Notes were compiled in 2018 based on the 2018 scope and expected outcomes hence adjustments may need to be made for adjustments in the scope or learning outcomes for the current year.
Chapter 9: The cost of capital
9.1 Overview of the cost of capital
Cost of capital – rate of return that a firm must earn on the projects in which it invests to maintain its
market value (of its shares) and attract funds from market supplier of capital
Link between firm’s long-term investment decisions and the wealth of the owners as determined by
investors in the marketplace
Project with a rate of return above cost of capital will increase the value of the firm
It is the ‘magic number’ that is used to decide whether a proposed investment will increase or decrease the
firm’s share price
Only invest if: NPV ≥ R0 or IRR ≥ cost of capital
Some key assumptions
Business risk: risk of firms being unable to cover operating cost – assume to be unchanged when new
project is accepted
o Acceptance will not affect ability to cover operating costs
Financial risk: risk of being unable to cover financial obligations – assume to be unchanged when new
project is accepted
o Acceptance will not affect ability to meet financing costs
After-tax basis: after-tax costs are considered relevant hence the cost of capital is measured on an after-tax
basis
o Assumed to be consistent with the after-tax framework used to make capital budgeting decisions
The basic concept
Positive relationship between risk and return ∴ therefore firm’s financing cost (cost of capital) will change if
the acceptance of a project changes firm’s business or financial risk
Cost of capital easily measured because assume new projects do not change these risks
Cost of capital estimated at given point in time – reflects future cost of funds over the long run – reflects the
interrelatedness of financing activities
Target capital structure – the desired optimal mix of debt and equity financing that most firms attempt to
maintain
o E.g. 40% debt + 60% equity
(Page 351 – 352 for example)
Specific sources of capital
Long-term sources of funds supply permanent financing
Long-term financing supports the firm’s fixed-asset investments
Four basic sources of long-term funds:
o Long-term debt
o Preference shares
o Ordinary shares
o Retained earnings
Specific cost of each source of financing is the after-tax cost of obtaining the financing today, not the
historically-based cost reflected by the existing financing on the firm’s books
Cost of capital values are rough approximates because numerous assumptions and forecasts underlie them
, 9.2 Cost of long-term debt
Cost of long-term debt, ri, is the after-tax cost today of raising long-term funds though borrowing
Assume that funds are raised through the sale of bonds (with annual interest)
Net proceeds received from the sale of a bond = funds actually received from sale (i.e. amount less flotations
cost)
Flotation cost: cost incurred to issue and sell a security
o Includes:
Underwriting costs – compensation earned by investment bankers for selling the security;
and
Administrative costs – issuer expenses (legal, accounting, printing and other expenses)
(Example page 353)
Before-tax cost of debt
Before-tax cost of debt, rd, for a bond can be obtained in any of three ways:
o Quotation
o Calculation
o Approximation
Using cost quotations
When net proceeds = par value, then before-tax cost = coupon interest rate
o E.g. Bond with 10% coupon interest rate that needs net proceeds equal to the bond’s R 1 000 par
value would have a before-tax cost of debt, rd, of 10%
Quotation sometimes used is the yield to maturity (YTM)
o Cost of debt = yield to maturity on the firm’s debt adjusted for floatation costs
o YTM – basically the IRR of a bond
o YTM depends on a number of factors:
Bond’s coupon ratee
Maturity date
Par value
Current market conditions and selling price
o Interest on debt is a tax-deductible expense
This will reduce cost of debt because we use after-tax costs
Calculating the cost
Find before-tax cost of debt by calculating the IRR on the bond cash flows
From issuers point of view, value = cost to maturity of cash flows associated with the debt
What is the cost of debt?
PV = - Net proceeds (selling price – flotation costs)
pmt = Annual interest payments (par value x coupon interest rate)
n = Number of years
FV = Par value
I = YIELD TO MATURITY
(example page 354)
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