Chapter # 03

Cost of Finance
LO 01: RELATIVE COST OF EQUITY AND DEBT:
Cost of equity, cost of debt and the weighted average cost of capital (WACC)
The cost of capital for investors is the return that investors The cost of capital for a company is the return that it must make
require from their investment. Companies must be able to on its investments so that it can afford to pay its investors the
make a sufficient return from their own capital investments returns that they require. The cost of capital for investors and
to pay the returns required by their shareholders and the cost of capital for companies should theoretically be the
holders of debt capital. The cost of capital for investors same. However, they are different because of the differing tax
therefore establishes a cost of capital for companies. positions of investors and companies.

 For each company there is a cost of equity. This is the  The cost of capital for investors is measured as a pre-tax
return required by its shareholders, in the form of cost of capital.
dividends or share price growth (capital gain).  The cost of capital for companies recognizes that interest
 There is a cost for each item of debt finance. This is the costs are an allowable expense for tax purposes, and the
yield required by the lender or bond investor. cost of debt capital to a company should allow for the tax
 When there are preference shares, there is also a cost relief that companies receive on interest payments,
of preference share capital. reducing their tax payments.
 The cost of debt capital for companies is measured as an
after-tax cost.
The weighted average cost of capital (WACC) is the average cost of all the sources of capital that a company uses. This average
is weighted, to allow for the relative proportions of the different types of capital in the company’s capital structure.
Comparing the cost of equity and the cost of debt:
Aspect Cost of Equity Cost of Debt
Riskiness Generally higher due to volatility in earnings Generally lower due to fixed interest payments.
per share.
Contractual Rights Shareholders do not have rights to dividend Debt capital providers have contractual rights to
payments. interest and principal payments.
Enforcement in Default Shareholders do not have security to enforce Providers of secured debt can enforce their
in default. security.
Priority in Insolvency Shareholders are paid last in the event of Debt capital providers are paid before
insolvency. shareholders.
Since equity has a higher investment risk for investors, the expected returns on equity are higher than the expected returns
on debt capital. In addition, from a company’s perspective, the cost of debt is also reduced by the tax relief on interest
payments. This makes debt finance even lower than the cost of equity.

The effect of more debt capital, and higher financial gearing, on the WACC is considered in more detail later.
LO 02: COST OF EQUITY:
Methods of calculating the cost of equity
The cost of equity is the annual return expected by ordinary shareholders, in the form of dividends and share price growth
(capital gain). However, share price growth is assumed to occur when shareholder expectations are raised about future
dividends. If future dividends are expected to increase, the share price will also increase over time. At any time, the share
price can be explained as a present value of all future dividend expectations.

Using this assumption, we can therefore say that the current value of a share is the present value of future dividends in
perpetuity, discounted at the cost of equity (i.e. the return required by the providers of equity capital).

METHODS FOR CALCULATION OF COST OF EQUITY

The Dividend Valuation Model The CAPM Model

(a) The Dividend Valuation Model Method:
The dividend valuation model (DVM) is a quantitative method used for predicting the price of a company's equity instrument
based on the theory that its present-day price equals the sum of all of its future dividend payments when discounted with the
Cost of Equity (ke) to their present value. It attempts to calculate the fair value of a share irrespective of the prevailing market
conditions and takes into consideration the dividend payout factors and the market expected returns.

DIVIDEND VALUATION MODEL

Without Growth With Growth

(i) Without Growth:
If it is assumed that future annual dividends are expected to remain constant into the foreseeable future and the whole of the
profit will be distributed as dividend, the cost of equity can be calculated by following formula
𝐷
ke = 𝑀𝑉
Market value of equity can be calculated by arranging above formula:
𝐷
MV = 𝑘𝑒
Where:
MV = Market price of the share (Ex – Div)
D = Constant Dividend paid from year 1 to infinity
ke = Shareholder’s required rate of return (expressed in fraction, not percentage)
Some Important Terms:
Cum-dividend market value of share:

Market price of the share prevailing in market, after announcement of dividends but before its payment.
Ex-dividend market value of share:

Market price of the share prevailing in market, immediately after the payment of dividend.

