6 Cost of capital - ICSA

C06_ST_CORP_FIN_MAN_9781860724237.QXD:ICSA 17/6/09 10:23 Page 95 

chapter 6 

Cost of capital 

1 Effects of risk on the cost of capital 

2 Cost of equity 

3 Cost of preference shares 

4 Cost of debt capital 

5 Weighted average cost of capital 

contents 

learning outcomes 

6 Assessment of risk in the debt versus 

equity decision 

7 Cost of capital for unquoted companies 

8 Cost of capital for not-for-profit 

organisations 

After reading and understanding the contents of this chapter and working through all the 

worked examples and practice questions, you should be able to: 

Understand why companies need to know their cost of capital. 

Understand the significance of risk in relation to the cost of capital. 

Calculate the cost of equity (allowing for growth), preference shares and irredeemable debt. 

Understand, in principle, how to calculate the return on redeemable debt capital and 

convertible loan stock. 

Allow for tax relief in calculating the cost of debt capital. 

Discuss the costs of using retained earnings as a source of capital. 

Be aware of the potential relevance of the capital asset pricing model. 

Calculate the weighted average cost of capital (WACC) and discuss its use. 

Calculate the effect of different forms of capital funding on earnings per share. 

Be aware of special problems faced by unquoted companies and not-for-profit organisations 

in determining their cost of capital.


96 COST OF CAPITAL AND CAPITAL STRUCTURE 

Introduction 

A company’s cost of capital is the return that it gives to the providers of capital.The 

form of the return depends on the nature of the capital. Shareholders receive dividends 

and usually expect capital growth from increases in the share price.The mix of 

dividend income and capital growth depends on the nature of the company.A hightech 

company that is growing fast, and investing in research and development to 

support this growth, is holding out the prospect of capital growth, but may pay little 

or none of its available cash out as dividends.A company in a mature industry, such as 

a water or electricity utility, may have few opportunities to invest for growth and will 

pay large dividends (in relation to the share price) which grow only slowly. 

Some investors need a large income straight away from their investment and are 

willing to forgo growth to get it. Others are willing and able to wait for their returns 

and may prefer them to be in the form of capital gains realised later rather than 

income that is subject to tax straight away.When investors buy shares, they have some 

understanding of the company’s investment and dividend policies, and select the 

companies in which they invest to match their own requirements. 

Loan stock holders receive their return in the form of regular, usually fixed, 

interest payments and redemption proceeds. Since the market price of loan stock 

varies, there is scope for capital gain, though usually less than that expected by many 

ordinary shareholders. The returns to holders of convertible loan stock and preference 

shareholders are slightly different and are considered below. 

The return that investors require, in whatever form they receive it, depends on 

their cost of capital and the risk of the investment (discussed below). An investor’s 

cost of capital may be his borrowing cost or his opportunity cost – the return that he 

can get by investing elsewhere and which he forgos by investing in this company. 

The nature of the risk associated with capital structure is discussed in chapter 9. 

The relation between investment risk and return is discussed in chapter 7 on 

Portfolio Theory and in chapter 8, which describes and explains the Capital Asset 

Pricing Model. 

Corporate financial managers need to know the cost of capital in order: 

To make well-informed choices about capital structure and what kinds of new 

capital to raise, which means that they need to know the costs of the alternatives. 

To keep informed about the expectations of providers of capital so that they can act 

to satisfy these expectations and encourage investors to keep their capital in the 

company. 

In particular, in making capital investment decisions, to invest in projects that give 

the return that shareholders require, and avoid those that do not. 

We shall first consider the costs of the different individual types of capital, before 

looking at the cost of the capital structure of the company as a whole. 

test your knowledge 6.1 

Why does a company need to know its cost of capital? 

1 Effects of risk on the cost of capital 

Investing in companies involves risk – investors may lose some or all of their money. 

The risk comprises two elements: 

business risk associated with the company’s prospects and projects; and 

financial risk associated with the company’s capital structure – the higher the level 

of gearing the higher the risk of insolvency and hence the financial risks.


