CHAPTER 5 – COST OF CAPITAL

OVERVIEW

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COST OF EQUITY [USING DIVIDEND VALUATION MODELS (DVM)]

1. Constant Dividend Model:

P0 = D / ke

Where:

P0 = market value of equity (ex-dividend)

D = annual dividend

ke = cost of equity

2. Gordon Growth Model:

P0 = D0 (1 + g)/(ke – g)

Where:

P0 = market value of equity (ex-dividend)

D0 = current dividend

ke = cost of equity

g = expected constant annual growth rate in dividends

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What is cum-div and ex-div share prices?

▪ Dividends are paid periodically on shares.

▪ During the period prior to the payment of dividends, the price rises in anticipation of the payment.
▪ At this stage the price is cum-div.
▪ The share goes ex-div shortly before the dividend is paid.
▪ Any person acquiring the share after this point will not receive the dividend, which will be paid to the original
shareholder.
▪ Thus, when a share is quoted cum-div – includes both the ex-div value of the share and the dividend due shortly.
▪ As the dividend valuation model considers the present value of future dividends, the ex-div share price for P0 must
be used.

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Example 1

a) A company’s shares are quoted at £2.50 ex-div. The dividend just paid was 50p. No growth in

dividends is expected and dividends are forecast to continue indefinitely. What rate of return ke, do

the investors anticipate?

b) Using the data above, but with an anticipated growth rate in dividends of 10%.

c) Investors in a company are known to require a rate of return of 15%. Current dividends are 30p per

share, just paid. No increase is anticipated. Estimate the share price.

d) As in (c), but dividends are expected to grow at 5% p.a.

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Example 2

a) The market value of a company’s shares is £2.20. It is about to pay a dividend of 20p, which is

expected to remain constant in future. What is the cost of equity?

b) A company currently pays a dividend of 12p which is expected to grow at 5% p.a. The ex-dividend

share price is £1.75. What is the cost of equity?

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Estimating dividend growth rates

Historical pattern
Gordon’s growth (or earnings retention model)
The anticipated growth rate, g, is an unknown,
representing a subjective estimate made by individual This growth estimate is based on the idea that retained profits are

investors. the only source of funds. With no re-invested profits, the investment
base of the company would not increase. Practically, this means no
new funds invested in new products, new markets, new factories,

It cannot be calculated precisely, but an important stores and so on. Therefore, profit will not grow, and by implication

factor in investors' estimates will be the historical dividends (taking a long-term view) will not grow.

pattern of growth in dividends.

Growth therefore comes about by retaining and reinvesting profits

However, the past is often a weak indicator of the on which a return is earned.
future.
The relationship between these variables is shown by:

g=rxb
Refer to Example 3
Where:

r = current ARR

b = proportion of profits retained for re-investment

Refer to Examples 4 & 5

Limitations of the Gordon Growth

1. Uses accounting profits rather than cash flows

2. r and b are assumed to be constant when in reality inflation can distort
the figures
3. Assumes growth is achieved through using equity finance only (gearing
is kept constant)

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Example 3

Shareholders require a 15% return on their shares and a company has just paid a dividend of 80 p per share.
Over the past 4 years, the company has paid dividends of 68 p, 73 p, 74 p and 77 p per share (most recent
dividend last).
What is a fair price for the share using the Gordon Growth Model?

Example 4

The summarized income statement for a company for the last year is as follows:
£’000

Profit before tax 100

Tax (40)

Profit after tax 60

Dividends on ordinary shares (40)

Retained earnings 20

Shareholders’ equity of £556 000 is shown in the balance sheet at the beginning of the year. The company
maintains a ratio of retained earnings to dividends of 1:2. Using Gordon’s Growth, what is the dividend
growth rate?

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Example 5

A company has 300,000 ordinary shares in issue with an ex-div market value of £1.35 per share. A dividend
of £50,000 has just been paid out of post-tax profits of £75,000.

