Sources of Finance and the
Cost of Capital
Session Summary (1)
learning objectives
sources of finance
equity capital compared with debt capital
gearing
the weighted average cost of capital (WACC)
cost of debt
Session Summary (2)
cost of equity
risk
CAPM and the  factor
return on equity and financial structure
economic value added (EVA) and market value
added (MVA)
Learning Objectives (1)
identify the different sources of finance available to
an organisation
explain the concept of gearing, or the debt/equity ratio
explain what is meant by the weighted average cost of
capital (WACC)
calculate the cost of equity and the cost of debt
Learning Objectives (2)
appreciate the concept of risk with regard to capital
investment
outline the capital asset pricing model (CAPM), and the 
factor
analyse return on equity as a function of financial structure
explain the use of economic value added (EVA) and
market value added (MVA) as performance measures and
value creation incentives
Sources of Finance (1)
Two main sources of external finance are available to
a company
equity (ordinary shares)
debt (loans or debentures)
or a combination of these such as convertible loans
(hybrid finance), or preference shares
other external sources are
leasing
UK Government and European funding
Sources of Finance (2)
Sources of internal finance to a company are
its retained earnings
extended credit from suppliers
benefits gained from more effective management of its
working capital
Equity Capital Compared with
Debt Capital
Gearing (1)
gearing, or the debt/equity ratio, is the relationship
between the two sources of finance, loans and
ordinary shares
a company having more debt capital than share capital
is highly geared, and a company having more share
capital than debt capital is low geared
Gearing (2)
The following are two of the most commonly-used
gearing ratios
gearing
=
debt equity ratio =
or leverage (D/E)
long-term debt
equity + long-term debt
long-term debt
equity
Gearing (3)
Other important ratios related to gearing are
dividend cover (times)
=
earnings per share (eps)
dividend per share
interest cover (times) = profit before gross interest and tax
gross interest payable
cash interest cover
= net cash inflow from operations + interest received
interest paid
The Weighted Average Cost of
Capital (WACC) (1)
The weighted average cost of capital (WACC) is
the average cost of the total financial resources of
a company
which are
the shareholders equity and the net financial debt
WACC may be used as the discount factor to evaluate
projects, and as a measure of company performance
The Weighted Average Cost of
Capital (WACC) (2)
If shareholders equity is E and net financial debt is D
then the relative proportions of equity and debt in the
total financing are:
E
E + D
and
D__
E + D
if the return on shareholders equity is e and the return on
financial debt is d, and t is the rate of corporation tax
WACC =
E
x e
(E + D)
+
D
x d (1 - t)
(E + D)
Cost of Debt
cost of debt is the cost of servicing debt capital, the
interest paid yearly of half-yearly, which is an allowable
expense for tax purposes
If i is the annual loan interest rate and L is the current
market value of the loan and the cost of debt is d then the
cost of debt may be stated as
d
=
i x (1 - t)
L
Cost of Equity
cost of equity is the cost to the company of its ordinary
share capital
cost of equity may be determined from the present value
of expected future dividend flows, growing at a constant
rate
If e is the cost of equity capital, v is the expected future
dividends for n years at a constant growth rate of G, and S
is the current market value of the share then the cost of
equity may be stated as
e = v + G
S
Risk
both the cost of debt and the cost of equity are based on
future income flows, and the risk associated with such
returns
a certain element of risk is unavoidable whenever any
investment is made, and unless a market investor settles
for risk-free securities, the actual return on investment
in equity (or debt) capital may be better or worse than
hoped for
systematic risk may be measured using the capital asset
pricing model (CAPM), and the  factor, in terms of its
effect on required returns and share prices
CAPM and the Beta  Factor
If Rf is the risk-free rate of return, and Rm is the return
from the market as a whole then (Rm - Rf) is the market
risk premium and
If e is the cost of equity capital and the beta value for the
company's equity capital is e, then
the return expected by ordinary shareholders, or the cost
of equity to the company = the risk-free rate of return plus
a premium for market risk adjusted by a measure of the
volatility of the ordinary shares of the company
e = Rf + {e x (Rm - Rf)}
Return on Equity and
Financial Structure
the return on equity may be considered as a function of
the gearing, or financial structure of the company
If D is the debt capital, E the equity capital, t the
corporation tax rate, i the interest rate on debt, ROI the
return on investment , and ROS the return on sales then
ROE return on equity may be expressed as
ROE = {ROI x (1 - t)} + {(ROI - i) x (1 - t) x D/E}
Economic Value Added (EVA)
and Market Value Added
(MVA) (1)
the recently-developed techniques of economic value
added (EVA) and market value added (MVA) are widely
becoming used in business performance measurement
and as value creation incentives
If profit after tax is PAT, weighted average cost of capital
is WACC, and the adjusted book value of net assets is NA
then we may define EVA as
EVA = PAT - (WACC x NA)
Economic Value Added (EVA)
and Market Value Added
(MVA) (2)
at the company level, the present value of EVAs equals
a business’s market value added (MVA)
MVA may be defined as the difference between the
market value of the company and the adjusted book
value of its assets