Fundamentals of Financial
Management
(ACCA F9)
Riffat Jabeen FCA
1
The Cost of Capital
Chapter 17
ACCA F9
2
Cost of Capital
3
Long term Sources of Finance
Main sources of longterm finance within a company as:
• equity (or ordinary shares)
• preference shares
• debt
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Cost of Equity - DVM
Estimating the cost of equity – the Dividend Valuation Model (DVM)
The cost of equity finance to the company is the return the investors
expect to achieve on their shares.
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Cost of Equity - DVM
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Cost of Equity – DVM (assuming constant dividends)
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Example 1
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Cost of Equity – DVM (assuming dividend growth at a
fixed rate)
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Cost of Equity – DVM (assuming dividend growth at a
fixed rate)
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Example 2 & 3
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Cost of Equity- The ex-div share price
The DVM model is based on the perpetuity formula, which assumes
that the first payment will arise in one year’s time (i.e. at the end of
year 1).
A share price quoted on this basis is termed an ex div share price.
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Cost of Equity- The ex-div share price
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Example 4 & 5
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Cost of Equity- Estimating growth
Two ways of estimating the likely growth rate of
dividends are:
• extrapolating based on past dividend patterns
• assuming growth is dependent on the level of
earnings retained in the business
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Example 6
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Example 7
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Cost of Equity- The earnings retention model
(Gordon’s growth model)
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Example 8
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Example 9
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Cost of Equity- DVM Weaknesses
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Cost of Equity- Estimating the cost of preference
shares
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Example 10
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Estimating the cost of debt
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Estimating the cost of debt
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The cost of debt & Tax Relief
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The cost of debt & Tax Relief
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The cost of debt - Irredeemable debt
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The cost of debt - Irredeemable debt
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The cost of debt - Irredeemable debt
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Example 11
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Example 12
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The Cost of debt - Redeemable debt
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Example 13
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Example 14
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The Cost of debt - Debt redeemable at current market
price
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The Cost of debt - Convertible debt
A form of loan note that allows the investor to choose between
taking the redemption proceeds or converting the loan note into
a pre-set number of shares.
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The Cost of debt - Convertible debt
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The Cost of debt - Non-tradeable debt
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Example 14
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Estimating the cost of capital
This average is known as the weighted average
cost of capital (WACC).
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Estimating the cost of capital
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Estimating the cost of capital
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Example 15
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Example 16
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The Cost of Capital - The impact of risk
The DVM and WACC calculations above assume that an investor’s current
required return will remain unchanged for future projects. For projects with
different risk profiles, this assumption may not hold true.
We therefore need a way to reflect any potential increase in risk in our
estimate of the cost of finance.
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The Cost of Capital - The impact of risk
the total return demanded by an investor is actually dependent
on two specific factors:
• the prevailing risk-free rate (Rf) of return
• the reward investors demand for the risk they take in
advancing funds to the firm.
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The Cost of Capital - The risk-free rate of return (Rf)
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The Cost of Capital - Return on risky investments –
loan notes
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The Cost of Capital - Return on risky investments –
equities
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Estimating the cost of equity – Systematic &
Unsystematic Risk
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Example 17
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The CAPM
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The CAPM
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Example 18
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The CAPM - Assumptions
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The CAPM – Advantages & Disadvantages
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