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TOPIC: COST OF CAPITAL

Coverage:

 Calculate a share price & cost of equity using the dividend valuation model (DVM)
 Calculate dividend growth using the dividend growth model (DGM)
 Discuss the weaknesses of the DVM
 Define and distinguish between systematic and unsystematic risk
 Explain the relationship between systematic risk and return and describe the assumptions and
components of the capital asset pricing model (CAPM)
 Use the CAPM to find a company’s cost of equity
 Explain and discuss the advantages and disadvantages of the CAPM
 Calculate the cost of finance for irredeemable debt, redeemable debt, convertible debt, preference
shares and bank debt
 Calculate an appropriate WACC for a company in a scenario, identifying the relevant data.

The cost of each source of finance to the company can be equated with the return which the providers of
finance (investors) are demanding on their investment.
This return can be expressed as a percentage (effectively, an interest rate) that can be used as the overall
measure of cost, i.e. the cost of money is the percentage return a firm needs to pay its investors.

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To calculate the return being demanded, we will assume that in a perfect market:
* Market value of investment = the present value of the expected future returns discounted at
the investors' required return
This is the same as saying:
* The investor's required rate of return = the IRR achieved by investing the current price and receiving the
future expected returns
This is the base premise that will be assumed for all of the subsequent workings in our cost of capital
calculation.
1) ESTIMATING THE COST OF EQUITY – Using Dividend Valuation Model (DVM)
The cost of equity finance to the company is the return the investors expect to achieve on their shares.
Using our base premise outlined above, we will be able to determine what return investors expect to
receive by looking at how much they are prepared to pay for a share.
Assumptions:
 Future income stream is the dividends paid out by the company
 Dividends will be paid in perpetuity
 Dividends will be constant or growing at a fixed rate.
Therefore;
Share price = Dividends paid in perpetuity discounted at the shareholder’s rate of return.
Weaknesses
 Future dividend patterns will probably not be constant. (Inflation & economic changes)
 The growth in earnings are ignored
 The current share price can be subject to other influences such as takeover bids
DVM – assuming constant dividends
The formula for valuing a share is therefore:
Po = D/re
Where:
D = constant dividend from year 1 to infinity
P0 = share price now (year 0)
re= shareholders’ required return
For a listed company, since the share price and dividend payment are known, the shareholder’s required
return can be found by rearranging the formula:
re = D/ P0

Example 1
A company has paid a dividend of 30c for many years. The company expects
to continue paying dividends at this level in the future. The company’s
current share price is $1.50. Calculate the cost of equity.

DVM - assuming dividend growth at a fixed rate

Although in reality a firm’s dividends will vary year on year, a practical assumption is to assume a constant
growth rate in perpetuity.

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The share valuation formula then becomes:

Where:
g = constant rate of growth in dividends, expressed as a decimal
D1 = dividend to be received in one year – i.e. at T1
Do (1+g) = dividend just paid, adjusted for one year’s growth.

Therefore to find the cost of equity the formula can be rearranged to:

Example 2
P Co has just paid a dividend of 10c. Shareholders expect dividends to grow
at 7% pa. P Co’s current share price is $2.05.
Calculate the cost of equity of P Co.

Note how the terms re (the shareholder's required return) and ke (the cost of equity) can be used
interchangeably. Don't let this terminology put you off.
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.
If the first dividend is receivable immediately, then the share is termed cum div. In such a case the share
price would have to be converted into an ex div share price, i.e. by subtracting the dividend due for
payment.

Po represents the ‘ex div’ share price. A question may give you the cum div share price by stating that the
dividend is to be paid shortly. Cum div share
price – dividend due = Ex div share price.

Example 3
D Co is about to pay a dividend of 15c. Shareholders expect dividends to
grow at 6% pa. D Co’s current share price is $1.25.
Calculate the cost of equity of D Co.

