CHAPTER FOUR

RISK, RETURN AND COST OF CAPITAL

INTRODUCTION
The relationship between risk and return is a major topic in finance theory.
• The conventional wisdom is that investors are risk averse, meaning investor
would avoid risk if they had a choice.
• The higher the risk they associate with a particular investment, the higher the
return they will demand.
RETURN
• Return is the income received on an investment plus any change in market price,
expressed as a percentage of the beginning market price of the investment. –
 cash payments received due to ownership the change in market price.
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• 
 
Where; R = Actual/expected return
t = refers to a particular time period in the past/future
Dt= cash dividend at the end of time period t
Pt= the stock’s price at time period t
` Pt-1= the stock price at time period t-1

2
The above formula can be used to determine both actual one-period
returns (when based on historical figures) and one period returns
(when based on future expected dividends and price).

For example, you might buy a security at K100 that would pay K7 in
cash to you and be worth K106 one year later. The return would be
(K7 + K6)/K100 = 13%. Here the return comes from two sources:
income plus any price appreciation (or loss in price).

3
RISK
• In investment risk means uncertainty as to the outcome or the
variability of returns from those that are expected.
• Any projections of the future need to recognise a margin of error and
any additional risk assumed should be rewarded additional return.
• In any investment there is an element of risk/return trade-off.
• The study will consider the measures of both historical and expected
rates of return and risk.

4
• When we invest, we differ consumption in order to add to our wealth
so that we can consume more in future.
• Our main concern is the change in wealth resulting from this
investment attributed to cash-flows such as interest or dividends or
the change in price of the asset (positive or negative) or a
combination of any of the three factors.

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•  HOLDING PERIOD RETURN (HPR)
The period within which an investment is held is called the Holding
Period, and the return for that period is the Holding Period Return
(HPR). 
 
Note: the HPR value will always be zero or greater, it can never be a
negative value.
• A value greater than one indicates increase in the investors’
wealth, meaning you received a positive rate of return during the
period.
  6
• •  A value less than one indicates a decline in value of wealth (loss).
• An HPR of zero indicates that you lost all your money.
Investors generally evaluate returns in percentages terms on an annual basis for easier
comparison between alternative investments with markedly different characteristics. The first
step is to convert HPR to percentage return called Holding Period Yield (HPY);
HPY = HPR – 1
To derive an annual HPY, you compute an Annual HPR and subtract 1. Annual HPR is
found by
Annual HPR =
Where; n = number of years the investment is held

7
•Mean
  Historical Return
In this section we will consider computation of mean rates of return for a single
investment and for a portfolio of investments.
Example 1
Consider an investment that cost K250 and is worth K350 after being held for
two years. Calculate the Annual HPR and HPY.
HPR = = = 1.40
Therefore, Annual HPR = = = 1.1832
Annual HPY = - 1 = 1.1832 – 1 = 0.1832 = 18.32%

8
• Single
  Investment
There are two sets of returns calculated for a single investment, the Arithmetic Mean and the
Geometric mean.
 
• Arithmetic Mean (AM) =

Where; ∑HPY = the sum of annual holding yields

 
• Geometric Mean (GM) = (πHPR)1/n – 1
 
Where; π = the product of annual holding period returns as follows
(HPR1) x (HPR2) x …………. x (HPRn)

9
Example 2
From the information given below, compute the Arithmetic and
Geometric means.

Year BV EV HPR HPY

1 100.0 115.0 1.15 0.15
2 115.0 138.0 1.20 0.20
3 138.0 110.4 0.80 -0.20

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•Solution
 
• AM = = = = 0.05 = 5%

• GM = (πHPR)1/n – 1
= -1
= 1.03353 – 1
= 0.03353
= 3.353%

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• Investors are typically long term oriented when comparing alternative investment performances.
• Geometric mean is considered superior when measuring the long term mean rate of return
because it indicates the compound annual rate of return based on the ending value of the
investment versus its beginning value.
• Arithmetic mean provides a good indication of the expected rate of return for an investment
during a future individual year, but it is biased upward if you are attempting to measure an
asset’s long term performance especially for a volatile security.
• It is also worth noting that;
 When rates of return are the same all years, both methods will give equal means.
If the rate of return vary over the years, GM will always be less than AM. But the difference will
depend on the year to year changes in the rates of return. More volatility will result in large
differences.
Knowledge of both methods is very important because published accounts uses both.