Gordon’s Model of 

Dividend Growth Equation 

relating the ex-dividend 

ordinary share price to the 

dividend, the expected 

annual growth in dividends 

and the cost of 

equity capital. 

worked example 6.1 

The return investors require depends on the level of risk – the higher the risk the 

higher the expected return, because investors expect to be compensated for bearing 

additional risk.This‘risk premium’ (made up of premiums for business and financial 

risks) will be required in addition to the risk-free rate of return.The risk-free return 

is the return that would be required if there were no risk and is typically taken to be 

the return on government bonds. The returns required from investing in different 

companies will vary with their different levels of business and financial risk. 

2 Cost of equity 

6 COST OF CAPITAL 97 

Two methods for calculating the cost of equity capital are described here. The first 

uses the dividend valuation model, which relates the dividends paid, and expected to 

be be paid in future, to the share price. This approach is described below, most 

importantly as the dividend growth model. When the cost of equity is calculated 

using dividend models, it takes account of risk implicitly.This is because, for higherrisk 

companies, either higher dividends are paid in relation to the value of the shares 

or dividends are expected to grow faster (or both) than for lower-risk companies.The 

second model for calculating the cost of equity capital is the Capital Asset Pricing 

Model, which takes account of risk explicitly and is dealt with in detail in chapter 8. 

2.1 Dividend valuation model 

The dividend valuation model is based on the principle that the market value of a 

share is the present value of the dividends paid on the share. The present value is 

obtained by discounting all expected future dividends to today’s date.The discount 

rate used to discount future dividends is the cost of capital. When dividends are 

expected to grow at a constant annual percentage rate, the relationship between the 

share price and the future dividends is given by the Dividend Growth Model or 

Gordon’s Model of Dividend Growth: 

(1 + g) 

Po = do –––––– 

(Ke – g) 

where: 

Po = the current ex-dividend market price 

do = the current dividend 

g =the expected annual growth in dividends 

Ke = the shareholder’s expected return on the shares 

The equation above can be rearranged to give the cost of equity, equivalent to the 

shareholder’s expected return, as: 

do (1 + g) 

Ke = –––––––––+g 

Po In order to use the dividend growth model to find the cost of equity, we need to find 

the growth rate of dividends. This is often done by finding the compound growth 

rate between the earliest available dividend and the latest dividend. 

Assume Puccini’s past dividends have been: 

Year 1 

Dividend per share 

0.26 

Year 2 0.27 

Year 3 0.28 

Year 4 0.32



worked example 6.1 continued 

We can now find the average rate of growth by using the following formula: 

n 

Latest dividend 

Growth rate (g) 1 

Earliest dividend 

where n number of years’ growth. 

g 

3 

0.32 

0.26 

1 0.072 or 7.2%. 

Note: Here we are using the cube root because there are three years of growth. If we had been given five years’ 

data (from which we could project four years’ growth) the fourth root would have been used. 


Having found g, the dividend growth rate, we can calculate the cost of capital using 

the dividend growth model: 

Using the example of Puccini above and assuming its share price is £8.00, then: 

0.32(1.072) 

Ke 8.00 0.072 0.043 0.072 11.5%. 

The dividend valuation and dividend growth model are based on the following 

assumptions: 

Taxation rates are assumed to be the same for all investors and in particular higher 

rates of tax are ignored. the dividends used are the gross dividends paid out from 

the company’s point of view. 

The costs incurred in issuing shares are ignored. 

All investors receive the same, perfect level of information. 

The cost of capital to the company remains unaltered by any new issue of shares. 

All projects undertaken as a result of new share issues have the same level of risk as 

the company’s existing activities. 

The dividends paid must be from after-tax profits – there must be sufficient funds 

to pay the shareholders from profits after tax. 

Share issue costs 

A new share issue involves costs, including the cost of preparing issue documents and 

the fees paid to advisers.These costs are described in chapter 4.This means that the 

capital raised by issuing one new share is reduced from P o , the issue price, to P o - I, 

the issue price less the issue cost per share. If the expression above for the cost of 

equity capital is adjusted to take account of this, it becomes: 

do (1 g) 

Ke g 

(Po I) 

where: 

Ke = cost of equity raised by the new issue 

d o = current dividend 

g =expected annual growth in dividends 

P o = issue price 

I = issue cost per share




Using the most recent dividend and current share price of Puccini shown above, what is the cost of Puccini’s 

equity given by the dividend yield? 

