Financial managers have to be aware of the costs involved with the different sources of finance by analysing the risk and return.
Cost of Equity
The cost of equity to a company is the shareholders expected return on shares. There are three methods that can be used to estimate the cost of equity:
- Dividend Valuation Model (DVM) – Assuming constant dividends
- Dividend Growth Model (DGM) – Assuming constant growth
- Capital Asset Pricing Model (CAPM) – Takes into account risk
Dividend Valuation Models (with & without growth)
The dividend valuation model allows us to predict the value of a share if we know the return the shareholder requires or we can calculate the cost of equity if we assume that the value of the share price is valued correctly.
The issues with the Dividend Valuation Model include:
- Does not consider risk
- Growth can be difficult to measure
- Taxation effects ignored
- Assumes there is no issue cost involved with buying new shares
- Based on past history therefore assuming the future reflects the past
How do we estimate future growth?
There are two ways we can estimate the growth of dividends, we can use the Gordon’s growth model or we can calculate the past averages of the company and this will give us the estimated growth.
Capital Asset Pricing Model
This model can be used to calculate cost of equity and incorporates the internal (Unsystematic) and external (Systematic) risk that affects companies’ shares. This model measures how systematic risk affects required returns and share prices. A high systematic risk would mean higher returns to compensate for greater risks.
Issues with CAPM include:
- Unrealistic assumptions
- Necessary estimates difficult to make
Cost of Debt
The type of debt will determine the cost associated with it. The types of debts include:
- Redeemable Debt – Calculated using Internal Rate of Return (IRR)
- Irredeemable Debt
- Convertible Debt – This is difficult to determine because depends on whether conversion happens or not.
- Preference Shares – Note tax relief is not given for preference share dividends
- Bank Loans
Weighted Cost of Capital
Most large businesses will use a mixture of debt and equity in order to raise finance for projects. Obtaining a balance of the cost of both is known as the weighted average cost of capital (WACC) it can help to measure/weigh the cost of the different sources of finance. They can be based upon:
- Book Values (historic cost)
- Market Values – Current opportunity cost of finance.
Note it is important that if possible market values are used because these are more accurate and will not cause underestimations that allow accepting of unprofitable projects.
The WACC calculation is based upon the cost of debt and equity.