Net assets at the year-end were valued at £1.06m. Estimate the cost of equity.

Limitations of the DVM

1. Shares have value because of the dividends, which is not always true – some firms have a deliberate
policy of no or low dividend payouts, which would render any valuations using the methodology rather
unrealistic
2. Dividends do not grow or grow at a constant rate, but the former is unrealistic, and whilst the latter may be
realistic in the long term it can be subject to short-term fluctuations which undermine calculations of the
cost of equity
3. Estimates of dividend growth rates tend to be based on historic patterns rather than the actual future facing
the firm and its likely future earnings, consideration of which might produce more meaningful cost of equity
calculations
4. Share prices are constant, which is clearly not the case

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COST OF EQUITY [USING CAPITAL ASSET PRICING MODEL (CAPM)]

SYSTEMATIC AND UNSYSTEMATIC RISK

Overall risk that investors and companies face can be separated into systematic and unsystematic risk.

Systematic Risk Unsystematic Risk

❖
❖
• Also known as non-diversifiable, non-specific, • Also known as diversifiable, specific, avoidable or
❖
unavoidable or market risk. non-market risk.
❖
• Is the❖type of risk that all companies are exposed to • Is the risk that affects a particular market sector or
no matter individual company.
❖ which market sector they operate in.
• Systematic risk cannot be eliminated through • Most of this risk can be diversified away by investing
❖
diversification. in a portfolio of 15-20 randomly selected securities.
• Examples of systematic risk include: interest rate • Examples of unsystematic risk include: The Chairman
changes; recession (business cycles); oil price resigning; strikes by the employees of a company;
changes; wars; government policy. changes in regulations that affects a particular market
sector.

DIVERSIFICATION AND THE PORTFOLIO EFFECT

▪ Investors should establish portfolios – a collection of investments.

▪ The logic is that an investor who puts all of their funds into one investment risks everything on the
performance of that individual investment.
▪ A wiser policy would be to spread the funds over several investments (establish a portfolio) so that the
unexpected losses from one investment may be offset to some extent by the unexpected gains from
another.
▪ Thus the key motivation in establishing a portfolio is the reduction of risk.

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Figure 1: Portfolio size and risk reduction

CAPM

▪ The dividend valuation models described above does not explicitly consider risk. Risk here is the risk that
actual returns, i.e. dividends, will not be the same as expected returns.
▪ The CAPM assumes that investors hold fully diversified portfolios. This means that investors are assumed
by the CAPM to want a return on an investment based on its systematic risk alone, rather than on its total
risk.
▪ The measure of risk used in the CAPM, which is called ‘beta’, is therefore a measure of systematic risk.
▪ The minimum level of return required by investors occurs when the actual return is the same as the
expected return, so that there is no risk at all of the return on the investment being different from the
expected return.
▪ This minimum level of return is called the ‘risk-free rate of return’.
▪ The formula for the CAPM is as follows:

ke = Rf + {Rm – Rf} β

Where:

ke = cost of equity

Rf = risk-free rate of return

Rm = expected return from the market portfolio

β = equity beta

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Components of the CAPM

THE RISK-FREE RATE OF RETURN

▪ In the real world, there is no such thing as a risk-free asset. Short-term government debt is a relatively safe
investment, however, and in practice, it can be used as an acceptable substitute for the risk-free asset.
▪ In order to have consistency of data, the yield on UK treasury bills is used as a substitute for the risk-free
rate of return when applying the CAPM to shares that are traded on the UK capital market. Note that it is the
yield on treasury bills which is used here, rather than the interest rate. The yield on treasury bills (sometimes
called the yield to maturity) is the cost of debt of the treasury bills.
▪ Because the CAPM is applied within a given financial system, the risk-free rate of return (the yield on short-
term government debt) will change depending on which country’s capital market is being considered and
with changing economic circumstances.

