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Paper 14: The cost of capital
Ifirst came across the term “cost of capital” 25 years ago, when I was a trainee accountant at the London headquarters of a global chemical manufacturer. My colleagues in the corporate reporting group and I were preparing the press release that announced the annual financial results to the London and New York stock markets and I saw the term in that release. Not knowing what it referred to, I asked a more experienced colleague to enlighten me and they responded: “It’s the return the investors need to justify putting their money in our business.” This struck me as an important piece of information. My instincts told me that keeping your investors satisfied was something that you should strive for.
In this article, I will look at the meaning behind the weighted average cost of capital with particular focus on AIA’s Paper 14 Financial Management.
The golden rules
Every commercial business, incorporated or not and regardless of its size, has a capital structure. The capital structure refers to the source or sources of finance the business has raised from its investors. This affects everyone from sole trader businesses which use little more than the finance provided by their proprietors when setting up their businesses to multinational corporations with much more complex and varied sources of finance.
Regardless of the size or simplicity of the capital structure, all capital structures have a cost. That is, as my former colleague pointed out to me nearly 25 years ago, the providers of finance expect a return from their investment. Rational investors do not provide their money for free. Based on the length of time they are parting with their money and a number of other factors generally relating to the riskiness
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of their investment, the rational investor will expect a reward in return for letting the business use their money. Generally, a rational investor only accepts higher risk if the reward is commensurately higher.
The golden rules in relation to the cost of capital are as follows: 1. All providers of capital (investors) expect to be rewarded for their investment. 2. Higher risk means higher reward, which means higher cost of capital.
Cost of equity
In most exam questions that I have seen over the last 20 years, a company’s capital structure comprises: finance from the company’s owners (equity); one or two sources of debt; and maybe some preference share capital (which is not
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dealt with here). We start with equity. This is because, with few exceptions, companies will start up with finance from their owners. Other sources of finance are provided to the company later.
If the cost of capital is the annual return required by a company’s investors, the cost of equity (k e) represents the annual return specifically required by the company’s shareholders.
Shareholders are typically rewarded in a combination of two ways.
Firstly, their return can be in the form of capital appreciation. In other words, the value of the company increases from one year to the next and so the shareholder owns something more valuable than before. The share price has gone up. Shareholder wealth has increased.
Secondly, shareholder return can be in the form of dividend payments. In other words, profits generated by the company’s activities are distributed, generally in cash, to the shareholders. The shareholder has more cash than before. Again, shareholder wealth has increased.
The cost of equity measures the total return that the shareholders are expecting. A company with a cost of equity of 16% might generate that return entirely in the form of dividends or entirely in the form of capital appreciation. Alternatively, the 16% return might be made up of a combination of the two.
Broadly speaking, there are two methods of estimating the cost of equity capital: 1. dividend growth model (DGM); and 2. capital asset pricing model (CAPM).
Dividend growth model
We begin by looking at the DGM formula for the cost of equity. A glance at the formula suggests that the cost of equity (k e) is made up of two parts which are added together to get the total required shareholder return. The first part of the formula is the fraction. This takes d0 , the current dividend per share and then multiplies it by 1 plus the expected growth in dividends. So d0(1+g) therefore represents the dividend per share that the shareholders are expecting next year. We then divide the expected dividend by today’s share price (p0). Today’s share price is the financial investment that the shareholder is making today, either by purchasing a new share or continuing to hold onto that share. It follows that the fraction in the DGM represents the expected return in the form of dividends, in percentage terms, over the coming year. The DGM then adds g to the dividend return to reflect that the shareholders may be expecting growth in addition to the dividends. Indeed, the shareholders may not be expecting dividends at all and the company is expected to generate their returns entirely in the form of growth by ploughing cash profits back into the business to fuel growth.
Capital asset pricing model
CAPM aims to estimate k e in a very different way. The formula itself does not differentiate dividends from growth. This does make sense as they both represent the same thing: increases in shareholder wealth. Instead, CAPM estimates k e based on the systematic risk associated with the shareholder’s investment.
Systematic risk is the risk inherent in a share which cannot be diversified away by the shareholder by building a portfolio of a range of different investments. We measure systematic risk using a range of mathematical models but what we are interested in here is how we represent it. We use a beta factor (β) to show the level of systematic risk associated with a share. What does this beta factor tell us? Well, if the beta factor of a share is higher than 1, that means that the share is more volatile than the market as a whole and is therefore riskier than the average share. Conversely, if the share has a beta lower than 1, it is less volatile and less risky than the average share. The higher the beta factor, the higher its systematic risk. And mindful of the second golden rule above, the higher beta factor leads to a higher expected return for those rational shareholders.
Let’s look at the CAPM formula:
ke = rf + β(rm -rf)
Like the DGM, CAPM supposes that the cost of equity is made up of two parts. First is the risk-free rate of return (rf). This is the rate of return you would have to offer an investor to persuade them to part with their money for a time, knowing that they would get every penny
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back at the end of the investment. No investment is entirely risk-free, so rf is quite a theoretical concept, but we often take the yields (returns) on short-term government bonds as the closest we can get to risk-free rates of return.
Then, we add a premium to the risk-free rate to reflect the systematic risk of the share. That premium takes the difference between the average market-rate of return (r m) and the risk-free rate and then multiplies that market premium by the share’s beta factor. Therefore, it follows that a share with a lot of systematic risk will lead to a higher required return. More risk means that a greater return is expected.
What factors affects the cost of equity?
