfolio return are estimated at
3 per cent and 9 per cent respectively.
Means testing
Bob Scarlett
The difference between efficiency and effectiveness in a not-for-profit organisation is
fine, but crucial – as it’s possible to be both efficient and ineffective at the same time
he not-for-profit (NFP) sector incor-
T porates a wide range of operations,
including central government, local
authorities, charitable trusts and executive
agencies. The obvious central feature of such
operations is that they are not primarily
motivated by the desire to make a profit.
The ultimate objective of a commercial
enterprise is to generate a profit for its
owners. Such a business may take a short-
or long-term view of how it wishes to do
this. There are often alternative methods of
achieving this objective, and managers have
to choose between them. But there is a clear
primary objective from which subsidiary
objectives may be derived.
The objectives of NFP organisations may
be partly legislated for, partly constitutional
20 CIMA Insider September 2003
4 Calculation of the IRR
Time Cash flow Df @ 5%
t0 (72) 1 (72)
t1 – t3 3.5 2.723
t3 100 100
IRR = R1 + NPV1(R2 – R1)
NPV1 – NPV2
= 5% + 23.93(20% – 5%)
23.93 – – 6.73
= 16.7%
Using the CAPM, the cost of equity of the
company is calculated as:
3% + 1.2(9% – 3%) = 10.2%
The fact that ß is greater 1 implies that the
company is more systematically risky than
the market on average. The cost of equity of
10.2 per cent is therefore higher than the
return on the market portfolio of 9 per cent.
Cost of capital is one of the key technical
areas in the IFIN syllabus and is also carried
through to final level in the Financial
Strategy paper. Students need to know the
and partly political. For example, the Driver
and Vehicle Licensing Agency is legally
required to keep records of vehicle registra-
tion and to issue motorists with driving
licences and road tax discs. Mencap, one of
the UK’s leading learning disability chari-
ties, has an obligation to provide assistance
for mentally handicapped people written
into its constitution. Sunderland City
Council has a duty to run local schools, but
has a wide measure of discretion over how it
does this. It can spend money on salaries for
teachers or it can switch some of that cash
into acquiring IT systems and making
greater use of computer-assisted learning.
It can provide teaching in classical Greek
or it can reinforce its sports provision. The
relevant choices the local authority makes
PV @ 5% Df @ 20% PV @ 20%
1 (72)
9.53 2.106 7.37
86.40 0.579 57.90
23.93 (6.73)
underlying theories as well as how to per-
form the calculations in their exams.
In reality, firms rarely conduct the depth
of analysis covered in IFIN and FLFS, since
there are simply too many assumptions and
unknowns in the real world. But it is criti-
cally important that they understand these
assumptions and theories so that they can
appreciate the real sensitivities that are
inherent in project appraisals. n
Kirsty Flint is a tutor at ATC
are determined by a political process.
Parties contesting local elections will
include their spending proposals in mani-
festos and the party with the most popular
proposals will be elected.
Practical problems with management in
the NFP sector include the following:
l objectives may be unclear;
l objectives may change regularly over time;
l radically different means may be avail-
able to achieve given objectives.
A further consideration is that the rela-
tionship between objectives and means is
often poorly understood. For example, one
public objective would be “to contain street
crime within limits considered to be accept-
able”. One means of achieving that objective
is through the use of traditional police foot