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• 
Example 3
Consider a security that increases in price from K50 to K100 during year 1 and drops
back to K50 during year 2. Calculate the AM and GM.
Solution
YearBV EV HPR HPY
K K
1 50 100 2.0 1.0
2 100 50 0.5 -0.5

• AM = = = 0.25= 25%

• GM = (πHPR)1/n – 1= - 1 = 1.00 – 1 = 0%

13
Portfolio Investment
• The mean historical rate of return (HPY) for a portfolio of investments
is measured as the weighted average of the HPYs for the individual
investments in the portfolio or overall change in value of the original
portfolio.
• The relative beginning market values for each investment are used as
weights in computing the averages.

14
Example 4
From the information provided below, compute the holding period
yield for the portfolio using distribution approach.
Investment # of shares Beginning Price Ending Price
K K
A 100 10 12
B 200 20 21
C 500 30 33

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• 
Solution - Distribution Approach
Inv # of BP BMP EP EMP HPR HPY MKW Weighted
Shares K K K K HPY
A 100 10 1,000 12 1,200 1.20 0.2 0.05 0.01
B 200 20 4,000 21 4,200 1.05 0.05 0.2 0.01
C 500 30 15,000 33 16,500 1.1 0.1 0.75 0.075
20,000 21,900 WHPY = 0.095

= 9.5%
Proof:
HPR = = 1.095
HPY = HPR – 1 = 1.095 – 1 = 0.095 = 9.5%

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Example 5
At the beginning of last year you invested K4,000 in 80 shares of the
Changu Corporation. During the year Changu paid dividends of K5 per
share. At the end of the year you sold the 80 shares for K59 a share.
Compute your total HPY on these shares and indicate how much was
due to the price change and how much was due to the dividend
income.

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• 
Solution K
Beginning value 4,000
Dividends (80 x K5) 400
Appreciation of share value (80 x K9) 720
Ending value 5,120

HPR = = = 1.28 ; and therefore HPY = HPR – 1 = 1.28 – 1 = 0.28 = 28%

Contributions from dividends and share appreciation;

= x 100% = x 100% =10% and = x 100% = x 100% = 18%

Therefore;
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Expected Rate of Return
• There is great uncertainty regarding future expectations, this uncertainty in investment is referred to
as risk.
• An investor determine how certain the expected rate of return on an investment is by estimates of
expected returns.
• Sometimes an investor can set a single target figure say 10% and this is called a point estimate.
• Sometimes an investor will come up with a range say from -10% to 10% because they realise the
possibility of making losses due to various circumstances and conditions surrounding the investment.
• To do this the investor assigns probability values to all possible returns.
• These probabilities will range from zero to one depending on the level of certainty that the
investment will provide the specified rate of return.

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The expected return from an investment is defined as:
n

Expected Return = ෍ ൫Probability of Return൯x (Possible Return)

i=1

E(Ri) = [(P1)(R1) + (P2)(R2) + (P3)(R3) + …….. + (Pn)(Rn)

Reduce to;
n

EሺR i ሻ = ෍ ሺPi ሻ(R i )

i=1

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Example 6
Economic Conditions Probability Rate of Return
Strong economy, no inflation 0.15 0.20
Weak economy, above average inflation 0.15 -0.20
No major change in economy 0.70 0.10

Compute the expected return.

