LONG TERM SOURCES OF FINANCE:

EQUITY
Equity relates to the ownership rights in a business.

Ordinary shares
1. Owning a share confers part ownership.
2. High risk investments offering higher returns.
3. Equity shareholders bear maximum risk as they are given lowest priority in terms of
cash payouts and in the events of liquidation.
4. As the company grows and demand for funds increases, equity shares are issued to
outsiders and may be offered to the public through an initial public offering (IPO).

Advantages
1. No fixed charges (e.g. interest payments).
2. No repayment required.
3. Carries a higher return than loan finance.
4. Shares in listed companies can be easily disposed of at a fair value.

Disadvantages
1. Issuing equity finance can be expensive in the case of a public issue
2. Problem of dilution of ownership if new shares issued.
3. Dividends are not tax-deductible.
4. A high proportion of equity can increase the overall cost of capital for the
company.
5. Shares in unlisted companies are difficult to value and sell.

Preference shares
1. As the name indicates, preference shares are given preference regarding payments
of dividends and repayment of capital as against ordinary shares.
2. Preference shares carry a fixed dividend.
3. Paid in preference to (before) ordinary shares.
4. Preference shares may be cumulative or non-cumulative. In the case of cumulative
preference shares, even where there are insufficient profits, the dividends are
carried forward to subsequent years.
5. The risk of non-receipt of dividends is lower.
6. The return expected by investors, and therefore, the cost of capital is slightly lower.

1
DEBT
The loan of funds to a business without any ownership rights.
1. Paid out as an expense of the business (pre-tax).
2. Risk of default if interest and principal payments are not met.

Security

Charges
The debtholder will normally require some form of security against which the funds
are advanced. This means that in the event of default the lender will be able to take
assets in exchange of the amounts owing.

Covenants
A further means of limiting the risk to the lender is to restrict the actions of the
directors through the means of covenants. These are specific requirements or
limitations laid down as a condition of taking on debt financing. They may include;
dividend restrictions, financial ratios, financial reports also issue of further debt.

Types of debt
Debt may be raised from two general sources, banks or investors.

Bank finance
For companies that are unlisted and for many listed companies the first port of call
for borrowing money would be the banks. These could be the high street banks or
more likely for larger companies the large number of merchant banks concentrating
on ‘securitized lending’.
This is a confidential agreement that is by negotiation between both parties.

Traded investments
Debt instruments sold by the company, through a broker, to investors. Typical
features may include:
1. The debt is denominated in units of $100, this is called the nominal or par
value and is the value at which the debt is subsequently redeemed.
2. Interest is paid at a fixed rate on the nominal or par value.
3. The debt has a lower risk than ordinary shares. It is protected by the charges
and covenants.

Types of issued debt

They include:

Debentures
Debt secured with a charge against assets (either fixed or floating), low risk debt
offering the lowest return of commercially issued debt.

2
 Unsecured loans
No security meaning the debt is more risky requiring a higher return.

OTHER SOURCES

Sale and Leaseback

1. Selling good quality fixed assets such as high street buildings and leasing
them back over many (25+) years.
2. Funds are released without any loss of use of assets.
3. Any potential capital gain on assets is forgone.

Grants
1. Often related to regional assistance, job creation or for high tech companies.
2. Important to small and medium sized businesses (ie unlisted).
3. They do not need to be paid back.
4. Developed countries especially in European Union are the major providers of loans.

Retained earnings
The single most important source of finance, for most businesses the use of
retained earnings is the core basis of their funding.

Warrants
1. An option to buy shares at a specified point in the future for a specified
(exercise) price.
2. The warrant offers a potential capital gain where the share price may rise
above the exercise price.
3. The holder has the option to buy the share on a future date at a pre-
determined date.
4. The warrant has many uses including:
● additional consideration when issuing debt.
● incentives to staff.

Convertible loan stock

A debt instrument that may, at the option of the debtholder, be converted into
shares. The terms are determined when the debt is issued and lay down the rate of
conversion (debt: shares) and the date or range of dates at which conversion can
take place.
The convertible is offered to encourage investors to take up the debt instrument.
The conversion offers a possible capital gain (value of shares › value of debt).

3
BASICS OF COST OF CAPITAL
A fundamental calculation for all companies is to establish its financing costs, both
individually for each component of finance and in total terms. These will be of use
both in terms of assessing the financing of the business and as a cost of capital for
use in investment appraisal.

Risk and return

The relationship between risk and return is easy to see, the higher the risk, the
higher the required to cover that risk. Importantly this helps as a starting point to
the calculation of a cost of capital.