MV (Ex-div) = MV (Cum-div) – Proposed dividend

Illustration # 01:
A company might declare on 1 March that it will pay a dividend of Rs.0.60 per share to all holders of equity shares on 30 April,
and the dividend will be paid on 31 May. Until 30 April the share price allows for the fact that a dividend of Rs.0.60 will be
paid in the near future and the shares are said to be traded ‘cum dividend’ or ‘with dividend’.

After 30 April, if shares are sold they are traded without the entitlement to dividend, or ‘ex dividend’. This is the share price to
use in the cost of equity formula whenever a dividend is payable in the near future and shares are being traded cum dividend.

Illustration # 02:
A company’s shares are currently valued at Rs.8.20 and the company is expected to pay an annual dividend of Rs.0.70 per
share for the foreseeable future. The cost of equity in the company can therefore be estimated as:

𝐷
ke = 𝑀𝑉

0.70
ke = 8.20 = 8.5%
Example # 01:
A company has paid a dividend of Rs. 6 per share for many years. The company expects to continue paying dividends at this
level in the future (means no growth). The company’s current share price is Rs. 30 ex div.
Required:
Calculate the cost of equity.

Answer:
𝐷
ke = 𝑀𝑉
𝑅𝑠. 6
ke = 𝑅𝑠. 30 = 20%

Example # 02:
ABC Company has paid a dividend of Rs. 3.50 for many years. The company expects to continue paying dividends at this level
in the future. The company's current share price is Rs. 20.
Required:
Calculate the cost of equity.

Answer:
𝐷
ke = 𝑀𝑉
𝑅𝑠. 3.50
ke = = 17.50%
𝑅𝑠. 20
Example # 03:
Description A B C D
Profits 460,000 3,000,000 250,000 1,800,000
Shares 25,000 75,000 12,500 60,000
MV per share ? 250 88.89 ?
Cost of Equity 12.50% ? ? 8.00%
Total MV of equity ? 18,750,000 1,111,111 ?
Required:
Complete the above table.
Answer:
Company A: Company B:
D 𝐷
MV = MV =
ke 𝑘𝑒
460,000 3,000,000
MV = = 3,680,000 18,750,000 = = 16%
12.5% 𝑘𝑒
3,680,000
MV per share = = Rs. 147.2/Share
25,000
Company C: Company D:
D 𝐷
MV = MV =
ke 𝑘𝑒
250,000 1,800,000
1,111,111 = = 22.5% MV = = 22,500,000
ke 8%
22,500,000
MV per share = = Rs. 375/Share
60,000
Important Exam Focus Point:
 If both book value and market value of equity are given we will use market value.

 If price to book ratio is given the first we will convert book value into market value

Illustrative Example # 01:

Arsal Limited distributes all its earnings as dividend, The book Value of the equity is Rs. 200,000. Price to book ratio is 1.45.
Annual dividend (which is constant since a long period) is 40,000.

Required:
Calculate the cost of equity.

Answer:
200,000 x 1.45 = 290,000

40,000
ke = = 13.79%
290,000
 (ii) With Growth:

If it is assumed that the annual dividend will grow at a constant percentage rate into the foreseeable future, the cost of equity
can be calculated by following formula.
𝐷𝑜 (1 + 𝑔)
ke = 𝑀𝑉
+g

Market value of equity can be calculated by arranging above formula:

𝐷𝑜 (1 + 𝑔)
MV = 𝑘𝑒 − 𝑔

Where:
Do = Most recent dividend paid or just to be paid
g = Constant Annual growth in dividend (Expressed as fraction)
Do (1 + g) = Dividend expressed after one year
Example # 04:
A company’s share price is Rs.8.20. The company has just paid an annual dividend of Rs.0.70 per share, and the dividend is
expected to grow by 3.5% into the foreseeable future. The next annual dividend will be paid in one year’s time.

Required:
Calculate the cost of equity in the company.

Answer:
𝐷𝑜 (1 + 𝑔)
ke = +g
𝑀𝑉
0.70 (1 + 0.035)
ke = + 0.035 = 12.3%
8.2
Example # 05:
A company has recently paid a dividend Rs. 3 per share and the dividend is expected to grow by 5% into the foreseeable
future. The next annual dividend will be paid in one year’s time. The shareholders require an annual return of 12%.