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Estimating Growth (g)

Two ways of estimating the likely growth rate of dividends are:
1. Based on past dividend patterns (extrapolating)
2. Based on level of retained earnings
Past dividends
This method assumes that the past pattern of dividends is a fair indicator of the future.
The formula for extrapolating growth can be written as:
𝑛
g = √(𝐷𝑜) – 1
𝐷𝑛

Where; n = number of years of dividend growth

Example 4
A company currently pays a dividend of 32c; Five years ago the dividend
was 20c. Estimate the annual growth rate in dividends.

The earnings retention model (Gordon’s growth model)

Assumption; The higher the level of retentions in a business, the higher the potential growth rate.
The formula is therefore: g = b × re
where:
re= accounting rate of return
b = earnings retention rate

Example 5
A company is about to pay an ordinary dividend of 16c a share. The share price is 200c.
The accounting rate of return on equity is 12.5% and 20% of earnings are paid out as
dividends. Calculate the cost of equity for the
company.
2) ESTIMATING THE COST OF EQUITY - Using Capital Asset Pricing Model (CAPM)
This method also looks at the cost of equity (like DVM) but looks more closely at the shareholder’s risk
rather than return. The more risk a shareholder takes, the more return he will want, so the cost of equity will
increase.
For example, a shareholder looking at a new investment in a different business area may have a different
risk. The model assumes a well-diversified investor.
It suggests that the required rate of return (cost of equity) will be the risk free return + any risk premium
associated with that particular investment.
Required Return (re) = Rf + β(Rm - Rf)

Where;
Rf = Risk free return for that investment/share

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Rm = Average return for the whole market

Rm - Rf = Average market risk premium
Beta (β )= How much of the average market risk premium (Rm - Rf) is needed
More technically Beta (β) = Systematic risk of the investment compared to the market
Advantages
 The relationship between risk and return is market based
 Correctly looks at systematic risk only
 Good for appraising specific projects and works well in practice
Disadvantages
 It presumes a well-diversified investor. Others, including managers and employees may well want
to know about the unsystematic risk also
 The return level is only seen as important not the way in which it is given. For example dividends
and capital gains have different tax treatments which may be more or less beneficial to individuals.
 It focuses on one period only.
 Some inputs are very difficult to get hold of. For example beta needs a subjective analysis
 Generally CAPM overstates the required return for high beta shares and vice versa
DVM or CAPM?

The dividend growth model allows the cost of equity to be calculated using empirical values readily
available for listed companies. Measure the dividends, estimate their growth (usually based on historical
growth), and measure the market value of the share (though some care is needed as share values are
often very volatile). Put these amounts into the formula and you have an estimate of the cost of equity.
However, the model gives no explanation as to why different shares have different costs of equity. Why
might one share have a cost of equity of 15% and another of 20%?
The reason that different shares have different rates of return is that they have different risks, but this is not
made explicit by the dividend growth model. That model simply measures what’s there without offering an
explanation. Note particularly that a business cannot alter its cost of equity by changing its dividends.
The equation: re = (D0(1 + g)/P0) + g might suggest that the rate of return would be lowered if the company
reduced its dividends or the growth rate. That is not so. All that would happen is that a cut in dividends or
dividend growth rate would cause the market value of the company to fall to a level where investors obtain
the return they require.
The CAPM explains why different companies give different returns. It states that the required return is
based on other returns available in the economy (the risk free and the market returns) and the systematic
risk of the investment – its beta value.

Not only does CAPM offer this explanation, it also offers ways of measuring the data needed. The risk free
rate and market returns can be estimated from economic data. So too can the beta values of listed
companies.

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When an investment and the market is in equilibrium, prices should have been adjusted and should have
settled down so that the return predicted by CAPM is the same as the return that is measured by the
dividend growth model.
Note also that both of these approaches give you the cost of equity. They do not give you the weighted
average cost of capital other than in the very special circumstances when a company has only equity in its
capital structure.
The CAPM represents the required rate of return as the sum of the risk-free rate of return and a risk
premium reflecting the systematic risk of an individual company relative to the systematic risk of the stock
market as a whole.
This risk premium is the product of the company’s equity beta and the equity risk premium. The CAPM
therefore tells us what the cost of equity should be, given an individual company’s level of systematic risk.
The individual components of the CAPM are found by empirical research and so the CAPM gives rise to a
much smaller degree of uncertainty than that attached to the future dividend growth rate in the dividend
growth model.
For this reason, it is usually suggested that the CAPM offers a better estimate of the cost of equity than the
dividend growth model.