Answer 

Using the above formula Ke 

32 

Ke 0.040 4.0% 

800 


do 

Po 

The cost of existing equity capital in Puccini calculated in worked example 6.2 was 

11.5 per cent.The cost of a new issue of equity capital for Puccini is 12 per cent. Both 

figures are based on the market price of one share, which is assumed to be the same in 

both cases, and the expected future dividends, which are also the same, since new and 

existing shares have identical rights and are therefore treated in exactly the same way 

for the payment of dividends.The difference is that the cost of existing capital is based 

on the market value of one share, while the cost of new capital is based on what the 

company receives when it issues the new share: the market value less the issue cost. 

2.2 Dividend yield 

One possible measure of the cost of equity is the dividend yield.The dividend yield is 

calculated as: 

do Ke = –– 

Po 

Where: Ke = dividend yield 

d o = current dividend (usually either the most recently paid or the most 

recently declared dividend) 

P o = current share price 

In the cast of Puccini in Worked Examples 6.1, 6.2 and 6.3 above, if issue costs amount to (say) 10 per cent 

of the capital raised, the issue cost per share is 10 per cent of £8.00 = £0.80. The cost of new equity, allowing 

for issue costs, is: 

0.32(1 + 0.72) 

Ke ––––––––––––– + 0.072 = 0.120 = 12% 

8.00 – 0.80 

If a company forecasts next year’s dividend (or if external analysts estimate it) this 

projection may be used instead of the latest dividend to give a projected dividend 

yield (usually still using the current share price). 

The dividend yield only gives a rough indication of the cost of capital, since it 

represents a return that ignores dividend growth, apart from the limited effect of one 

year’s growth if forecasts of next year’s dividend are used. 

As the worked examples above show, the dividend yield often accounts for only a 

small part of the expected return on (and cost of) capital. 

2.3 Capital asset pricing model 

The capital asset pricing model (CAPM) can also be used to find the cost of equity, 

making explicit allowance for risk.The whole of chapter 8 is devoted to the CAPM. 

You should review the cost of equity capital after you have worked through chapter 8.



retained earnings Profits 

reinvested in the business 

instead of being paid out as 

dividends. They belong to the 

shareholders and form part of 

shareholders’ funds, together 

with equity capital 

subscribed by shareholders 

and reserves. The cost of 

retained earnings is the same 

as the cost of other forms of 

equity capital included in 

shareholders’ funds. 


2.4 Retained earnings 

Retained earnings are profits reinvested in the business instead of being paid out as 

dividends. They belong to the shareholders and form part of shareholders’ funds, 

together with equity capital subscribed by shareholders and reserves. As such, the 

cost of retained earnings is essentially the same as the cost of other equity capital 

calculated above.There is a small difference, since the use of retained funds does not 

involve the costs associated with a new equity issue, as discussed above. Subject to 

this small difference, shareholders will expect their company to make the same 

return on retained profits as they get on the money that they have invested in shares. 

Many companies use retained earnings and other internally generated funds as 

their main source of new equity capital. Reasons for preferring this form of equity 

capital include the avoidance of issue costs, but are not limited to this, and were 

discussed in chapter 4. 

3 Cost of preference shares 

The formula for calculating the cost of preference shares is: 

dp Kp = –– 

Sp 

where: 

Kp = cost of preference shares 

d = fixed dividend based on the nominal value of the shares 

p 

Sp = market price of preference shares 

Anorak plc has 8% preference shares which have a nominal value of £1 and a market price of 80p. What is the 

cost of preference shares? 

Answer 

The dividend is 8 per cent of the nominal value (8 per cent of £1 8 pence). 

Using the above formula: 

dp 8 

Kp 10%. Sp 80 

4 Cost of debt capital 

We saw in chapter 5 that debentures can be either redeemable or irredeemable. It is 

important that you know the type of debenture a firm has in issue when calculating 

its cost of capital because, as you will see, the approach used varies with the form of 

debentures being considered. 

4.1 Irredeemable debt 

The formula for calculating the cost of irredeemable debt is: 

I (1 – t) 

Kd = –––––– 

Sd 

where: 

Kd = cost of debt capital 

I =annual interest payment



Sd = current market price of debt capital 

t = the rate of corporation tax applicable. 