THE EQUITY RISK PREMIUM

▪ Rather than finding the average return on the capital market, E(rm), research has concentrated on finding an
appropriate value for (E(rm) - Rf), which is the difference between the average return on the capital market
and the risk-free rate of return.
▪ This difference is called the equity risk premium, and it represents the extra return required for investing in
equity (shares on the capital market as a whole) rather than investing in risk-free assets.
▪ In the short term, share prices can fall as well as increase, so the average return on a capital market can be
negative as well as positive. To smooth out short-term changes in the equity risk premium, a time-
smoothed moving average analysis can be carried out over longer periods of time, often several decades.

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BETA

▪ Beta is an indirect measure which compares the systematic risk associated with a company’s shares with
the systematic risk of the capital market as a whole. If the beta value of a company’s shares is 1, the
systematic risk associated with the shares is the same as the systematic risk of the capital market as a
whole. Beta is ‘an index of responsiveness of the returns on a company’s shares compared to the returns
on the market as a whole’.
▪ Shares can have high betas (aggressive shares) or have betas less than one (defensive shares).
▪ Beta values are found by using regression analysis to compare the returns on a share with the returns on
the capital market. When applying the CAPM to shares that are traded on the UK capital market, the beta
value for UK companies can readily be found on the Internet, on Datastream, and from the London Business
School Risk Management Service.

• Beta > 1 - aggressive shares

These shares tend to go up faster than the market in a rising (bull) market and fall more than the market in a
declining (bear) market.
• Beta < 1 - defensive shares
These shares will generally experience smaller than average gains in a rising market and smaller than average
falls in a declining market.
• Beta = 1 - neutral shares
These shares are expected to follow the market.

The beta value of a share is normally between 0 and 2.5. A risk-free investment (a treasury bill) has a b = 0 (no
risk). The most risky shares like some of the more questionable penny share investments would have a beta value
closer to 2.5. Therefore, if you are in the exam and you calculate a beta of 11 you know that you have made a
mistake.

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ASSUMPTIONS OF THE CAPM

Investors hold diversified portfolios This assumption means that investors will only require a return for the systematic risk of their
portfolios, since unsystematic risk has been removed and can be ignored.

Single-period transaction horizon A standardized holding period is assumed by the CAPM in order to make comparable the returns
on different securities. A return over six months, for example, cannot be compared to a return
over 12 months. A holding period of one year is usually used.

Investors can borrow and lend at the This is an assumption made by portfolio theory, from which the CAPM was developed, and
risk-free rate of return provides a minimum level of return required by investors.
The risk-free rate of return corresponds to the intersection of the security market line (SML) and
the y-axis (see Figure 1). The SML is a graphical representation of the CAPM formula.

Perfect capital market This assumption means that all securities are valued correctly and that their returns will plot on to
the SML. A perfect capital market requires the following: that there are no taxes or transaction
costs; that perfect information is freely available to all investors who, as a result, have the same
expectations; that all investors are risk averse, rational and desire to maximise their own utility;
and that there are a large number of buyers and sellers in the market.

LIMITATIONS

• Real-world capital markets are clearly not perfect. Even though well-developed stock markets do, in practice,
exhibit a high degree of efficiency, there is scope for stock market securities to be priced incorrectly and, as a result, for
their returns not to plot on to the SML.
• The assumption of a single-period transaction horizon appears reasonable from a real-world perspective, because
even though many investors hold securities for much longer than one year, returns on securities are usually
quoted on an annual basis.
• The assumption that investors hold diversified portfolios means that all investors want to hold a portfolio that reflects
the stock market as a whole. Although it is not possible to own the market portfolio itself, it is quite easy and
inexpensive for investors to diversify away specific or unsystematic risk and to construct portfolios that ‘track’
the stock market. Assuming that investors are concerned only with receiving financial compensation for systematic
risk seems therefore to be quite reasonable.
• A more serious problem is that, in reality, it is not possible for investors to borrow at the risk-free rate (for which
the yield on short-dated Government debt is taken as a proxy). The reason for this is that the risk associated with
individual investors is much higher than that associated with the Government. This inability to borrow at the risk-free
rate means that the slope of the SML is shallower in practice than in theory.
• Overall, it seems reasonable to conclude that while the assumptions of the CAPM represent an idealised rather than
real-world view, there is a strong possibility, in reality, of a linear relationship existing between required return and
systematic risk.