Systematic Risk vs. Unsystematic Risk

Systematic risk is caused by general economic factors. All companies, though, do not have the same
systematic risk as some are affected more or less than others by external economic factors. So it is a
market wide risk - such as state of the economy
Beta (β) = Measures systematic risk of the investment compared to the market

How risky is the specific investment compared to the market as a whole? This is the ‘beta’ of the
investment (ß).
 If ß is 1, the investment has the same risk as the market overall.
 If ß > 1, the investment is riskier (more volatile) than the market and investors should demand a
higher return than the market return to compensate for the additional risk
 If ß < 1, the investment is less risky than the market and investors would be satisfied with a lower
return than the market return.
Illustration
Risk free rate = 5%; Market return = 14%
What returns should be required from investments whose beta values are: (i) 1 (ii) 2 (iii) 0.5
Solution:
Cost of Equity = Rf + ß(Rm - Rf)
(i) = 5 + 1(14 - 5) = 14%
The return required from an investment with the same risk as the market, which is simply the market return.

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(ii) = 5 + 2(14 - 5) = 23%

The return required from an investment with twice the risk as the market. A higher return than that given by
the market is therefore required.
(iii) = 5 + 0.5(14 - 5) = 9.5%
The return required from an investment with half the risk as the market. A lower return than that given by
the market is therefore required.
Non Systematic Risk; Risk that is unique to a certain asset or company. An example of nonsystematic risk
is the possibility of poor earnings or a strike amongst a company's employees.
One may mitigate non-systematic risk by buying different securities in the same industry or different
industries. For example, a particular oil company has the diversifiable risk that it may drill little or no oil in a
given year. An investor may mitigate this risk by investing in several different oil companies as well as in
companies having nothing to do with oil.

Nonsystematic risk is also called diversifiable risk.

EXERCISE!!!
IAA Ltd wishes to calculate its Cost of Equity and the following is the current information relating to the
company.
Number of ordinary shares 2 million
Market price of ordinary shares Tshs 50 cum dividend
Total dividend just paid Tshs 4 million
Equity beta of IAA company 1.5
Treasury bill rate 5%
Expected return on the market 12%
Additional information:
i. The corporate tax rate applicable to IAA Ltd is 35%.
ii. The dividends of IAA Ltd are expected to grow at an average rate of 6%.
REQUIRED:
a) Estimate the IAA Ltd’s equity risk premium
b) Calculate the Company Cost of Equity using:
(i) The dividend growth model
(ii) The Capital Asset Pricing Mode

3) Estimating the cost of preference shares

Preference shares usually have a constant dividend. So the same approach can be used as we saw with
estimating the cost of equity with no growth in dividends.
The formulae are therefore:
Kp = D/P0 P0 = D/KP
Where:
D = the constant annual preference dividend

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Po = ex div Market Value (MV) of the share

Kp = cost of the preference share.
The fixed dividend is based on the nominal value of the preference share, which may vary. Do not assume
the nominal value is always $1.

Example 6
A company has 50,000 8% preference shares in issue, nominal value$1. The current ex
div MV is $1.20/share. What is the cost of the preference
shares?
4) Estimating the cost of debt
Types of debt

Terminology
Key points to note:
 The terms loan notes, bonds, loan stock and marketable debt, are used interchangeably. Gilts are
debts issued by the government.
 Irredeemable debt – no repayment of principal – interest in perpetuity.
 Redeemable debt – interest paid until redemption of principal.
 Convertible debt – may be later converted to equity.
 Debt is always quoted in $100 nominal value blocks.
 Interest paid on debt is stated as a percentage of nominal value – called the coupon rate
 The terms ex-interest and cum-interest are used in much the same way as ex-div and cum-div was
for the cost of equity calculations
The coupon rate