The rate of corporation tax comes into the formula because interest can be offset 

against taxation, which lowers the net rate and thus the cost of debt capital. The 

higher the rate of corporation tax payable by the company, the lower will be the aftertax 

cost of debt capital.Thus the cost of debt capital is lower than the cost of preference 

shares with the same coupon rate and market value as the debentures because 

there is no tax relief on preference dividends.The effect of tax relief on the interest 

cost only applies if the business has taxable profits from which to deduct its interest 

payments. If there is a taxable loss for the year, there is no immediate tax relief for 

loan stock interest, but the interest increases taxable losses, which can be carried 

forward and may be set against profits in future years. 

Clown plc has £10,000 of 8% irredeemable debentures in issue which have a current market price of £92 per 

£100 of nominal value. 

Required 

If the corporation tax rate is 28 per cent what is the cost of the debt capital? 

Answer 

The annual interest payment will be based on the nominal value, i.e. 8 per cent of £10,000 or £800, so using 

the above formula: 

Kd 

I(1 t) 

Sd 

800(1 0.28) 

92/100 10,000 0.0626 6.26%. 

internal rate of return The 

discount rate that makes the 

Net Present Value of a project 

zero – equals the rate of 

return on capital invested in 

the project (see Discounted 

cash flow analysis). 


4.2 Redeemable debt 

Redeemable debt is repayable at a fixed future date. The cost of debt capital can be 

found using discounted cash flow methods of investment analysis to find the 

Internal Rate of Return – the return on capital that an investor gets by investing in 

redeemable loan stock.The example that follows describes a situation in which this 

approach would be used and states the result.The calculation leading to this result is 

set out in chapter 12. 

Pierrot plc has redeemable 10 per cent loan stock, redeemable on 31 December year 4, with a current market 

price on 31 December year 1 of £96.03 per £100 nominal. The corporation tax rate is 28 per cent. 

Required 

Find the cost of the loan stock capital. 

Answer 

Pierrot plc will make the following cash payments to a holder of £100 nominal of 10 per cent redeemable loan 

stock: £10 in interest on 31 December in each of the years 2, 3 and 4 and repayment of £100 capital on 31 

December year 4. Pierrot will receive tax relief on interest paid (for this example, we assume that tax relief is 

given one year after each interest payment is made: £2.80 on 31 December in each of the years 3, 4 and 5). 

The cash payments for each £100 nominal of 10 per cent loan stock are set out in Table 6.1.



discounted cash flow 

(DCF) analysis Technique 

for evaluating investment 

projects by identifying the 

future cash flows 

attributable to the project 

and calculating their present 

values so that they can be 

compared on a like-for-like 

basis. The present value of a 

future cash flow is the 

amount of money at today’s 

date that has an equivalent 

value. The present value is 

calculated by discounting 

the future cash flow to allow 

for its timing and the cost of 

capital. The sum of the 

present values of all the 

project’s cash flows is the 

net present value (NPV) of 

the project. The discount 

rate that makes the NPV of a 

project zero is the project’s 

Internal Rate of Return. 

present value The amount 

of money at today’s date that 

is equivalent to a sum of 

money in the future. 

Calculated by discounting 

the future sum to reflect its 

timing and the cost of 

capital (see discounted cash 

flow analysis). 

discount rate Cost of capital 

used to define interest rates 

or to discount cash flows to 

find present values (see 

discounted cash flow 

analysis). 

table 6.1 Cash payments for each £100 nominal of loan stock 

Instead of making these payments, Pierrot plc has the option of buying the loan stock 

in the market at the market price of £96.03. By paying £96.03 now, Pierrot can free 

itself of the obligation to make the future cash payments shown above.The sum of 

£96.03 now is therefore equivalent to the total future cash payments.The reason why 

the total of the cash payments shown above (£121.60) is greater than the current 

market price of the stock is that the series of cash payments are deferred. By investing 

£96.03 now, Pierrot expects to get a return by not having to pay out larger amounts 

in the future. The total amount of money now that is equivalent to the future 

payments is calculated by discounting each of the future cash flows (i.e. discounted 

cash flow analysis) to express it in terms of money at today’s date (in the example, 

31 December in year 1).This value expressed in today’s money is the present value 

of the future cash flow.The calculation of present values uses a discount rate equal to 

the cost of capital and is explained in detail in chapter 12. For the moment, we show 

the present values of the cash flows below, using a discount rate of 9 per cent. 

