BUSF_A01.qxd

Cost of individual capital elements

from the capital market having changed its perceptions of the risk of default (by the

business) in payment of interest or principal. Thus a particular business’s cost of cap-

ital is not necessarily static over time. Given capital market efficiency, the cost of any

element of capital is the market’s best estimate of that cost for the future.

Perpetual loan notes are occasionally issued by businesses. These are loan notes

that have no repayment date and which will, in theory, continue paying interest for-

ever. Their cost of capital calculation is similar to, though simpler than, the calculation

for redeemable loan notes.

Where each of the Cnvalues is identical and ngoes on to infinity,

pL 0 =

where Tis the rate of corporation tax. This can be written as

kL=

Thus in the above example, if there were to be no repayment of principal but the

annual £10 interest payments were to continue indefinitely, then

kL=

=7.5%

Term loans

With term loans (a very major means of business borrowing) and unlisted loan notes,

there is no readily accessible figure for p 0 that can be put into the valuation model

(equation (10.2) above) to deduce k. Logically p 0 should be the amount that the bor-

rowing business would need to pay immediately to induce the lender to cancel the

loan contract. Alternatively, it is the amount that could currently be borrowed, given

the future payments of interest and capital it is obliged to make under the terms of the

loan in question. In theory these two should be alternative routes to the same value for

p 0 ; in practice they may not be.

The real problem is that, equal or not, in practice p 0 is not readily observable, so

some estimate of it needs to be made. In practical terms, unless the value of the loan is

particularly large and/or there have been major changes in interest rates since the loan

was negotiated, the contracted rate of interest would probably serve adequately as the

present opportunity cost of the source. Alternatively, an estimate, based on observa-

tion of current interest rates, could be made.

Finance leases

As we saw in Chapter 8, a finance lease is in effect a secured term loan with cap-

ital repayments at intervals during the period of the loan, rather than all at the end.

Where it is not explicit in the lease contract, we can discover the interest rate fairly

easily.

10 (1 −0.30)

93

Cn(1 −T)

pL 0

Cn(1 −T)

(1 +kL)n

∞

∑

n= 1