The coupon rate is fixed at the time of issue, in line with the prevailing market interest rate. An 8% coupon
rate means that $8 of interest will be paid on $100 nominal value block of debt.
The market value (MV) of loan notes may change daily. The main influence on the price of a loan note is
the general level of interest rates for debt at that level of risk and for the same period to maturity.
Cost of debt and the impact of tax relief

A distinction must be made between the required return of debt holders /lenders (Kd) and the company’s
cost of debt (Kd(1-T)).
Although in the context of equity the company’s cost is equal to the investor’s required return, the same is
not true of debt. This is because of the impact of tax relief.
The impact of tax

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Consider two companies, identical apart from the choice of finance: A is all equity financed; B has $10,000
of 10% fixed interest debt.
Profit before interest and tax 10,000 10,000
Interest cost (1000)
Profit before tax 10,000 9,000
Tax @ 30% 3,000 2,700

B has paid $300 less tax because of the tax deductibility of the debt interest.
Therefore the net cost of the debt interest to B is:
Interest cost 1,000
Less: Tax saving (300)
Net cost 700
So B’s actual cost of debt is 700/10,000 = 7%
i.e. I (1 – T)
where:
I = coupon rate
T = rate of corporation tax.
Consequently we will use separate terms to distinguish the two figures:
• 'Kd' = the required return of the debt holder (pre-tax)
• 'Kd (1 – T)' = the cost of the debt to the company (post-tax).

Irredeemable debt
The company does not intend to repay the principal but to pay interest forever.
Assumptions:
 Market price (MV) = Future expected income stream from the debenture discountedat the
investor’s required return.
 Expected income stream will be the interest paid in perpetuity
The formula for valuing a loan note is therefore:
MV = I/Kd
Where:
I = annual interest starting in one year's time
MV = market price of the loan note now (year 0)
Kd = debt holders’ required return (pretax cost of debt), expressed as a decimal.

The required return (pretax cost of debt) can be found by rearranging the formula:
Kd = I/MV
The post-tax cost of debt to the company is found by adjusting the formula to take account of the tax relief
on the interest:
Kd(1-T) = I(1-T)/MV
Where T = rate of corporation tax.

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The MV of the loan notes is set by the investor, who does not get tax relief, and is therefore based on the
interest before tax. The company gets corporation tax relief so the cost of debt calculation for the company
is based on interest after tax.

Example 7
A company has in issue 10% irredeemable debt quoted at $80 ex interest. The
corporation tax rate is 30%
(a) What is the return required by the debt providers (the pretax cost of
debt)?
(b) What is the post-tax cost of debt to the company?

Example 8
A company has irredeemable loan notes currently trading at $50 ex
interest. The coupon rate is 8% and the rate of corporation tax is 30%.
(a) What is the return required by the debt providers (the pretax cost of
debt)?
(b) What is the post-tax cost of debt to the company?

Redeemable debt
The Company will pay interest for a number of years and then repay the principal (sometimes at a premium
or a discount to the original loan amount).
Assumptions:
 Market price = Future expected income stream from the loan notes at the investor’s required return
(pretax cost of debt).
 expected income stream will be:
– Interest paid to redemption
– The repayment of the principal.
Hence the market value of redeemable loan notes is the sum of the PVs of the interest and the redemption
payment.
Illustration of redeemable debt

A company has in issue 12% redeemable loan notes with 5 years to redemption. Redemption will be at par.
The investors require a return of 10%. What is the MV of the loan notes?
Solution
The MV is calculated by finding the PVs of the interest and the principal and totaling them as shown below.
Annuity Cash flow Discount factor @ 10% PV ($)
0 MV Bal. figure (107.59)
1-5 interest payments 12 3.791 45.49
5 capital repayment 100 0.621 62.10
NPV 0

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Note that for the investor the purchase is effectively a zero NPV project, as the present value of the income
they receive in the future is exactly equivalent to the amount they invest today.
The investor’s required return is therefore the internal rate of return (IRR) (breakeven discount rate) for the
investment in the loan notes.
The return an investor requires can therefore be found by calculating the IRR of the investment flows:
T0 MV (x)
T1 – n Interest payments x
Tn Capital repayment x

Example 9
A company has in issue 12% redeemable debt with 5 years to redemption.
Redemption is at par. The current market value of the debt is $107.59. The
corporation tax rate is 30%. What is the return required by the debt
providers (pretax cost of debt)?