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ADVANTAGES OF THE CAPM DISADVANTAGES OF THE CAPM

The CAPM has several advantages over other methods of The CAPM suffers from a number of disadvantages and
calculating required return, explaining why it has remained limitations that should be noted in a balanced discussion of this
popular for more than 40 years: important theoretical model.

▪ It considers only systematic risk, reflecting a reality in Assigning values to CAPM variables
which most investors have diversified portfolios from
▪ In order to use the CAPM, values need to be assigned to the
which unsystematic risk has been essentially eliminated.
risk-free rate of return, the return on the market, or the equity
risk premium (ERP), and the equity beta.
▪ It generates a theoretically-derived relationship between
▪ The yield on short-term Government debt, which is used as a
required return and systematic risk which has been
substitute for the risk-free rate of return, is not fixed but
subject to frequent empirical research and testing.
changes on a daily basis according to economic
circumstances. A short-term average value can be used in
▪ It is generally seen as a much better method of
order to smooth out this volatility.
calculating the cost of equity than the dividend growth
▪ Finding a value for the ERP is more difficult.
model (DGM) in that it explicitly takes into account a
▪ The return on a stock market is the sum of the average
company’s level of systematic risk relative to the stock
capital gain and the average dividend yield.
market as a whole.
▪ In the short term, a stock market can provide a negative
rather than a positive return if the effect of falling share prices
▪ It is clearly superior to the WACC in providing
outweighs the dividend yield. It is therefore usual to use a
discount rates for use in investment appraisal.
long-term average value for the ERP, taken from empirical
research, but it has been found that the ERP is not stable
over time.
▪ In the UK, an ERP value of between 2% and 5% is currently
seen as reasonable. However, uncertainty about the exact
ERP value introduces uncertainty into the calculated value
for the required return.
▪ Beta values are now calculated and published regularly for all
stock exchange-listed companies.
▪ The problem here is that uncertainty arises in the value of the
expected return because the value of beta is not constant,
but changes over time.

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Example 6

(1)

(2)

(3)

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Valuation models beyond the CAPM

Refer to STUDY MANUAL p.129

COST OF PREFERENCE SHARES

• Preference shares usually have a constant dividend.

• Preference dividends are normally quoted as a percentage, eg. 10% £1 preference shares will provide
an annual dividend of 10% of the £1 nominal value (not the market value).
• Tax relief is not given for preference share dividends.
• When calculating WACC, the cost of preference shares is a separate component and should not be
combined with the cost of debt or the cost of equity.
• So using the perpetuity valuation formula:

Po = D/ Kp

Where Po = ex-div market value

D = constant annual dividend

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Example 7

a) A plc has 100 000 12% preference shares in issue, nominal value of £1. The current ex-div market
value is £1.15/share. What is the cost of the preference shares?

b) B plc’s irredeemable preference shares have a coupon rate of 8% and pay a dividend of £4 per £100
nominal value on 1 January and 1 July each year. If the cum-dividend price on 1 January is £86, what
is the annual cost of the preference share capital to the company?

c) C plc’s 6% irredeemable preference shares of £1 each have a market price of 65p. The company is
paying corporation tax at a rate of 30%. What is the cost of preference share capital?

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COST OF DEBT FINANCE

IRREDEEMABLE DEBENTURES/LOAN STOCK OR THOSE REDEEMABLE AT CURRENT MARKET PRICE

Formula:

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Example 8

a) A company issued its 10% irredeemable debentures at 95. The current market price is 90. The
company is paying corporation tax at a rate of 30%. What is the current cost of capital p.a. of these
debentures?

b) 12% irredeemable debentures with a nominal value of £100 are quoted at £92 cum-interest. The rate
of corporation tax is 30%. (1) Find the gross return required by debenture holders. (2) Find the net of
tax cost to the company.

c) A company has 15% debentures of £100 nominal value. Investors require a gross yield of 12% on
such debenture stock. If the corporation tax rate is 30% and the basic rate of income tax is 23%, what
is the cost of the debentures to the company?