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•Solution
 

= (0.15 x 0.20) + [(0.15 x (-0.2)] + (0.7 x0.1)

= 0.07
= 7%

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•   of the Expected Rate of Return
Risk
• Investors are believed to be risk averse, that is if everything else is the same, they would rather
go for investments that offers greater certainty.
• Investors are still willing to take up extra risk if there is an extra reward commensurate to the
extra risk assumed (Risk Premium).
• There are basically three variables or methods by which risk is measured, these are Variance (),
Standard Deviation (σ) and Coefficient of Variation (CV).
• Variance and standard deviation measures the dispersion of possible rates of return around the
expected rate of return.
• In some cases when conditions are not similar for alternative investments, variance and standard
deviation can be misleading.
• I such situations it is better to use an adjusted or a relative variability to indicate risk per unit of
the expected return. A widely used relative measure of risk is the coefficient of variation (CV).

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Formulae:
n

Variance (σ2 ) ෍ ሺProbabilityሻx (Possible Return − Expected Return)2

i=1

σ2 = ෍ (Pi ) [R i − E(R i )]2

i=1

Standard deviation (σ) = ξ σ2

Coefficient of variation (CV) = 𝜎ൗ

𝐸𝑅

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Example 7
Probability of Possible Return Possible Return
(Pi) (Ri)
0.15 0.20
0.15 - 0.20
0.70 0.10
Compute the variance, standard deviation and the coefficient of
variation.

25
• 
Solution
-E
0.15 0.20 0.03 0.13 0.0169 0.002535
0.15- 0.20 - 0.03 - 0.27 0.0729 0.010935
0.70 0.10 0.07 0.03 0.0009 0.000630
E() = 0.07 = 0.014100
= 7% = 0.0141

Therefore; σ = = = 0.11874 = 0.12

CV = = = 1.696285714 = 1.7

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Risk Measure for Historical Returns
To measure the risk for a series of historical rates of returns, we use the same
measures as for the expected returns and these are variance and standard deviation
except that we consider the historical holding period yields (HPY) as follow;

σ2 = ෍ [HPYi − E(HPY)]2 /𝑛
i=1

Where; σ2 = the variance of the series

HPYi = the holding period yield during period i
E(HPY) = the expected value of the HPY that is equal to the arithmetic
mean of the series
n = the number of observations
The standard deviation is the square root of the variance. Both measures indicate how
much the individual observations over time deviated from the expected values of the
series.
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Example 8
You are given the following information on annual rates of return (HPY) for common stocks
listed on the stock exchange.
Year Annual Rate of Return
2012 0.07
2013 0.11
2014 -0.04
2015 0.12
2016 -0.06

Compute the expected return, variance, standard deviation and coefficient of variation.

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• 
Solution
Year )
1 0.07 0.03 0.0009
2 0.11 0.07 0.0049
3 - 0.04 - 0.08 0.0064
4 0.12 0.08 0.0064
5 - 0.06 - 0.10 0.0110
0.20 0.0286

Therefore; E = = 0.04

= = 0.00572 ; while σ = = = 0.0756; while CV = = = 1.89

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Determinants of Required Rates of Return
Required rate of return is the minimum rate of return that an investor should accept from an investment
in order to be compensated for deferring consumption.
• Investment decisions involves finding opportunities that provide a rate of return that compensates you
for;
(1) The time value of money during the investment
(2) The expected rate of inflation during the period and
(3) The risk involved.
• Estimation of required rate of return is complicated by three factors in the market;
(a) A wide range of rates are available for alternative investments at any time.
(b) The rate of return on specific assets change dramatically overtime.
(c) The difference between the rates available (spread) on different assets changes over
time.

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COST OF CAPITAL
• Cost of capital is the rate of return that the enterprise must pay to satisfy
the providers of funds, and it reflects the riskiness of providing funds.
• It is the cut-off rate which separates viable from non-viable opportunities.
• Aspects of the Cost of Capital and Risk
The price (cost) the company pays to raise and use funds, and the return
investors receives for investing in the company.
The minimum return the company should make from its investments to
earn enough cash flows out of which investors can be paid in return.