If it is the post-tax cost of debt to the company that is required, an IRR is still calculated but as the interest
payments are tax-deductible, the IRR calculation is based on the following cash flows:
T0 MV (x)
T1 – n Interest payments (1 – T) x
Tn Capital repayment x

Example 10
Using the same information as given in the previous example
A company has in issue 12% redeemable debt with 5 years to redemption.
Redemption is at par. The current market value of the debt is $107.59. The
corporation tax rate is 30%. What is the cost of debt to the company (post-
tax 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 preset number of shares.
To calculate the cost of convertible debt you should:
(1) Calculate the value of the conversion option using available data
(2) Compare the conversion option with the cash option. Assume all investors will choose the option with
the higher value.
(3) Calculate the IRR of the flows as for redeemable debt
Note: there is no tax effect whichever option is chosen at the conversion date.

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Example 11
A company has issued convertible loan notes which are due to be redeemed
at a 5% premium in five years’ time. The coupon rate is 8% and the current
MV is $85. Alternatively, the investor can choose to convert each loan note
into 20 shares in five years’ time. The company pays tax at 30% per annum.
The company’s shares are currently worth $4 and their value is expected to
grow at a rate of 7% pa. Find the post-tax cost of the convertible debt to
the company.

Non-tradeable debt
Bank and other non-tradeable fixed interest loans simply need to be adjusted for tax relief:
Cost to company = Interest rate × (1 – T).
Alternatively, the cost of any 'normal' traded company debt could be used instead
Example 12
A firm has a fixed rate bank loan of $1 million. It is charged 11% pa. The
corporation tax rate is 30%. What is the post-tax cost of the loan?

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Estimating the cost of capital

The need for a weighted average cost of capital (WACC)

In the analysis so far carried out, each source of finance has been examined in isolation. However, the
practical business situation is that there is a continuous raising of funds from various sources.
Even if a question tells you that a project is to be financed by the raising of a particular loan or through an
issue of shares, in practice the funds raised will still be added to the firm’s pool of funds and it is from that pool
that the project will be funded.
It is therefore not the marginal cost of the additional finance, but the overall average cost of all finance
raised, that is required for project appraisal.
The general approach is to calculate the cost of each individual source of medium long term finance and
then weight it according to its importance in the financing mix.
This average is known as the weighted average cost of capital (WACC).
A firm’s average cost of capital (ACC) is the average cost of the funds, normally represented by the WACC.
The computed WACC represents the cost of the capital currently employed. This represents financial
decisions taken in previous periods.
Choice of weights
To find an average cost, the various sources of finance must be weighted according to the amount of each
held by the company.
The weights for the sources of finance could be:

 Book values (BVs) – represents historic cost of finance

 Market values (MVs) – represent current opportunity cost of finance.

Wherever possible MVs should be used.

If we use the current proportions in which funds are raised, their weights may be measured by reference to
BVs or MVs.
Note that when using BVs, reserves such as share premium and retained profits are included in the BV of
equity, in addition to the nominal value of share capital.
However, the value of shareholders’ equity shown in a set of accounts will often reflect historic asset
values, and will not reflect the future prospects of an organization or the opportunity cost of equity entrusted
by shareholders. Consequently it is preferable to use MV weights for the equity. Note that when using MVs,
reserves such as share premium and retained profits are ignored as they are in effect incorporated into the
value of equity.
Equally, we should also use the MV rather than the BV of the debt, although the discrepancy between
these is likely to be much smaller than the discrepancy between the MV and BVs of equity.
Calculating weights
When using market values to weight the sources of finance, you should use the following calculations:
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Equity = Market value of each share × number of shares in issue