Overall return
A combination of two elements determine the return required by an investor for a
given financial instrument.
1. Risk-free return – The level of return expected of an investment with zero
risk to the investor.
2. Risk premium – the amount of return required above and beyond the risk-
free rate for an investor to be willing to invest in the company

Risk-free return
The risk-free rate is normally equated to the return offered by short-dated
government bonds or treasury bills. The government is not expected (we would
hope!) to default on either interest payments or capital repayments.
The risk-free rate is determined by the market reflecting prevailing interest and
inflation rates and market conditions.

Cost of equity
The rate of return required by a shareholder. This may be calculated in one of two
ways:
1. Dividend Valuation Model (DVM).
2. Capital Asset Pricing Model (CAPM).

Dividend valuation model

The valuation of the share in terms of the cash returns of dividends into the future. The
cash inflow is normally an perpetuity to reflect the permanent nature of the share capital.

4
Perpetuity formula
Cashinflow p.a.
PV of a perpetuity =
Rate of return

Introducing terminology
Dividend p.a.
Share price =
Cost of Equity

d
P0 =
Ke

where Ke = cost of equity

d = is a constant dividend p.a.
P0 = the ex-div market price of the share
We can rearrange the formula to get the one below:
The dividend valuation model with constant dividends
d
Ke =
P0

Example 1
The ordinary shares of Jones Ltd are quoted at Tzs 10,000 per share ex div. A
dividend of Tzs 800 per share has just been paid and there is expected to be no
growth in dividends.

Required:
What is the cost of equity?

Example 2
The ordinary shares of Nyanza Ltd are quoted at Tzs 10,000 per share. A dividend of
Tzs 300 is about to be paid. There is expected to be no growth in dividends.

Required:
What is the cost of equity?

Introducing growth
The dividend valuation model with constant growth
d 1 d0 (1 + g)
Ke = +g or Ke = +g
P0 P0

where g = a constant rate of growth in dividends

d1 = dividend to be paid in one year’s time
d0 = current dividend

5
Example 3
Arusha Ltd has a share price of Tzs 8,000 ex-div and has recently paid out a
dividend Tzs 400. Dividends are expected to growth at an annual rate of 5%

Required:
What is the cost of equity?

Estimating Growth
There are 2 main methods of determining growth:
1 THE AVERAGING METHOD

do
g = n - 1
dn

Where do = current dividend

dn = dividend n years ago

Example 4
Marine Ltd paid a dividend of Tzs 400 per share 4 years ago, and the current
dividend is Tzs 660. The current share price is Tzs 12,000 ex div.

Required:
(a) Estimate the rate of growth in dividends.
(b) Calculate the cost of equity.

Example 5
ABC Ltd paid a dividend of Tzs 120 per share 8 years ago, and the current dividend
is Tzs 220. The current share price is Tzs 5,160 ex div.

Required:

Calculate the cost of equity.

2 GORDON’S GROWTH MODEL

g = rb
where r = return on reinvested funds
b = proportion of funds retained

Example 6
The ordinary shares of XYZ Ltd are quoted at TZS 10,000 cum div. A dividend of
Tzs 800 is just about to be paid. The company has an annual accounting rate of
return of 12% and each year pays out 30% of its profits after tax as dividends.

Required:
Estimate the cost of equity.

6
THE CAPITAL ASSET PRICING MODEL (CAPM)
A model that values financial instruments by measuring relative risk. The basis of
the CAPM is the adoption of portfolio theory by investors.

Portfolio theory

Risk and Return

The basis of portfolio theory is that an investor may reduce risk with no impact on
return as a result of holding a mix of investments.

Risk of
portfolio
() Unsystematic
Risk

Systematic
Risk

No. of shares in portfolio

Capital asset pricing model

Systematic and non-systematic risk

If we start constructing a portfolio with one share and gradually add other shares to
it we will tend to find that the total risk of the portfolio reduces as follows:
Initially substantial reductions in total risk are possible; however, as the portfolio
becomes increasingly diversified, risk reduction slows down and eventually stops.
The risk that can be eliminated by diversification is referred to as unsystematic risk.
This risk is related to factors that affect the returns of individual investments in
unique ways, this may be described as company specific risk.
The risk that cannot be eliminated by diversification is referred to as systematic
risk. To some extent the fortunes of all companies move together with the
economy. This may be described as economy wide risk.
The relevant risk of an individual security is its systematic risk and it is on this basis
that we should judge investments. Non systematic risk can be eliminated and
is of no consequence to the well-diversified investor.

Implications
1. If an investor wants to avoid risk altogether, he must invest in a portfolio
consisting entirely of risk-free securities such as government debt.
2. If the investor holds only an undiversified portfolio of shares he will suffer
unsystematic risk as well as systematic risk.