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Cost of capital has three elements; risk free rate of return + premium for business risk +
premium for financial risk.
Risk-free rate of return – sometimes it is called the pure time value of money, because the
only sacrifice the investor makes is differing the use of money for a period of time.
• risk-free rate of return is the price charged for the exchange between current consumption
and future spending.
• Government securities (Treasury bills) are a classic example of risk free.
Premium from business risk –investors will demand a risk premium in addition to the risk-free
rate that is based on the uncertainty caused by the basic business of the firm.
• For example, a food company would a low business risk compared to a firm in the auto
industry over the business cycle.
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Premium from financial risk – financial risk is the uncertainty resulting from the
method with which the business finances its investments.
• All common stock financed company only incurs business risk.

• For a company partly financed through borrowing, the firm is expected to pay
interest to creditors prior to providing income to the common stockholders as a
result uncertainty to equity stockholders increases.
• Increase in uncertainty because of the fixed cost financing is called financial risk
or financial leverage and this should be reflected in higher risk premium by
charge higher cost of capital.

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ESTIMATING THE COST OF EQUITY, COST OF DEBT AND OTHER CAPITAL INSTRUMENTS
Cost of Equity
Equity capital can be raised either internally by retaining earnings or externally by selling common stock and both
sources of funds attract a cost. It is worth noting that;
• Shareholders will not be prepared to provide funds for a new issue of shares unless the return on their investment
is sufficiently attractive.
• Retained earnings also have a cost. This is an opportunity cost, the dividend forgone by shareholders.

The cost of equity can be estimated using several different methods or models. These include
the dividend valuation model
the dividend growth model
the capital asset pricing model.
Each method is a way of estimating the cost of equity, so in theory they should produce identical answers. However,
as each involves different sources of data and estimates, in practice they would probably result in differing
estimates for the cost of equity.

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Dividend Valuation Model
• The value of an asset can be defined in terms of the stream of future
benefits that arise from holding that asset.
• The value of an ordinary share will be the present value of the expected
future dividends from the particular share.
• The market value of the share at the time of sale should reflect the
present value of the (remaining) future dividends.
• Thus, when determining an appropriate selling price, the expected
dividend stream beyond the point at which the share is held should be
highly relevant to the investor.
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• The
  equation for current market value of the share can be defined :
=
Then;
ke =
Where; = is the ex-dividend current market price of a share of stock at
time 0 (price of a share after dividends have been paid),
= is the dividend per share expected to be paid at the end of time
period t,
= is the appropriate discount rate or cost of equity capital
36
•Example
  9
Kowloon Investments plc has ordinary shares in issue that have a
current market value of K2.20. The annual dividend to be paid by the
business in future years is expected to be K0.40. What is the cost of the
ordinary shares to the business?

Solution
= = = 0.182 = 18.2%

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•Example
  10
Cygnus has a dividend cover ratio of 4.0 times and expects zero growth in
dividends. The company has one million K1 ordinary shares in issue and the
market capitalisation (value) of the company is K50 million. After-tax profits for
next year are expected to be K20 million. What is the cost of equity capital?

Solution
Total dividends = = K5,000,000

Therefore; = = = 0.1 = 10%

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Dividend growth Model
Another way by which cost of equity can be estimated is by use of dividend growth
model.
• The model uses the assumption that the market value of shares is directly related
to the expected future dividends from the equity stock.
• Under this model we use the second simplifying assumption that dividends will
grow at a constant rate over time.
• Where dividends are expected to have a constant growth rate, the equation to
deduce the current market value of a share can be:

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•   P0 = , and this can be rearranged to:

ke = or ke =
Where; P0= is the current market price (ex-div)
D0= is the current net dividend
Ke= is the cost of equity capital
g = is the expected annual growth rate in dividend payments
 The assumption of the model is that ke is greater than g.

40
•Example
  11
If dividends are expected to grow at an 8 percent annual rate into the
foreseeable future. The expected dividend in the first year were K2 and the
present market price were K27. Compute the cost of equity.