It is not possible to list all the factors that could make a company’s cost of equity higher than that of another. But whether you measure it using the DGM or the CAPM, it all boils down to the risk that shareholders are bearing by investing in that company. Here are a few of the more important factors. 1. Business activities: Some businesses are just riskier than others. Investing money in a research project which promises to cure a deadly disease is hugely risky. On the upside, a company that can cure cancer would generate massive profits if successful.
The downside risk is that the research fails or that the cure has dangerous side-effects, which could mean that the project leaves the shareholders with nothing but losses. The cost of equity of an organisation which engages in this type of activity is likely to be on the high side. The beta factor is likely to be higher than 1 and shareholders would want to see results fast either in the form of dividends or, more likely, growth in the share price. 2. Life cycle of the business: Start-up ventures are riskier than their more mature counterparts. More mature companies have more backers, more organisational experience and more resources, which means that they are likely to be more stable than a new business with no or little track record. 3. Other sources of finance: The presence of financial gearing affects the stability of returns to shareholders because profits and cash are reduced because of the interest paid to the company’s creditors. That risk to shareholders’ returns will inevitably increase the minimum return acceptable to shareholders. 4. General economic conditions: In times of economic growth, the business environment can generate optimism among shareholders and other investors, encouraging them to put money into businesses with confidence. In more difficult and uncertain times, companies may have to promise their shareholders greater reward before they are willing to part with their money. This expectation of greater reward will inevitably push the cost of equity up from the company’s point of view.
Cost of debt
The cost of debt (kd) is the cost to a company of providing its lenders with their expected annual percentage return. In very simple terms, this could be viewed as the interest that a business has to pay to its lenders in order to persuade the lenders to lend. However, in a world with tax, the cost of debt is likely to be lower than the annual return expected by lenders. This is because the borrowing company will get tax relief for their finance costs relating to debt, whereas this is not the case for equity. If a company must pay £100 million in interest to its lenders in a year, it will deduct the interest from its taxable profits and thereby get a tax saving on that interest. So, if the company pays its corporate tax at 20%, then the after-tax cost of the interest is:
£100m x (1-0.20) = £80m.
In other words, the return is £100 million but the cost is only £80 million. The same effect is true if we express kd as a percentage. The cost of loan finance is generally the interest rate agreed with the bank, adjusted for tax (multiplied by (1-t)). So, if the interest rate is 7% per annum and the company pays tax at 15%, the cost of this loan finance is:
7% x (1-0.15) = 5.95%.
Debt can take other forms in addition to straightforward loans. Larger companies can raise debt on the bond markets. These are securitised debt instruments, which often allows the lender to sell their investment on to alternative lenders. These debt instruments can be redeemable, irredeemable or convertible. Irredeemable bonds are never repaid to lenders; the interest is paid every year into perpetuity. Redeemable bonds pay interest to lenders but will also be repaid on a predetermined date. Convertible bonds are like redeemable bonds, but the lender has a choice of having the bond redeemed or converted into shares in the borrowing company. In this case, the lender becomes a shareholder.
Irredeemable bonds
The cost of irredeemable bonds is calculated by taking the annual interest (i) on each bond and dividing it by the current market value of the bond (p0). If there is tax present in the exam question, you should adjust the interest by multiplying it by (1-t) as follows:
Redeemable and convertible bonds
It is a little more complex for redeemable bonds because the return to lenders consists not just of interest but also a redemption of the bond where the borrowing company buys the bond back from the lender – this acts as a repayment of the debt. To estimate the kd of a redeemable bond, we have to find an internal rate of return (IRR) of the bond cash flows: the current market value of the bond at T0, the interest payments adjusted for tax from T1-n and then the redemption value that is repaid at Tn .
This approach is identical for convertible bonds, except that at Tn we need to use the greater of the redemption value and the conversion value (the predicted value of the shares). This is because at Time n the lender can choose to convert the bond into shares or have the debt repaid. A rational lender would take whichever option is worth more at that time.
What affects the cost of debt?
The same golden rule about risk and return applicable to shareholders also applies to lenders. The higher the risk associated with lending money to a company, the higher the return expected by lenders. The factors affecting the cost of equity also affect the cost of debt. Business activities, lifecycle, stability and maturity are all very relevant to potential and existing lenders. In addition, however, with debt, the existence of security can be helpful in lowering the cost of debt. This is because lenders know that in the event of a default, an asset or assets may be seized in order to compensate for the loss to the lender, thus lowering the lender’s risk.
Also, it is worth bearing in mind that, unless the debt is irredeemable, debt is temporary finance – it has to be paid back at some point, whereas equity is permanent. All other things being equal, the returns required by lenders are generally greater on debt with longer terms to maturity.
Weighted average cost of capital (WACC)
The WACC is the weighted average cost of the capital structure. The calculation is weighted by market values. A company has a cost of equity of 15% and a cost of debt of 5% with shares trading at £700m and debt trading at £300m then the WACC is:
(15% x 700/1,000) + (5% x 300/1,000) = 12%
Why do we need the WACC?
In terms of Paper 14 Financial Management, once the examiner has asked you to calculate the WACC, it is possible that you may have to put it to some use. The most likely way it will be used is in a net present value (NPV) calculation as a discount rate. Discounting projected cash flows using the WACC puts them into present value. An investment with a positive NPV is worthwhile for the organisation because, financially, it meets the requirements of the investors. Even if the investors require a very high return from the organisation’s activities, discounting the cash flows using WACC still ensures that we take account of the cost of rewarding the shareholders and lenders. ● An investment with a positive net present value is worthwhile for the organisation because, financially, it meets the requirements of the investors.”
