BUSF_A01.qxd

Cost of individual capital elements

If a fixed proportion (b) of funds generated by trading each year is retained (as

opposed to being paid as a dividend), and the funds are reinvested at a constant rate

(r), then:

Rate of growth (g) =b×r

Assuming either that dividends will be constant, on the one hand, or that the rate

of growth will be constant, on the other hand, is clearly unrealistic. In practice, divi-

dends tend to increase from time to time, and to remain steady at the new level for

a period before the next increase. These particular assumptions need not be made,

although they provide a practical, if inaccurate, way of estimating the cost of equity.

Retained profit

As was made clear in Chapter 8, retained profit is not a free source of finance. It has

an opportunity cost to shareholders because, if such profits were to be distributed,

shareholders could use them to make revenue-generating investments. It would be

incorrect, however, to deal with retained profit separately in deducing its cost. When

we derive the cost of equity, we are deriving the cost of the entire equity, which,

in effect, includes retained profit. Thus, provided that the cost of equity is properly

derived, the fact that the equity is part share capital and part retained profit will

automatically be taken into account.

Convertible loan notes

Convertible loan notes may be viewed as redeemable loan notes on which interest will

be paid until a date in the future when they will be redeemedby their conversion into

equities. Estimating the cost of convertibles is, therefore, a similar operation to valu-

ing loan notes, except that the redemption amount is unknown, to the extent that we

do not know what the equity share price will be at the conversion date. As with estim-

ating the cost of equities, we can make some assumptions – for example, that the

equity dividends will remain constant or that they will grow at a steady rate.

The convertible loan notes of Tower plc currently trade in the capital market at £140 per £100

nominal. The notes pay annual interest of £11 per £100 nominal and may be converted in

exactly five years’ time at a rate of 50 ordinary shares in the business per £100 nominal of

loan notes. The present price of the ordinary shares is £2.20, which is expected to grow by

5 per cent p.a. over the next five years. What is the cost of the convertible loan notes?

Note that corporation tax is charged at 30 per cent.

Example 10.3

The price of the convertible pC0is given by:

pC0=+pE^0 (1 +g)

tRC

(1 +kC)t

i

(1 +kC)n

t

∑

n= 1

Solution

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