Solution
= +g
= + 0.08
= 0.1541
= 15.41%
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•Example
  12
A share has a current market value of K0.96, and the last dividend was K0.12. If the
expected annual growth rate of dividends is 4%, calculate the cost of equity capital.

Solution
+g
= + 0.04
= 0.13 + 0.04
= 0.17
= 17%

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•No  Growth Model
• here growth rate, g, of zero.
• the assumption is that dividends will be maintained at their current level
forever.
• In this case the valuation equation reduces to;
P0 = and ke =
 
Estimating the Growth Rate
There are two methods for estimating the growth rate that you need to be
familiar with.
43
Example 13
The future growth rate can be predicted from an analysis of the growth in dividends over the past
few years.
 
Year Dividends (K) Earnings (K)
2011 150,000 400,000
2012 192,000 510,000
2013 206,000 550,000
2014 245,000 650,000
2015 262,350 700,000
 
Compute the growth rate.

44
•Solution
 
Dividends have risen from K150,000 to K262,350 over a period of 4 years.
=

= 1.749
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•  1+ g =

1+ g = 1.15

g = 1.15 – 1

g = 0.15

g = 15%
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The future growth rate can be estimated using Gordon’s growth
approximation. The rate of growth is expressed as;

g = br

Where; g = is the annual growth rate in dividends

b = is the proportion of profits that are retained
r = is the rate of return on new investments

47
Example 14
If a company retains 65% of its earnings for capital investment projects
it has identified and these projects are expected to have an average
return of 8%:

Solution
g = br = 0.65 x 0.08 = 0.052 = 5.2%

48
Advantages of the dividend growth model (Gordon Growth Model)
• most commonly used model to calculate share price
• the easiest to understand.
• Its ability to values a company's stock without taking into account
market conditions makes it easier to make comparisons across
companies of different sizes and in different industries.

49
Disadvantages of the dividend growth model
• Only applicable to companies currently paying dividends
• Not applicable if dividends aren’t growing at a reasonably constant
rate
• Extremely sensitive to the estimated growth rate – an increase in g of
1% increases the cost of equity by 1%
• Does not explicitly consider risk
• It does not take into account non-dividend factors such as brand
loyalty, customer retention and the ownership of intangible assets.

50
Capital Asset Pricing Model (Expected Return and Risk)
• The Capital Asset Pricing Model (CAPM) is a model used to calculate a
cost of equity and it incorporates risk.
• The CAPM is based on a comparison of the systematic risk of
individual investments with the risk of all share in the market.
• The risk involved in holding securities (shares) divides the risk into risk
specific to the company or asset (unsystematic risk) and risk due to
variations of market activity (systematic risk).

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Systematic Risk and Unsystematic Risk: Implications for Investments
The implications of systematic and unsystematic risk are as follows:
• If an investor want to avoid risk all together, he must invest entirely in risk-free securities.
• If an investor holds shares in share in just a few companies, there will be some
unsystematic risk as well as systematic risk in his portfolio.
• To eliminate unsystematic risk, he must build up a well-diversified portfolio of
investment.
• If an investor holds a balanced portfolio of all the stocks on the market, he will incur
systematic risk which is exactly equal to the average systematic risk in the stock market
as a whole.
• Shares in individual companies will have different systematic risk characteristics to the
market average. Some shares will be more risky than the market average.

52
• 
Systematic Risk and the CAPM
• The beta factor () measures a share’s volatility in terms of market risk.
• Beta factor is the measure of the systematic risk of a security/asset relative to the market portfolio.
• if a share price were to rise or fall at double the market rate, it would have a beta () of 2.
Conversely, if the share price moved at half the market rate, the beta () factor would be 0.5.

Assumptions in CAPM Theory:

• Investors in shares require a return in excess of the risk-free rate, to compensate them for
systematic risk.
• Investors should not require a premium for unsystematic risk, because this can be diversified away
by holding a wide portfolio of investment.
• Because systematic risk varies between companies, investors will require a higher return from
shares in those companies where the systematic risk is bigger.