Debt = (Total nominal value/100) × current market value
Calculating the WACC
The calculation involves a series of steps.
Step 1 Calculate weights for each source of capital.
Step 2 Estimate cost of each source of capital.
Step 3 Multiply proportion of total of each source of capital by cost of that source of capital.
Step 4 Sum the results of Step 3 to give the WACC.
All of the above can be summarized in the following formula,

Where:
Ve and Vd are the market values of equity and debt respectively
Ke is the cost of equity
Kd (1 – T) is the post-tax cost of debt

Example 13
Butch Co has $1 million loan notes in i ssue, quoted at $50 per $100 of
nominal value (also equal to their book value); 625,000 preference shares
quoted at 40c (book value 30c per share) and 5 million ordinary shares
quoted at 25c (book value 20c per share). The cost of capital of these
securities is 9%, 12% and 18% respectively. This capital structure is to be
maintained.
(a) Calculate the weighted average cost of capital using market values
(b) Calculate the weighted average cost of capital using book values and
comment on the difference to your answer from part (a)

Example 14
B Co has 10 million 25c ordinary shares in issue with a current price of 155c cum div. An
annual dividend of 9c has just been proposed. The company
earns an accounting rate of return to equity (ROE) of 10% and pays out 40%
of the return as dividends.
The company also has 13% redeemable loan notes with a nominal value of
$7 million, trading at $105. They are due to be redeemed at par in five
years’ time. If the rate of corporation tax is 33%, what is the company ’s WACC?

© Laurian, Vicent CPA(T), MSc.

 REVIEW QUESTIONS
QUESTION ONE
Gema & Sons Company is an information technology service company listed on the local stock exchange
since 2015. It is based in Dar es Salaam. The company is looking to expand its operations into the provision of
self-service point of sale system for supermarkets across Tanzania. Extracts from the company’s most recent
statement of financial position as 31st December 2021 are set out below:
TZS TZS
Ordinary shares at TZS 2,600 par 36,400,000
5.5% TZS 2,600 irredeemable preference shares 26,000,000
Retained earnings 50,440,000
Total Equity 112,840,000
7% irredeemable debentures at TZS 1,000 par 130,000,000
Current ordinary share dividend is TZS 410 per share and company expects ordinary share dividends to grow
for the foreseeable future at a rate of 12%
The current ex-dividend ordinary share price is TZS 9,100, whilst the current ex-dividend preference share
price is TZS 2,002. The irredeemable debentures have a current ex-interest market price of 84 percent. The
company pays corporation tax at a rate of 35%. The company’s current liabilities do not include any overdraft
borrowing. Regarding the company’s proposed expansion plan, the Chief Executive Officer has expressed his
preference for any financing requirement to come from increasing debt rather than increasing equity in order to
move towards minimizing the company’s weighted average cost of capital.
REQUIRED:
a) Calculate the weighted average cost of capital for Gema & Sons Company and advise the CEO on the
suitability of the WACC on appraising the proposed expansion plan.
b) Construct a brief note discussing the preference of the CEO for any financing requirements to come
from increasing debt rather than increasing equity in order to move towards minimizing the weighted
average cost of capital.

QUESTION TWO
Safari Company wishes to calculate its Weighted Average Cost of Capital (WACC) and the following is the
current information relating to the company.
Number of ordinary shares 2 million
Number of 5%, Tshs.100 non-callable preferred stock 1 million
Book value of 10%, Tshs.1,000, irredeemable bonds Tshs.20 million
Market price of ordinary shares Tshs.50 cum dividend
Market price of 5%, Tshs.100 non-callable preferred stock Tshs.43 ex dividend
Total dividend just paid Tshs.4 million
Market price of 10% Tshs.1,000, irredeemable debt 105 percent ex interest
Equity beta of Safari company 1.5
Treasury bill rate 5%
Expected return on the market 12%
Additional information:
i. The corporate tax rate applicable to Safari Company is 35%.
 ii. The dividends of Safari Company are expected to grow at an average rate of 6%.
REQUIRED:
a) Estimate the Safari Company’s equity risk premium and the cost of equity using the Capital Asset
Pricing Model (CAPM).
b) Calculate the market value Weighted Average Cost of Capital of Safari Company using:
(i) The dividend growth model
(ii) The Capital Asset Pricing Model
c) Discuss whether the dividend growth model or the CAPM offers the better estimate of the equity of a
company.
d) Discuss the circumstances under which the weighted average cost of capital can be used in
investment appraisal.

