Financial Management 244 (Stellenbosch University) Lecture notes on Chapter 11: Cost of Capital. These notes are in-depth lecture notes taken during the online lecture.
11.1. Introduction
The cost of capital is the cost that an entity incurs when raising capital to fund their operations. To
determine exactly what cost of capital means, this term can be subdivided into two main parts:
Cost: this is the price that the business has to pay in order to gain access to various sources
of capital. The business normally has to pay interest on debt instruments and/or dividends
on equity capital. The cost does not refer to the transaction costs incurred to raise the
finance cost, but rather the cost that is incurred that the provider of the capital requires as a
return on the finance that is provided.
Capital: This is the actual finance or funds that is required by the business in order to
operate or expand, and it falls into two broad categories:
o Debt instruments: bonds, debentures, loans and overdrafts
o Equity instruments: ordinary and preference shares
In order for a business to generate a suitable return for the providers of these capital sources, it
needs to know what the cost of the capital associated with these sources is. This is why the business
needs to astatine their cost of capital.
11.2. Pooling of Funds
Projects are not necessarily funded using only debt or equity capital. The pooling of funds principle
states that various sources of finance are pooled or grouped together, and then used to fund the
total project that the business has. Therefore investments are financed out of a pool of funds made
up of debt and equity capital according to the target capital structure of the business. This
essentially means that the entity will decide in advance how much debt and how much equity as a
percentage it is aiming to include into its capital structure. This mix is what the business will use to
fund investments and operations moving forward.
If an entity raises equity today to finance a new investment, it should not use the cost of the equity
to appraise the new investment, but instead use its WACC. Conversely, where an entity uses debt to
finance a new investment, it should not use the cost of the new debt to appraise the investment, but
instead, again, the WACC. The WACC is usually preferred because it is not always possible to identify
which funds are used to fund which investments.
11.3. Cost of Capital
The cost of capital is therefore used during the investment appraisal as a cut-off rate to determine
worthwhile and less worthwhile investments. A business is only going to invest into a project if the
return earned on that project is greater than the cost of the capital that is going to be employed in
order to fund the project. The weighted average cost of capital is the rate that is usually used, rather
than just the cost of each individual source. The WACC takes all the capital sources into
consideration and calculates a weighted cost based on the percentage contribution of each financing
source. The following components are important for calculating WACC:
The cost of ordinary shares (ke)
The cost of preference shares (kp)
Cost of debt capital (kd)
, Types of Equity Financing
There are various types of equity financing that a business can raise:
Ordinary Shares: Ordinary shareholders are essentially the owners of the business. Each
ordinary shareholder has a specific spec within the business, and they expect a return on
their investment (they have a required rate of return). These returns are normally paid in the
form of dividends, but the shareholders can sometimes make a capital gain by purchasing
these shares, holding them for a period, and reselling them at a later stage (usually for a
profit). We know that in South Africa, shares trade on the JSE, and the JSE acts as both a
primary market (when a company issues shares for the very first time) and secondary market
(where existing shares are resold).
11.3.1.2. Preference Shares: These shares earn a fixed dividend rate (a fixed percentage
earned in every period). The types of preference shares are as follows: cumulative, non-
cumulative, redeemable, participating and convertible. Recall chapter 9 for detail on the
different types of preference shares.
11.3.1.3. Reserves and Retained Earnings: Retained earnings are not free, in the sense that
there is an opportunity cost that is associated with using this type of financing.
Types of debt Financing
Like equity financing, there are various types of debt financing that a business can make use of:
Long-term: These are things such as debentures, bonds, mortgages and long-term loans.
Short term: These are things such as short-term loans, bank overdrafts, creditors, tax
payable and dividends payable. For the purpose of the weighted average cost of capital,
these short-term sources of debt (which are usually less than 1 year) are ignored.
11.3.1. Cost of Ordinary Shareholder’s Equity (Ke)
Ordinary shareholders equity consists of ordinary shares raised externally by a new share issue or a
rights issue, or internally by retained earnings. Calculating the cost of ordinary shareholders equity is
challenging because the return that the ordinary shareholders require must include the risk
undertaken in investing in these ordinary shares of the business. The investors required rate of
return is likely to vary 1 year to the next. The cost of ordinary shareholders equity is often referred
to as the cost of ordinary shares, or alternatively, the cost of equity. We can say that the required
rate of return of ordinary shareholders is equal to the cost of equity for the business. There are two
methods used to calculate the cost of equity:
The dividend method: this is only valid if the company pays dividends, and either:
o the dividend valuation model or
o the dividend growth model can be used.
The Capital Asset Pricing Model (CAPM): this takes the risk associated with investing in the
business into consideration.
Method 1A: Dividend valuation model:
This model assumes that the market price of a share is the present value of all future dividends
where a constant annual dividend is paid in perpetuity. So D1 = D2 = D3 because there is essentially
no growth in the dividends. Here, the price of the share equals the dividend divided by the cost of
equity capital. This can be written so that the cost of
equity equals the dividend divided by the price of
the share.
Method 1B: Dividend growth model:
Ordinary shareholders usually expect dividends to increase each year rather than remain constant
forever. The dividend growth model states that the market price of a share is assumed to be the
present value of all future dividends where a constant growing annual dividend is paid in perpetuity.
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