53
•The
  CAPM formula:
Ke = Rf + (Rm – Rf)
 
Where; ke = the cost of equity capital
Rf = the risk-free rate of return
Rm= return from the market as a whole
= the beta factor of the individual security

54
Example 15
The following information is available about a portfolio of an individual company’s shares and the
stock market as a whole.

Individual Stock Market

Company as whole
K K
Price at start of period 105.00 480.00
Price at end of period 110.00 490.00
Dividend during period 7.60 39.20
 
What are the expected returns on both company and market portfolio?

55
•Solution
 
Return =

= = 0.12 = 12%

= = 0.1025 = 10.25%

56
• 
Example 16
Investors have an expected rate of return of 8% from ordinary shares in Algo, which
have a beta of 1.2. The expected returns to the market are 7%. What will be the
expected rate of return from ordinary shares in Rigel, which have a beta of 1.8?
Solution
Algol; = +
8 = + 1.2
8 = + 8.4 – 1.2
0.2 = 0.4
= 2%

57
•Rigel;
  = +
= 2 + 1.8
= 2 + 1.8(5)
=2+9
= 11%

58
Example 17
The risk-free rate of return is 7%. The average market return is 11%.
A. What will be the return expected from a share whose beta factor is
0.9?
B. What would be the share’s expected value if it is expected to earn
an annual dividend of K5.30, with no capital growth?

59
•Solution
 
A. = +
= 7 + 0.9
= 7 + 0.9 (4)
= 7 + 3.6
= 10.6%

60
•B.  =
=

= K50

61
Example 18
Consider a highly diversified pension fund portfolio investment below:
Investment Quoted beta Proportion (%)
BTR 1.14 20
Tesco 0.83 25
RTZ 1.15 20
British Petroleum 0.83 35
 
Compute the portfolio beta.
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• 
Solution

Investment Proportion Weighted

%
BTR 1.14 0.2 0.228
Tesco 0.83 0.25 0.208
RTZ 1.15 0.2 0.230
BP 0.83 0.35 0.291
= 0.957

63
Cost of debt
• The cost of debt is the price a business pays to the lenders of capital.
• Any fixed interest debt, e.g. bonds or debentures, when issued will carry A rate of
interest payable on the face or nominal value of the debt. Thus, $100 (face value) of 7
percent debentures has a coupon rate of 7 percent.
• When a debt is issued, the coupon rate will be fixed in accord with interest rates ruling
in the market at that particular time for debt of similar nature and maturity.
• After issue of debt, its market value will depend on the relationship of the coupon rate
to the rate of return required by investors at any particular time.
• For instance, if the market value of $100 of 7 percent debentures on a particular day is
$90, the rate of return required at that time (gross of tax) is 7/90 x 100 ≈ 7.78 percent.

64
• 
Irredeemable Debt
• Loan capital may be irredeemable (that is, the business is not expected to repay the principal sum
and so interest will be paid indefinitely).
• the equation used to derive the value of irredeemable loan capital is similar to the equation used
to derive the value of ordinary shares, where the dividends remain constant over time.

Where; P0 = market value of debt (ex-interest i.e. immediately after payment)

Kd net = cost of debt (after tax)
i = the annual rate of interest on the loan capital

65
• This
  equation can be rearranged to provide an equation for deducing the cost of
loan capital. Hence:
kd net =
• Interest payments on loan capital are an allowable expense for taxation purposes
• the net cash flows incurred in servicing the loan capital will be the rate of
interest payable less the tax charge, which can be offset.
• The post-tax cost of loan capital will be:
kd net =
Where; t = is the rate of tax payable

66
•Example
  19
Assume a K100 of 7 percent debentures quoted at K90 (ex-int), interest just paid,
and corporation tax is 30 percent, calculate the cost of debt. Also calculate the cost
of debt if K90 was the cumulative interest market price (i.e. the price includes the
pending interest payment).