QUESTION THREE
The equity beta of Fence Co is 0·9 and the company has issued 10 million ordinary shares. The market value
of each ordinary share is TZS 75. The company is also financed by 7% bonds with a nominal value of TZS
1,000 per bond, which will be redeemed in seven years’ time at nominal value. The bonds have a total nominal
value of TZS 140 million. Interest on the bonds has just been paid and the current market value of each bond
is TZS 1,071.4.
Fence Co plans to invest in a project which is different to its existing business operations and has identified a
company in the same business area as the project, Hex Co. The equity beta of Hex Co is 1·2 and the
company has an equity market value of TZS 540 million. The market value of the debt of Hex Co is TZS 120
million.
The risk-free rate of return is 4% per year and the average return on the stock market is 11% per year. Both
companies pay corporation tax at a rate of 20% per year.
REQUIRED:
a) Calculate the current weighted average cost of capital (WACC) of Fence Co.
b) Calculate a risk adjusted weighted average cost of capital (WACC) which could be used in appraising
the new project.
c) Explain the difference between systematic and unsystematic risk in relation to the capital asset pricing
model.

QUESTION FOUR
AMH Co wishes to calculate its current cost of capital for use as a discount rate in investment appraisal. The
following financial information relates to AMH Co:
Financial position statement extracts as at 31 December 2012
TZS000 TZS000
Equity
Ordinary shares (nominal value 50 cents) 4,000
Reserves 18,000 22,000
Long-term liabilities
4% Preference shares (nominal value TZS1) 3,000
7% Bonds redeemable after six years 3,000
 Long-term bank loan 1,000 7,000
29,000
The ordinary shares of AMH Co have an ex div market value of TZS4·70 per share and an ordinary dividend of
36·3 cents per share has just been paid. Historic dividend payments have been as follows:

Year 2008 2009 2010 2011

Dividends per share (cents) 30·9 32·2 33·6 35·0
The preference shares of AMH Co are not redeemable and have an ex div market value of 40 cents per share.
The 7% bonds are redeemable at a 5% premium to their nominal value of TZS100 per bond and have an ex
interest market value of TZS104·50 per bond. The bank loan has a variable interest rate that has averaged 4%
per year in recent years.
AMH Co pays profit tax at an annual rate of 30% per year.
Required:
a) Calculate the market value weighted average cost of capital of AMH Co.
b) Discuss how the capital asset pricing model can be used to calculate a project-specific cost of capital
for AMH Co, referring in your discussion to the key concepts of systematic risk, business risk and
financial risk.
c) Discuss why the cost of equity is always greater than the cost of debt.

QUESTION FIVE
IRQ Co has recently taken out a new variable rate bank loan to fund an expansion programme into the Middle
East. The capital structure of the company is now as follows:
$400m par value of 50c shares trading at $2.30 – IRQ Co has an equity beta of 1.1.
$600m par value of 6% irredeemable loan notes trading at $107.
$100m variable rate bank loan – the current interest charge is 5%.
The directors of IRQ Co are keen to know what the weighted average cost of capital has now become in order
to evaluate projects the company is considering. The expansion into the Middle East is progressing well and
further expansion in the future is likely. During their trips to the Middle East a number of key clients and contacts
have suggested that IRQ Co should consider the use of Islamic Finance for any future expansion.
The risk free rate is 4% and the market premium is 7%. Corporation tax is 28%.
REQUIRED:
a) Calculate the WACC of IRQ Co.
b) Explain the key principles of Islamic Finance and describe how any future variable rate bank loan could
be structured under the principles of Islamic Finance.