Required:
Calculate the market value of each equity share.

Answer:
𝐷𝑜 (1 + 𝑔)
MV = 𝑘𝑒 − 𝑔

3 (1 + 0.05)
MV = = Rs. 45/Share
0.12 − 0.05
Example # 06:
Ahmed and Co. is about to pay a dividend of Rs. 3.60. Shareholders expect dividends to grow at 12% Pa. Ahmed and Co.’s
current share price is Rs. 16.50.

Required:
Calculate the cost of equity of Ahmed and Co.

Answer:
𝐷𝑜 (1 + 𝑔)
ke = 𝑀𝑉
+g

3.60 (1 + 0.12)
ke = + 0.12= 36.44%
16.50
Methods for Estimation of Growth:
The growth rate used in the expression is the growth rate that investors expect to occur in the future. This can be estimated in
following ways:

Extrapolation of historical growth

Gordon’s Growth Model

Extension of Gordon’s Growth Model

Growth in Profit

Growth in Net Assets

(i) Extrapolation of Historical Growth:

This is based on the idea that the shareholders’ expectations will be based on what has been experienced in the past. An
average rate of growth is estimated by taking the geometric mean of growth rates in recent years.

𝑉𝑎𝑙𝑢𝑒 𝑎𝑡 𝑒𝑛𝑑 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑 𝑜𝑓 𝑁 𝑦𝑒𝑎𝑟𝑠

Geometric Mean Growth Rate = 𝑛 –1
𝑉𝑎𝑙𝑢𝑒 𝑎𝑡 𝑆𝑡𝑎𝑟𝑡

Formula can also be stated as:

Value at start (1 + g)n = Value at end of period of n years

Where:

n = Number of terms in the series (e.g years of growth)

Example # 07:
A company has paid out the following dividends in recent years:

Year Dividend
20X1 100
20X2 110
20X3 120
20X4 134
20X5 148
Required:
Calculate Growth Rate.

Answer:

𝑉𝑎𝑙𝑢𝑒 𝑎𝑡 𝑒𝑛𝑑 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑 𝑜𝑓 𝑁 𝑦𝑒𝑎𝑟𝑠

Geometric Mean Growth Rate = 𝑛 –1
𝑉𝑎𝑙𝑢𝑒 𝑎𝑡 𝑆𝑡𝑎𝑟𝑡

148
Geometric Mean Growth Rate = 4 – 1 = 10.3%
100
Example # 08:
Dividend history of Shehroz Limited:
Year Dividend Per Share (Rs.)
2016 20
2017 21.5
2018 23.2
2019 24.8
2020 26.2
Cost of equity of SL is 25%.
Required:
Find Market Value Share on 31.12.2020.
Answer:

𝐷𝑜 (1 + 𝑔)
MV = 𝑘𝑒 − 𝑔

26.20 (1 + 0.07)
MV = = Rs. 156/Share
25% − 7%

(W-1) 20 (1 + g)4 = 26.2  g = 7%

Example # 09:
Stop Limited has the following dividend history

Year Dividend Per Share (Rs.)

1 50
2 53

Price per share now is Rs. 432.154.

Required:
Find cost of equity.

Answer:

𝐷𝑜 (1 + 𝑔)
ke = +g
𝑀𝑉

53 (1 + 6%)
ke = + 6% = 19%
432.154

(W-1) 50 (1 + g)1 = 53
g = 6%
(ii) Gordon’s Growth Model: (The earnings retention valuation model)

Dividend growth can be achieved by retaining some profits (retained earnings) for reinvestment in the business. Reinvested
earnings should provide extra profits in the future, so that higher dividends can be paid. When a company retains a
proportion of its earnings each year, the expected annual future growth rate in dividends can be estimated using the formula:

g=bxr

Where:

g = annual growth rate in dividends in perpetuity

b = Proportion of earnings retained or Retention Ratio (for reinvestment in the business)

r = Rate of return that the company will make on its investments