I. kd net = = = 0.054 = 5.4%

II. kd net = = = 0.059 = 5.9%

67
•Redeemable
  Debt
The cost of redeemable debt is calculated using an internal rate of return
(IRR) approach.
kd net = A +

Where; A = lower rate of return with positive NPV

B = higher rate of return with negative NPV
P = amount of positive NPV
N = absolute amount of the negative NPV
68
Example 20
Calculate the cost of a 7 percent debenture with K100 nominal value
quoted at K90. It will be redeemed at K101 in five years’ time. Interest
and redemption payment are assumed to be payable at year end and
tax of 30 percent to be immediately recovered.

69
Solution
Yr CF(1 – t) DF@5% PV@5% DF@10%PV@10%
0 (90) 1.000 (90) 1.000 (90)
1 7(1 - .3)=4.9 0.952 4.6648 0.909 4.4541
2 7(1 - .3)=4.9 0.907 4.4443 0.826 4.0474
3 7(1 - .3)=4.9 0.864 4.2336 0.751 3.6799
4 7(1 - .3)=4.9 0.823 4.0327 0.683 3.3467
5 7(1 - .3)=4.9 0.784 3.8416 0.621 3.0429
5 101 0.784 79.184 0.621 62.721
10.401 (8.708)
70
Or

Yr CF(1 – t) DF@5% PV@5% DF@10% PV@10%

0 (90) 1.000 (90) 1.000 (90)
1-5 7(1 - .3)=4.9 4.329 21.212 3.791 18.576
5 101 0.784 79.184 0.621 62.721
10.401 (8.708)

71
• 
Kd net = A +
=5+
= 5 + 2.72
= 7.72%

72
•Cost
  of Preference Shares
• The cost of preference share capital is related to the amount of dividends
payable on the share.
• The dividend is an appropriation from post-tax profits, which means that it is
not allowable for tax.
• The cost can be defined by:
kpref =
Where; kpref = cost of preference shares
d = annual dividend
P0 = current ex-div market price
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ESTIMATING THE OVERALL COST OF CAPITAL AND IMPACT OF COST OF CAPITAL ON
INVESTMENT
Weighted Average Cost Of Capital (WACC)
• Weighted average cost of capital (WACC) is the average rate of return a company
expects to compensate all its different investors.
• The weights are the fraction of each financing source in the company's target capital
structure.
• A company is typically financed using a combination of debt (bonds) and equity
(stocks).
• In theory, market values of securities are used in the gearing calculations as these give
more accurate measure of the company’s value, though in practice book values are
frequently used.
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•  Using the market values for a firm with equity, debt and preference
shares in its capital structure, the WACC can be defined by:
k0 =
• Where Ve, Vp and Vd denotes the market value of equity, preference
shares and debt respectively. If we assume that the company is only
capitalised using equity and debt, the weighted average cost of capital
is shown as:
k0 = ke + kd net

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•  Now if we introduce preference shares into the formula will have:
k0 = ke +

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Example 21
The following is an extract from the balance sheet of Mutende plc at 28 February 2017: K
Ordinary shares of K0.25 each 250,000
Reserves 350,000
7% preference shares of K1.00 each 250,000
15% unsecured loan stock 150,000
Total long-term funds 1,000,000

The ordinary shares are currently quoted at K1.25 each, the loan stock is trading at K85.00 per K100
nominal and the preference shares at K0.65 each. The ordinary dividend of K0.10 has just been paid,
and the expected growth rate in the dividend is 10 percent. Corporate tax is at the rate of 30 percent.
Compute the weighted average cost of capital for Mutende plc.