As we shall see, if a discount rate of less than 9 per cent is used the present values of 

the cash flows inTable 6.1 total more than £96.03. If the discount rate is more than 9 

per cent, the present values of the cash flows are less than £96.03. With a discount 

rate of 9 per cent, the present values of all the cash flows for £100 nominal of loan 

stock are exactly £96.03 – the same as the current market price of the loan stock.This 

means that the cost of Pierrot’s loan stock capital is nine per cent. 


Cash flow 

£ 

Interest (31 Dec year 2) 10 

Tax relief (31 Dec year 3) (2.80) 




Redemption (31 Dec year 4) 100 


–––––– 

Total 121.60 

table 6.2 Present values of cash flows 

Cash flow Present value of 

cash flow 

£ £ 

Interest (31 Dec year 2) 10 9.17 

Tax relief (31 Dec year 3) (2.80) (2.36) 




Redemption (31 Dec year 4) 100 77.22 


Total 95.57 

Why is the calculation of the cost of redeemable debt capital or convertible loan 

stock more complicated than the calculation of the cost of irredeemable debt capital 

or preference shares?



4.3 Cost of floating rate debt 


If a company has floating rate debt in its capital structure, then an estimated fixed rate 

of interest should be used to calculate its cost of debt in a way similar to the above.The 

‘equivalent’ rate will be that of a similar company for a similar maturity. 

4.4 Cost of fixed rate bank loans 

The cost of this major source of finance is given by: 

Kd = Interest rate × (1 + t) 

4.5 Cost of short-term funds and overdrafts 

The cost of short-term bank loans and overdrafts is the current interest rate being 

charged on the capital lent. 

4.6 Cost of convertible stock 

To determine the cost of convertible stock we have to find the internal rate of return 

(IRR) as the value of r that satisfies the following equation: 

K(1 t) K(1 t) K(1 t) K(1 t) VnCR P0 . . . 

(1 r) (1 r) 2 (1 r) 3 (1 r) n (1 r) n 

where: 

P0 = current market price of the convertible ex-interest (i.e. after paying the 

current year’s interest) 

K = annual interest payment 

t = rate of corporation tax 

r = cost of capital 

Vn = projected market value of the shares at year n, when conversion can take 

place 

CR = conversion ratio (the number of shares issued on conversion of £1 nominal 

of convertible stock). 

What this equation means is that the cost of the convertible loan stock to the 

company is the after-tax cost of the interest payments in future years, together with 

the value of the shares issued when the stock is converted. The terms on the right 

hand side of the equation represent these cash flows, discounted to bring them to 

today’s values.The company could discharge its liability to make these payments by 

buying back the convertible loan stock at today’s price.This is the figure on the left 

hand side of the equation.The discount rate r that makes the two liabilities equal is 

the cost of capital. 

The calculation above assumes that the stock will be converted n years from now. 

If the projected value of the stockV s at that time is greater than the conversion value 

V n × CR, investors will not convert, so V n CR should be replaced by V s in the 

equation above. 

Quality plc has 10 per cent convertible debentures due for conversion in two years’ time. They have a current 

market value of £165.32 per cent. The conversion terms are five shares per £10 of debentures. All the debentureholders 

are expected to convert and the shares are expected to have a price of £4 at the conversion date.




Required 

What is the cost of capital? Assume the rate of corporation tax is 30 per cent and is payable in the same year as 

profits are made. 

Answer 

The ‘market value of 165.32 per cent’ means that the market price of £100 nominal of 10 per cent. 

convertible debentures is £165.32. Interest on convertible stock can be offset against tax and is shown as a 

saving in the following calculation: 

Year 0 1 2 

£ £ £ 

Current market value of debenture (165.32) 

Interest 10 10 

Tax relief 

Value of shares on conversion 

(3) (3) 

((5 £100/£10) £4) 200 

Total yearly cash flow (165.32) 7 207 

Using a cost of capital of 14%: 

Year 0 1 2 

£ £ £ 

Total yearly cash flow (165.320) 7 207 

Discount factor at 14% 1 0.877 0.769 

Present value (165.320) 6.139 159.183 

Net present value (165.32) 6.139 159.183 (0.002) 

This shows that with a discount rate (cost of capital) of 14 per cent, the present value of the future cash flows 

is equal to the market value of the debenture. This means that the cost of capital is 14 per cent. 

weighted average cost of 

capital (WACC) A weighted 

average of the costs of 

different kinds of long-term 

capital, calculated to reflect 

the amounts of different 

kinds of capital (most 

importantly shareholders’ 

funds and debt) in the 

company’s capital structure. 