7
 3. If an investor holds a ‘balanced portfolio’ of all the stocks and shares on the
stock market, he will suffer systematic risk which is the same as the average
systematic risk in the market.
4. Individual shares will have systematic risk characteristics which are different
to this market average. Their risk will be determined by the industry sector
and gearing (see later). Some shares will be more risky and some less.

 (beta) factor
The method adopted by CAPM to measure systematic risk is an index . The 
factor is the measure of a share’s volatility in terms of market risk
The  factor of the market as a whole is 1. Market risk makes market returns
volatile and the  factor is simply a yardstick against which the risk of other
investments can be measured.
The  factor is critical to applying the CAPM, it illustrates the relationship of an
individual security to the market as a whole or conversely the market return given
the return on an individual security.
For example, suppose that it has been assessed statistically that the returns on
shares in XYZ plc tend to vary twice as much as returns from the market as a
whole, so that if market returns went up by 6%, XYZ’s returns would go up by 12%
and if market returns fell by 4% then XYZ’s returns would fall by 8%, XYZ would be
said to have a  factor of 2.

The security market line

The security market line gives the relationship between systematic risk and return.
We know 2 relationships.

1 The risk-free security

This carries no risk and therefore no systematic risk and therefore has a eta of
zero.

2 The market portfolio

This represents the ultimate in diversification and therefore contains only
systematic risk. It has a eta of 1.

Return
(%age)

Rm

Rf

1.0 Risk (β)

8
From the graph it can be seen that the higher the systematic risk, the higher the
required rate of return.
The SML and the relationship between required return and risk can be shown using
the following formula:
Ke = Rf + (Rm - Rf) 
where Ke = required return from individual security
 = Beta factor of individual security
Rf = risk-free rate of interest
Rm = return on market portfolio

Criticisms of the CAPM

1. CAPM is a single period model, this means that the values calculated are only
valid for a finite period of time and will need to be recalculated or updated at
regular intervals.
2. CAPM assumes no transaction costs associated with trading securities
3. Any eta value calculated will be based on historic data which may not be
appropriate currently. This is particularly so if the company has changed the
capital structure of the business or the type of business they are trading in.
4. The market return may change considerably over short periods of time.
5. CAPM assumes an efficient investment market where it is possible to diversify
away risk. This is not necessarily the case meaning that some unsystematic
risk may remain.
6. Additionally, the idea that all unsystematic risk is diversified away will not
hold true if stocks change in terms of volatility. As stocks change over time it
is very likely that the portfolio becomes less than optimal.
7. CAPM assumes all stocks relate to going concerns, this may not be the case.

Example 7 Plan Ltd

The market return is 15%. Plan Ltd has a beta of 1.2 and the risk-free return is
8%.

Required:
What is the cost of capital?

Example 8 Task plc

The risk-free rate of return is 8%
The market risk premium is 6%
The beta factor for Task plc is 0.8

Required:
What would be the expected annual return?

9
KD – THE COST OF DEBT
The cost of debt is the rate of return that debt providers require on the funds that
they provide. We would expect this to be lower than the cost of equity.
The value of debt is assumed to be the present value of its future cash flows.

Terminology
1. Loan notes, bonds and debentures are all types of debt issued by a company.
Treasury bills are debt issues by a government.
2. Traded debt is always quoted in $100 nominal units or blocks
3. Interest paid on the debt is stated as a percentage of nominal value ($100 as
stated). This is known as the coupon rate. It is not the same as the cost of
debt.
4. Debt can be:
(i) Irredeemable – never paid back
(ii) redeemable at par (nominal value)
(iii) or redeemable at a premium or discount (for more or less).
5. Interest can be either fixed or floating (variable). All questions are likely to
give fixed rate debt.

Kd for irredeemable debt

Irredeemable debt is very rare. (The reason for learning the valuation is that it
gives a quick way to calculate the cost of debt if the current market value and the
redemption value of the debt are the same (see example 14).)
i(1 - T)
Kd =
P0

where i = interest paid

T = marginal rate of tax
P0 = ex interest (similar to ex div) market price of the loan stock.

Example 9 Rafa
The 10% irredeemable loan notes of Rafa plc are quoted at Tzs 240,000 ex int.
Corporation tax is payable at 30%.

Required:
What is the net of tax cost of debt?

10
Kd for redeemable debt
The Kd for redeemable debt is given by the IRR of the relevant cash flows. The
relevant cash flows would be:

Year Cash flow

0 Market value of the loan note P0
1 to n Annual interest payments i(1 - T)
N Redemption value of loan RV

Example 10 Warnock Ltd

Warnock Ltd has 10% loan notes quoted at Tzs 204,000 ex int redeemable in 5
years’ time at par. Corporation tax is paid at 30%.