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•Solution
 
Market values of the securities K
Equity - (1,000,000 x 1.25) 1,250,000
Preference - (250,000 x 0.65) 162,500
Loan stock - (150,000 x 0.85) 127,500
1,540,000

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•(i) 
+g
= + 0.10
= 0.088 + 0.10
= 0.188
= 18.8%

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• 
(ii)
kPref =

= 0.107692307

= 0.108

= 10.8%
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•(iii)
 
kd net =

= 0.124

= 12.4%

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• 
Therefore, WACC can be calculated as follows;

= 0.174

= 17.4%

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Example 23
The entity has the following information in its statement of financial position.
K’000
Ordinary shares of K0.50 2,500
12% unsecured bonds 1,000

The ordinary shares are currently quoted at K1.30 each and the bonds are trading at K72
per K100 nominal. The ordinary dividend of K0.15 has just been paid with an expected
growth rate of 10%. Corporation tax is currently 30%.

Calculate the weighted average cost of capital for this entity.

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•Solution
 
Market values of the securities K’000
Equity - [(2,500/0.5) x 1.30] 6,500
Bonds - [1,000 x (K72/100)] 720
7,220

(i) + g = + 0.1 = 0.2269 = 22.69%

(ii) kd net = = = 0.1667 = 16.67%

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• 
Therefore, Weighted average cost of capital can be calculated as;

k0 = ke + kd net

Where; + = 7,220

k0 = 22.69% x + (16.67% x 0.7) x

= 20.43% + 1.16%

= 21.59%
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Marginal Cost of Capital
• The marginal cost of capital (MCC) is defined as the cost of the last unit (in monetary terms) of new capital
the firm raises, and
• the marginal cost rises as more and more capital is raised during a given period.

Example 24
Consider a company with the following cost of capital:
Source After-tax cost Market value
(%) (K’m)
A B
Equity20 5
Preference 10 1
Loan stock 84

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The company above has a large investment project under considering. The estimated project cost
is K1,000,000, to be financed in equal proportions by a new share issue and a new issue of loan
stock as shown below:
Source after-tax cost Market value
(%) (K’m)
A B
Equity22 5.5
Preference 10 1.0
Loan stock 8 4.0
New loan stock 10 0.5

Compute the marginal cost of capital.

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• 
Solution
1. Initial weighted average cost of capital

Source After tax cost Market Value

(%) (K’m) (% x K’m)
E 20 5 1.00
P 10 1 0.10
LS 8 4 0.32
10 1.42

Therefore; WACC = X 100% = 14.2%

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•  New weighted average cost of capital
2.
Source After tax cost Market Value
(%) (K’m) (% x K’m)
E 22 5.5 1.21
P 10 1.0 0.10
LS 8 4.0 0.32
NLS 10 0.5 0.05
11.0 1.68

Therefore; WACC = X 100% = 15.3%

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•Therefore;
 
Marginal cost of capital = x 100% = 26%

90
Example 25
Quarry Inc. has the following capital structure
After tax cost Market Value
Source % K’m
Equity 12 10
Preference 10 2
Bonds 7.5 8

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Quarry Inc.’s directors have decided to embark on major capital
expenditure, which will be financed by a major issue of funds. The
estimated project cost is K3,000,000, 1/3 of which will be financed by
equity, 2/3 of which will be financed by bonds. As a result of
undertaking the project, the cost of equity (existing and new shares)
will rise from 12% to 14%. The cost of preference shares and the cost of
existing bonds will remain the same, while the after tax cost of the new
bonds will be 9%.
Compute the marginal cost of capital.

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• 
Solution
1. Initial weighted average cost of capital

Source After tax cost Market Value

(%) (K’m) (% x K’m)
E12 10 1.2
P10 2 0.2
B 7.5 8 0.6
20 2.0

Therefore; WACC = X 100% = 10%

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•2. New weighted average cost of capital
Source After tax cost Market Value
(%) (K’m) (% x K’m)
E 14 11 1.54
P 10 2 0.20
EB 7.5 8 0.60
NB 9 2 0.18
23 2.52
Therefore; WACC = X 100% = 11%

94
•Therefore;
 
Marginal cost of capital = x 100% = 17.3%

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96
END

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