The weights used for the 

different kinds of capital 

may be either the book 

values or the market values. 

The WACC is commonly 

used as the cost of capital in 

evaluating projects. It 

represents the cost of 

capital for projects with a 

normal level of business risk 

and where funds are raised 

in similar proportions to the 

existing capital structure. 

Remember that discounted cash flow calculations will be covered in greater detail in 

chapter 12. 

5 Weighted average cost of capital 

Companies tend to have a mixture of the different types of capital in their structure 

and when considering the cost of capital used to finance a project it is common to use 

the cost of the mix of capital held by the company.We use the weighted average cost 

of capital (WACC) because the cost of capital that should be used in evaluating projects 

is the marginal cost of the funds raised to finance the project and the WACC is 

considered to be the best estimate of marginal cost (the capital structure of a 

company changes slowly over time). Note, however, that it only gives the most reliable 

estimate if the company is investing in projects with a normal level of business 

risk and funds are raised in similar proportions to its existing capital structure. 

WACC can be calculated using the following formula: 

E D 

WACC = Keg(––––– ) + Kd (1 – t)(––––––) 

E + D E + D



where: 

K eg = is the cost of equity in the geared company 

K d = the cost of debt before tax relief 

E = the market value of the company’s equity 

D = the market value of the company’s debt 

t = the rate of corporation tax applicable to the company 

The formula above assumes that debt is irredeemable, which means that the cost of 

debt capital is purely interest, all of which qualifies for tax relief. If debt is 

redeemable, the cost of debt is calculated as described in section 4.2 and used to 

replace K d (1 – t) in the formula above. 

The weighted average cost of capital is the average of costs of the different types of 

finance in a company’s structure weighted by the proportion of the different forms of 

capital employed within the business.The financial manager needs to ensure that any 

project under consideration will produce a return that is positive in terms of the business 

as a whole and not just in terms of an issue of capital made to finance it. 

Investments which offer a return in excess of theWACC will increase the market value 

of the company’s equity, reflecting the increase in expected future earnings and dividends 

arising as a result of the project. 

There is no one accepted method of calculating the weighting factors for different 

forms of capital. Some companies use book values from the company’s balance sheet 

and some use market values. Unquoted companies may have to use book values 

because of the problems that we have discussed earlier in estimating market values. 

The choice between market values and book values is discussed further in chapter 9. 



(a) Using book values in the proportions in which they appear in the company’s accounts: 

Weighting Cost Weighted cost 

Ordinary shares 60 per cent 12 per cent 7.2 per cent 

Debentures 40 per cent 8 per cent 3.2 per cent 

WACC 10.4 per cent 

(b) Using market values: 

Number Price Market Cost Market 

value per cent value 

Cost 

£ £ £ £ 

Ordinary shares 6,000 2.50 15,000 12 per cent 1,800 

Debentures 4,000 1.50 6,000 8 per cent 1,480 

21,000 2,280 

The WACC is then calculated as: 

£2,280 

10.86% 

£21,000 

Both methods produce the historic WACC (based on the relative weights of equity and debt capital in the past). 

You should remember that raising fresh capital may alter the weighting and therefore the cost of capital. A 

change in the company’s level of risk will also affect the company’s cost of capital. 

Which companies are relatively more likely to calculate WACC using book values?




5.1 Assumptions when using WACC 

To use WACC in capital investment appraisal the following assumptions have to be 

made: 

The cost of capital used in project evaluation is the marginal cost of funds raised to 

finance the project. 

New investments must be financed from new sources of funds, including new 

share issues, new debentures or loans. 

The weighted average cost of capital must reflect the long-term future capital 

structure of the company. 

5.2 Arguments against using the WACC 

There are arguments against using WACC for investment appraisal based mainly on 

the assumptions underlyingWACC. 

1 Businesses may have floating rate debt whose cost changes frequently and as we 

have seen only an estimate is used to calculate the cost of this type of finance.Thus 

the company’s cost of capital will not be accurate and will need frequent updating. 

2 The business risk of individual projects may be different from that of the company 

and will thus require a different premium included in the cost of capital. 

3 The finance used for the project may alter the company’s gearing and thus its 

financial risk. 