Required:
What is the net of tax cost of debt?

Technique
1. 7 columns
2. Identify the cash flows
3. discount at 5% and 10%
4. slot values in the IRR formula
3. discount at 10%
4. if npv is positive discount at 15%, if negative, discount at 5%
5. slot values in the IRR formula.

Kd for redeemable debt (when redeemed at current market

value)
We could just use the technique outlined above but if the current market value and
the redemption value are the same instead the irredeemable debt formula can be
used.

Example 11 Rafa
The 10% loan notes of Rafa plc are quoted at Tzs 240,000 ex int. Corporation tax is
payable at 30%. They will be redeemed at a premium of Tzs 40,000 over par in 4
years’ time

Required:
What is the net of tax cost of debt?
(a) Using redeemable debt calculation?
(b) Using irredeemable debt calculation?

11
Convertible debt
A loan note with an option to convert the debt into shares at a future date with a
predetermined price. In this situation the holder of the debt has the option
therefore the redemption value is the greater of either:
1. The share value on conversion or
2. The cash redemption value if not converted.

Example 12 Dudek
Dudek has convertible loan notes in issue that may be redeemed at a 10%
premium to par value in 4 years. The coupon is 10% and the current market value
is Tzs 190,000.
Alternatively, the loan notes may be converted at that date into 25 ordinary shares.
The current value of the shares is Tzs 8,000 and they are expected to appreciate in
value by 6% per annum

Required:
What is the cost of the redeemable debt?

Non-tradeable debt
A substantial proportion of the debt of companies is not traded. Bank loans and
other non-traded loans have a cost of debt equal to the coupon rate adjusted for
tax.
Kd = Interest (Coupon) rate x (1 – T)

Example 13 Traore
Traore has a loan from the bank at 12% per annum. Corporation tax is charged at
30%

Required:
What is the cost of debt?

12
 Preference shares
A fixed rate charge to the company in the form of a dividend rather than in terms of
interest. Preference shares are normally treated as debt rather than equity but they
are not tax deductible. They can be treated using the dividend valuation model with
no growth
d
Kp =
P0

Example 14 Hamann
Hamann’s 9% preference shares (Tzs 1,000) are currently trading at Tzs
1,400 ex-div.

Required:
What is the cost of the preference shares?

WACC – WEIGHTED AVERAGE COST OF CAPITAL

The weighted average cost of capital is the average of cost of the company’s
finance (equity, loan notes, bank loans, preference shares) weighted according to
the proportion each element bears to the total pool of funds
A company’s WACC can be regarded as its opportunity cost of capital/marginal cost
of capital, and this cost of capital can be used to evaluate the company’s
investment projects if the following conditions apply:
1. The project is insignificant relative to the size of the company;
2. Or the company adopts a ‘pooled funds’ approach and:
(i) The company will maintain its existing capital structure in the long run
(i.e. same financial risk);
(ii) The project has the same degree of systematic (business) risk as the
company has now.

Example 15 Baros plc

Baros plc has 20m ordinary Tzs 250 shares quoted at Tzs 3,000, and Tzs 8 billion of
loan notes quoted at Tzs 85,000.
The cost of equity has already been calculated at 15% and the cost of debt (net of
tax) is 7.6%

Required:
Calculate the weighted average cost of capital.

13
Review Question:

Widnor Co wishes to calculate its Weighted Average Cost of Capital (WACC) and the following is the
current information relating to the company.

Number of ordinary shares 4 million

Number of 5%, $ 200 Non-callable preferred stock 2 million

Book value of 10%, $ 2000, irredeemable bonds $ 40 million

Market price of ordinary shares $ 100 cum dividend

Market price of 5%, $ 200, Non-callable preferred stock $ 86 ex dividend

Total dividend just paid $ 8 million

Market price of 10%, $ 2,000, irredeemable bonds 105 percent ex interest

Equity beta of Widnor Company 1.5

Treasury bill rate 5%

Expected return on the market 12%

Additional information:

(i) The dividends of Widnor Co are expected to grow at an average rate of 8%.
(ii) The Corporate tax rate applicable to Widnor Co is 30%.

Required:

(a) Using the Dividend Growth Model (DGM), calculate the market value Weighted Average Cost of
Capital of Widnor Co.
(b) Using the Capital Asset Pricing Model (CAPM), calculate the market value Weighted Average
Cost of Capital of Widnor Co.
(c) Discuss whether the Dividend Growth Model or the Capital Asset Pricing Model offers the
better estimate of the cost of equity of Widnor Co.

14