REDEEMABLE DEBENTURES/LOAN STOCK AT OTHER THAN CURRENT MARKET PRICE

Where there is a difference between the current market price and the redemption price, there are 2 elements to
the cost of that security:

1. Interest payments, i.e. an income return

2. A capital gain or loss represented by the difference between the current market price and the redemption
price.

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Example 9

A company has 10% debentures in issue quoted at £98 ex-interest. The debentures will be redeemed in 5
years at par. Corporation tax is 30%. What is the cost to the company if interest is paid annually?

Year Cash flows Amount DF@ PV@ DF@ PV@

IRR =

Post-tax kd =

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CONVERTIBLE DEBENTURES/LOAN STOCK

Convertible debentures/loan stock, allows the investor to choose between taking cash on redemption or
converting the debentures into a pre-determined number of shares.

Example 10

A company has in issue 8% convertible loan stock currently quoted at £85 ex-interest. The loan stock is
redeemable at 5% premium in 5 years’ time, or can be converted into 40 ordinary shares at that date. The
current market value ex div of shares is £2/share with a dividend growth of 7%. Corporation tax = 30%.
What is the cost to the company of the loan stock?

Year Cash flows Amount DF@ PV@ DF@ PV@

IRR =

Post-tax kd =

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COST OF BANK LOAN

Kd = Interest rate x (1-T)

Weighted Average Cost of Capital (WACC)

k = MVe x Ke+ MVd x Kd

Mve + MVd

Example 11

The market value of the equity is £2m and its cost is 15%.

The market value the debt is £1m and its cost is 6%.

Calculate the WACC

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Example 12

Jordan plc, which pays corporation tax at 33%, has the following capital structure:

▪ Ordinary shares: 1 million shares or nominal value of 25p/share. The market value of the shares is
49p/share. A dividend of 7p/share has just been paid and dividends are expected to grow by 8% p.a. for
the foreseeable future.
▪ Preference shares: 250 000 shares of nominal value of 50p/share. The market value of the shares is
32p/share and the annual net dividend of 7.5 % has just been paid.
▪ Debentures: £100 000 of irredeemable debentures with a market price of £92 per £100 par. These
debentures have a coupon rate of 10% and the annual interest payment has just been made.

Calculate the WACC

Solution:
MV ordinary shares = ke =

MV preference shares = kp =

MV debentures = kd =

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Weights in WACC

▪ Weightings should be based on the long-run proportions in which funds are to be raised, and this is often
estimated from the past proportions in which funds were raised (historical mix).
▪ If there is good evidence that the future mix will change (deviation from historical long-run proportions), then
weights should be based on these new proportions.
▪ Also note that if proportions of debt and equity change, their costs could also alter.
▪ Weights should be based on market values whenever possible: book values (historical accounting) normally
give a lower cost as the proportion of equity is underestimated (use book value only when market value is
unavailable).

When to use WACC

The weighted average cost of capital (WACC) can be used as the discount rate in investment appraisal provided
that a number of restrictive assumptions are met.

These assumptions are that:

▪ The investment project is small compared to the investing organization.

▪ The business activities of the investment project are similar to the business activities currently
undertaken by the investing organization. The operating risk of the firm is not to be changed.
▪ The financing mix used to undertake the investment project is similar to the current financing mix (or
capital structure) of the investing company. The historical proportions of debt and equity are not to be
changed.
▪ Existing finance providers of the investing company do not change their required rates of return as a result of
the investment project being undertaken.
▪ The finance is not project specific.

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PRACTICE QUESTIONS

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