6 Assessment of risk in the debt versus equity 

decision 

6.1 Effect on market value 

The direct cost of borrowing consists of interest, together with any fees charged by 

the lender. Both interest and fees are generally deductible for tax purposes.Although 

borrowing may appear cheaper than equity, there is a risk to the company that should 

be taken into account when comparing costs. Consider worked example 6.10. 

A company has a current profit before interest and tax (PBIT) of £5m pa and current interest payable of 

£1.7m. The company’s issued share capital comprises 10m £1 ordinary shares and the earnings per share 

(EPS) are 5p. 

The firm wishes to invest £7.5m of new capital and it expects to increase its PBIT by £1.25m pa as a result. 

The alternatives under consideration by the directors are as follows: 

(a) To issue 3.75 million shares at 200p, representing a discount on the current market price of 240p. 

(b) To issue £7.5 million of 10-year debentures with a 12 per cent interest coupon. 

Assume a corporation tax rate of 28 per cent. 

Answer 

One approach to decide on the better route would be to attempt to predict the effect on the market value of the 

ordinary shares. The company would then elect for the opportunity which gives the best return to shareholders 

(remember the dominant objective of financial management). Table 6.3 below shows the effect on the earnings 

per share.



EPS will be improved if capital is raised in the form of debt rather than equity, provided PBIT really does 

increase by £1.25m. 

However, the use of debt has a higher level of risk than equity, because interest payments and debt capital 

repayments cannot be deferred if projected returns fail to materialise, whereas dividends can be reduced or 

passed (not paid at all); 

In our example the debt option would increase the gearing ratio and the interest cover (PBIT/interest) would 

fall from the present 2.94 to 2.4. (We shall consider gearing in detail in chapter 9.) 

table 6.3 Effect on earnings per share 

Current Projected Projected 

equity debt 

(£m) (£m) (£m) 

PBIT (5.00 (6.25 (6.25 

Interest payable (1.70) (1.70) (2.60) 

Profit before tax (3.30 (4.55 (3.65 

Tax at 28 per cent (0.99) (1.274) (1.022) 

Profit after tax (2.31 (3.276 (2.682 

Issued ordinary shares (10m (13.75m (10m 

Earnings per share (23.1p (23.8p (26.3p 

cost of capital The cost to a 

company of the return 

offered to different kinds of 

capital. This may be in the 

form of interest (for debt 

capital) or dividends and 

participation in the growth 

of profit (for ordinary shares) 

or dividends alone (for 

preference shares) or 

conversion rights (for 

convertible loan stock or 

convertible preference 

A lower interest cover means a greater risk that, in the event of a fall in PBIT, there will 

not be enough profits to pay the interest. 

6.2 Break-even profit before interest and tax 

The financial manager may choose to compute the break-even PBIT at which the 

earnings per share will be the same for the use of either equity or debt. For the 

example above, this is done as follows (y represents the break-even level of PBIT): 

Debt Equity 

(1 t) (PBIT Interest) 0.72(y 2.60) 0.72(y 1.70) 

EPS 

no. of shares 

10 

13.75 

which gives: 

y = 5.0 

The break-even level of PBIT is £5 million. Earnings per share will be greater using 

debt if PBIT is greater than £5 million and greater using equity if PBIT is less than £5 

million. In practice, more than one source of financing may be used and the financial 

manager needs to consider the risks and rewards of the alternatives. 

It is quite common for a company to use leases for a large part of its expenditure 

on capital items and to use equity for its increased working capital needs (though the 

expenses involved in an equity issue mean that a quoted company will be unlikely to 

consider raising less than £250,000 in a new equity issue).While the calculations in 

this chapter are easier to do for quoted companies (because share prices are known) 

the underlying principles are applicable to all businesses seeking new capital. 

7 Cost of capital for unquoted companies 


Unquoted companies do not have market values for their shares and thus calculating 

the cost of equity can be difficult.To estimate an approximate cost of capital the firm 

can either use the cost of equity of a similar quoted company and adjust it for



stop and think 6.1 

stop and think 6.2 

differences in financial and business risk, or it could add estimated premiums for its 

financial and business risk to the risk-free return on government bonds. 

If a company calculates how its projected EPS will be affected by raising new capital through (a) new equity or (b) 

new debt and makes its decision on whether to issue equity or debt on the basis of which gives the higher EPS 

figure, what risks is it ignoring? 

