COST

OF

CAPITAL

Group 3

Luke Naisila (S02000356)

Sera Bose (S92476450)

Aisake Mausio (S11088915)

Nirupa Devi (S01007128)

Raymond Kumar (S11037932)

Anup Prakash (S01001914)

Lanieta Cheer (S94003879)

Ateca Vakaloloma (S11100600)

Discussion Outline
What is the Cost of Capital?
The Cost of Equity
Dividend Growth Model Approach
The SML Approach

The Cost of Debt

Weighted Average Cost of Capital
Divisional & Project Cost of Capital
Case Study

What is Cost of Capital?

Cost of Capital associated with an investment
depends on the risk of that investment
Cost of Capital depends on the use of the
funds, not the source.
Cost of a companys funds (both debt &
equity) or from an investment point of view
the required rate of return
Minimum return that investors expect for
providing capital to the company

Relevance of Cost of Capital

Cost of Capital provides an
indication of how the
market views the risk of
our assets
Knowing Cost of Capital
helps determine the
required return for capital
budgeting projects.

Introducing Cost of Equity

Definition:
The return that equity investors require on their investment in
the firm.

There is no direct way of observing the return

that the firms equity investors require on their
investment.
Dividend Growth Model

Security Market Line (SML)

Dividend Growth Model

0 1 +
1
0 =
=


Thus, may be rearranged to determine Return on
Equity.

Next Dividend Projection

1
=
Price per share
0 + Growth rate
A model that determines the current price of a
share as its dividend next period divided by the
discounted rate less the dividend growth rate
Return on Equity

Dividend Growth Model

3 Critical pieces of information required to use
the Dividend Growth Model:
Price per share (P0)
Dividend payout (D0)
Growth rate (g)

Estimating (g)
Use either

Dividend Growth Model

ADVANTAGE
Simple to use
Easy to understand

DISADVANTAGE
Only applicable to
companies that pay
dividends
Key assumption that
dividend grows at a
constant rate only steady
growth applicable
Estimated cost of equity is
sensitive to the estimated
growth rate
Does not account for risk

Security Market Line Method

The required or expected return on a risky
investment depends on 3 things:
The risk-free rate (Rf)
The market risk premium E(Rm) - Rf
The Beta coefficient ()

Determining Cost of Equity Capital:

Market risk premium

Coefficient
Return on Equity

= +
Risk-free rate

Security Market Line Method

ADVANTAGE
Explicitly adjusts for risk
Applicable to companies
other than those with
steady dividend growth
Also applied to individual
projects and not limited to
companies

DISADVANTAGE
Requires the market risk
premium and the beta
coefficient values to be
estimated
If estimates are poor
results will be inaccurate.
Uses the past info to predict
the future (economic
conditions can change fairly
quickly)

The Cost of Debt

The required return on a companys debt
The cost of debt is simply the interest rate
the firm must pay on new borrowing.
Focusing on long-term debts or bonds
Method 1
Compute the yield to maturity on existing debt

Method 2
Use estimates of current rates based on the
bond rating expected on new debt.

What is WACC?
The minimum return a company needs to earn to
satisfy all of its investors, including shareholders,
debt holders and preference shareholders.

The weighted average of the cost of equity and the

after-tax cost of debt
The required return on any investments by the firm
that have essentially the same risks as existing
operations.

More about WACC

Capital Structure Weights
=+
Value
Equity

Debt

Taxes & WACC

= + (1 )

When using preference shares (Classical Tax System):

Corporate Tax Rate

= + + (1 )

Cost of Equity

Cost of preference share

Cost of Debt

More about WACC

Imputation Tax System
= 1 + (1 )
Equity Weights

Corporate Tax

Return on Debt

Return on Equity

Weighted Debt

CASE STUDY

Case Study Highlights

You have recently been employed by Hubbart
Computer Ltd (HCL)
Founded 8-years ago by Bob Hubbart
Operates 14 stores on the South Island of New
Zealand
Ran sales of $9.7 million the previous year
Orders are made to fill with customers paying for
the order immediately. Average 15 days for
delivery and a 30 day guaranteed delivery.
HCL finances its growth via profits where new
stores are opened when there is sufficient capital.

Case Study Outline

Part A Find the most recent yearly/half-yearly report
for Harvey Norman. Find the book value of debt and
book value of equity.
Part B:
i.

(i) What is the most recent stock price listed for Harvey
Norman?
ii. What is the market capitalization?
iii. How many shares does Harvey Norman have outstanding?
iv. What is the most recent annual dividend?
v. Can the dividend discount model be used for Harvey
Norman?
vi. What is ?
vii. What is the yield on government debt?
viii. What is the cost of Equity using the CAPM?

Case Study Outline

Part C Calculate cost of debt for Harvey
Norman. What is the WACC value of debt for
Harvey Norman using the book-value weights
and the market-value weights? Does it make a
difference in this case if you use book-value
weights or market-value weights?
Part D Calculate the WACC using book value
weights and market value weights.

Before we begin
PURE PLAY
APPROACH

Find one or more companies

Compute Beta for each company
Take an average
Use beta along with CAPM to find return

SUBJECTIVE
APPROACH

Consider overall risk relative to overall firm

If project is less risky than firm, use
discount rate less than WACC
Decision can go either way (If data indicate
reject, you may accept or vice-versa)

Case Study Answers

Part A (i) Book Value (Debt)

Part A (ii) Book Value (Equity)

Case Study Answers

Part B (i)

Part B (ii)

Market Capitalization:
Shares x Stock Price
$4,806 million
(1,063,291,352 x $4.520)

Part B (iii) Outstanding Shares

Case Study Answers

Part B (iv) Annual Dividend

Case Study Answers

Part B (v) Can we use the
Dividend Growth Model?

We cannot as the growth is

not constant as indicated
above

Part B (vi) What is ?

Case Study Answers

Case Study Answers

Part B (vii) Government Yield

Part B (viii) Cost of Equity

RE = RF + BE x (RM RF)
= 3.01 + 1.04 x 4.29
= 3.01 + (4.4616)
= 7.47%

Case Study Answers

Interest Rates
with
corresponding
borrowings

Case Study Answers

Part C Calculating weighted average cost of debt

Cost of Debt
(book value)

= RD x (1 TC)
= 3.14 x (1 0.30)
= 3.14 x 0.70
= 2.20%

Cost of Debt
(market value)

= RD x (1 TC)
= 5.43 x (1 0.30)
= 5.43 x 0.70
= 3.80%

Case Study Answers

Part D Calculate WACC for Harvey Norman

= + (1 )

Using Book Value

= 0.781 x 0.0747 + 0.22 x 0.022 x 0.70
= 0.062 or 6.2%

Using Market Value

= 0.781 x 0.0747 + 0.22 x 0.038 x 0.70
= 0.064 or 6.4%

CONCLUSION CASE STUDY

Harvey Normans return on Invested Capital as
at June 14 is 5.22% (http://www.gurufocus.com/) while the
Weighted Average Cost of Capital sat @ 6.4%.
Therefore, the returns on investments are lower
than the costs required to raise capital needed
for the investment.

QUESTIONS