Chapter # 03
Cost of Finance
(a) The CAPM (Capital Asset Pricing) Method:
Another approach to calculating the cost of equity in a company is to use the capital asset pricing model (CAPM).
The formula for the model is as follows:
ke = rf +(rm – rf) β
Where:
ke = The cost of equity for a company’s shares
rf = The risk-free rate of return (This is the return that investors receive on risk-free investments)
rm = The average return on market investments as a whole, excluding risk-free investments
β = the beta factor for the company’s equity shares.
Example # 15:
The rate of return available for investors on government bonds is 4%. The average return on market investments is 7%. The
company’s equity beta is 0.92.
Required:
Using the CAPM, Find the company’s cost of equity.
Answer:
ke = rf +(rm – rf) β
4% + (7% – 4%) 0.92
ke = 6.76%
Example # 16:
The ABC Company's current share price is Rs. 11.60 and they have beta of 1.10. The current dividend of Rs. 1 is due to be paid
in two weeks’ time and dividends are expected to grow at 6% per year in future. The market return is 15% and the risk free
rate of return is 5%.
Required:
Estimate the company's cost of equity capital using both the DVM and the CАРМ.
Answer:
DVM Method: CAPM Method:
𝐷𝑜 (1 + 𝑔) ke = rf +(rm – rf) β
ke = 𝑀𝑉(𝐸𝑥 𝐷𝑖𝑣) + g
5% + (15% – 5%) 1.10
1 (1 + 0.06)
ke = + 0.06 ke = 16%
11.60 − 1
ke = 16%
Right Issue:
Deciding the issue price for a rights issue:
The offer price in a rights issue will be lower than the current market price of existing shares. The size of the discount will
vary, and will be larger for difficult issues. The offer price must however be at or above the nominal value of the shares, so as
not to contravene company law.
A company making a rights issue must set a price which is low enough to secure the acceptance of shareholders, who are
being asked to provide extra funds, but not too low, so as to avoid excessive dilution of the earnings per share.
A question could ask for discussion on the effect of a rights issue, as well as calculations, e.g of the effect on EPS.
Illustrative Example # 01:
Seagull can achieve a profit after tax of 20% on the capital employed. At present its capital structure is as follows.
Rs.
200,000 ordinary shares of Rs. 1 each 200,000
Retained Earnings 100,000
300,000
The directors propose to raise an additional Rs. 126,000 from a rights issue. The current market price is Rs. 1.80.
Required
(a) Calculate the number of shares that must be issued if the rights price is: Rs. 1.60; Rs. 1.50; Rs. 1.40; Rs. 1.20.
(b) Calculate the dilution in earnings per share in each case.
Right Issue:
The market price of shares after a rights issue: (Theoretical ex rights price)
When a rights issue is announced, all existing shareholders have the right to subscribe for new shares, and so there are rights
attached to the existing shares. The shares are therefore described as being 'cum rights' (with rights attached) and are
traded cum rights. On the first day of dealings in the newly issued shares, the rights no longer exist and the old shares are
now 'ex rights' (without rights attached).
After the announcement of a rights issue, share prices normally fall. The extent and duration of the fall may depend on the
number of shareholders and the size of their holdings. This temporary fall is due to uncertainty in the market about the
consequences of the issue, with respect to future profits, earnings and dividends.
After the issue has actually been made, the market price per share will normally fall, because there are more shares in issue
and the new shares were issued at a discount price. In theory, the new market price will be the consequence of an
adjustment to allow for the discount price of the new issue, and a theoretical ex rights price can be calculated.
Illustrative Example # 02:
Fundraiser has 1,000,000 ordinary shares of Rs. 1 in issue, which have a market price on 1 September of Rs. 2.10 per share.
The company decides to make a rights issue, and offers its shareholders the right to subscribe for one new share at Rs. 1.50
each for every four shares already held. After the announcement of the issue, the share price fell to Rs. 1.95, but by the time
just prior to the issue being made, it had recovered to Rs. 2 per share. This market value just before the issue is known as the
cum rights price.
Required:
What is the theoretical ex rights price?
Right Issue:
The theoretical gain or loss to shareholders:
The possible courses of action open to shareholders are:
(a) To 'take up' or 'exercise' the rights, that is, to buy the new shares at the rights price. Shareholders who do this will
maintain their percentage holdings in the company by subscribing for new shares.
(b) To 'renounce' the rights and sell them on the market. Shareholders who do this will have lower percentage
holdings of the company's equity after the issue than before the issue, and total value of their shares will be less.
(c) To renounce part of the rights and take up the remainder. For example, a shareholder may sell enough of his
rights to enable him to buy the remaining rights shares he is entitled to with the sale proceeds, and so keep the
total market value of his shareholding in the company unchanged.
(d) To do nothing. Shareholders may be protected from consequences of their inaction because rights not taken up
are sold on a shareholder's behalf by the company. The Stock Exchange rules state that if new securities are not
taken up, they should be sold by the company to new subscribers for the benefit of the shareholders who were
entitled to the rights.
Illustrative Example # 03:
Gopher has issued 3,000,000 ordinary shares of Rs. 1 each, which are at present selling for Rs. 4 per share. The company
plans to issue rights to purchase one new equity share at a price of Rs. 3.20 per share for every three shares held. A
shareholder who owns 900 shares thinks that he will suffer a loss in his personal wealth because the new shares are being
offered at a price lower than market value. On the assumption that the actual market value of shares will be equal to the
theoretical ex rights price.
Required:
What would be the effect on the shareholder's wealth if:
(a) He sells all the rights.
(b) He exercises half of the rights and sells the other half.
(c) He does nothing at all?