8 Cost of capital for not-for-profit organisations 

Government departments do not have a market value, nor do they have business or 

financial risk. So they cannot calculate the cost of capital.To evaluate projects they use 

a targeted ‘real rate of return’ set by the Treasury as a cost of capital. Not-for-profit 

organisations do not have market values and have to determine their cost of capital in 

other ways. Many use the cost of borrowing.You will appreciate from this chapter that 

this gives only a partial picture. 

(a) What does this approach to identifying the cost of capital miss out? 

(b) How does your organisation determine its cost of capital? What is the result? 

In this chapter we considered the costs of the different 

types of capital individually, before looking at the cost of 

capital structure on the company as a whole. 

We also saw the problems in determining the cost of 

capital for unquoted companies and other organisations. 

chapter summary 

practice questions 

It is important when you are revising this area to consider 

also the capital asset pricing model, which we shall 

discuss in chapter 8. 

Section A (4 marks each) 

6.1 ’Companies should use retained earnings to finance new projects because they are free.’ Discuss this point. 

6.2 Describe the difficulties in obtaining a cost of capital for a private limited company 

6.3 Explain why, if a company uses internally generated funds to finance investment, this capital has a cost. 

6.4 Calculate the cost of equity capital using the following equation based on Gordon’s growth model: 

K = do (1+g) 

e 

––––––– + g 

Po 

Where: 

the current ex-dividend share price is 520 p 

the current dividend is 13 p per share 

the expected annual rate of growth of the dividend is 12 per cent



6.5 A company’s cost of equity capital is 12 per cent, and the cost of its debt capital, which consists of 10 per cent loan stock 

currently traded at par, is 10 per cent. The company receives relief against corporation tax at 30 per cent on interest 

paid. The market value of the ordinary shares is £30 million and the market value of the loan stock is £20 million. 

Calculate the company’s after-tax weighted average cost of capital. 

6.6 Explain how a company can determine the cost of the capital represented by 

its redeemable loan stock (you do not need to do calculations). 

6.7 An investment in the ordinary shares of a large public company gives a return, based on the share price, the current 

dividend and the expected rate of dividend growth, of 12 per cent. An investment in the loan stock of the same company 

gives a return of 7 per cent. Explain why an investor might be equally happy to invest in either the ordinary shares or the 

loan stock. 

6.8 Explain why debt capital may be cheaper than ordinary share capital or preference share capital. 

Section B (20 marks each) 

6.9 

(a) (i) Describe the purpose of the dividend valuation and dividend growth models. 

(ii) State the relevant formulae. 

(iii) State the assumptions underlying them. 

(b) A company has a share value of £1.27 (ex-div) and has recently paid a dividend of 8p per share. If dividend growth is 

expected to be approximately 3 per cent p.a. into the foreseeable future, calculate the cost of equity. 

(c) What is the attraction of issuing debt capital as opposed to preference shares? 

6.10 

(a) Why should the weighted average cost of capital (WACC) be used to evaluate the required return on a project? 

(b) Calculate the WACC from the following, using two different approaches to calculate the weighting factors: 

Balance Sheet Extract from CD Plc 

Capital 

Ordinary shares 

Balance sheet value Market value 

(20,000 – 50p ordinary) 

8% preference shares 

£10,000 £1.72 per share 

(£1 nominal value) 

Long-term liabilities 

£5,000 £0.98 per £1 

10% debentures £7,500 £1.04 per £1 

The cost of equity has been calculated at 9.5 per cent. The corporation tax rate is 30 per cent. 

6.11 Zeta plc is planning to raise £2.5 million (before expenses) through an issue of ordinary shares. The issue price is 

£1.25. The expenses of the issue are expected to be £300,000. The company has just paid a dividend of 4 pence per 

share for 2002. Three years ago it paid a dividend of 3 pence for 1999. Investors expect future dividend growth at the 

same rate as in recent years. 

Required 

(a) Calculate the cost of equity capital using the Gordon dividend growth model. 

(b) Calculate the dividend yield, and explain the difference between this and the cost of capital in (a). 

(c) Calculate the cost of Zeta’s irredeemable 8 per cent debenture capital, the market price of which is £110 per £100 

nominal (Zeta pays corporation tax at 30 per cent). State any assumptions you make, and justify any choices you make 

in doing your calculations. 

(d) Explain (without doing any calculations) how you would calculate the cost of redeemable debt capital.

6 Cost of capital - ICSA

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