Summary Cost of Capital

2600 WordsNov 6, 201411 Pages
The Cost of Capital 1 Background As investors desire to obtain the best/highest return on their investments in securities such as shares (Equity) and loans to companies such as debentures (Debt), these returns are costs to the companies paying these Dividends (on equity) and Interest (on Debts)! It all depends on the perspective from which we chose to view the calculation (are we Earning or Paying?) Companies MUST consider the cost of financing they receive in the form of equity or debt if they are to manage their finances better; cheaper finance cost to the company means higher profitability and in most cases, superior cash flow. Generally, the cost of EQUITY has no tax effect but the cost of DEBT finance to companies are technically…show more content…
An Example G plc is about to pay a dividend of £50m in total. When G plc first obtained a stock market listing four (4) years ago, it paid a dividend of £30m in total. Over the last four years there have been no changes in the share capital of G plc. You are required to estimate the annual rate of dividend growth. Solution [£30m × 3 (1 + g) 4 = £50m] therefore, [g = 13.62% p.a] The Cost of Debt Based on equivalent assumptions to those used in the DVM above, we conclude that: PV interest stream = Market Value (MV of debenture ) Note: (DEBT in this case!) The tax system gives tax relief on interest payments by allowing tax deductions from company’s Profit & Loss account (thus REDUCING taxable profit). This has the effect of reducing the Cost of DEBT or what do you think? Lower Tax means lower cost of finance as WITHOUT the tax relief, the company will pay HIGHER tax bills and the full cost of the loan BUT in this case, you pay the FULL interest BUT save on TAX, see it? Therefore the true cost to the company of servicing the debentures will be after the tax relief subsidy is taken into account. www.goldsmithibs.com An Example – irredeemable debentures M plc has some 8 per cent coupon irredeemable debentures in issue trading at 90 ex int. Corporation tax is 30 per cent with no lag in payment. Interest is paid annually. Solution PV of after–tax interest = current debenture price £8(1 − 0.30) Kd Kd = 90 = 5.60 90 = 6.2% per

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