BUSF_A01.qxd

Chapter 10 • Cost of capital estimations and the discount rate

Warrants are valued similarly except that the returns from the warrant continue

after the equity is taken up.

10.3 Weighted average cost of capital ( WACC)

We have seen how the cost of individual elements can be estimated from current

capital market prices and predictions of future cash flows associated with the element

concerned. Most businesses use at least two of the financing methods that we have

considered, and each is likely to have a different cost. For example, to the capital mar-

ket investor, loan notes tend to be much less risky than equities in the same business.

Expectations of returns from equities are therefore higher. Given this disparity in the

cost of the various elements, which discount rate should be applied to the estimated

cash flows of prospective investment projects?

Target gearing ratios

Evidence shows that, generally, businesses have a target ratio, based on capital mar-

ket values, of the various financing elements. In other words, a particular business

seeks to keep equity finance as a relatively fixed proportion (by market value) of the

total finance. Similarly, it seeks to keep loan-type finance as more or less a fixed pro-

portion. Minor variations may occur from time to time, but businesses are believed to

take steps to get back to target as soon as it is practical to do so.

Marsh (1982) found that, in practice, most businesses maintain a stable capital

structure and appear to have a target gearing ratio. Ozkan (2001), studying 390 UK

businesses over the period 1984 to 1996, concluded that, generally, businesses have

a long-term target gearing ratio. Businesses seem rapidly to readjust their gearing to

meet this target whenever they find themselves diverging from it. Graham and Harvey

(2001) found that 81 per cent of the US businesses surveyed by them in 1999 had a

where iis the interest payment in each year until conversion in year t, pE0is the current

market price of an equity share, gis the growth rate of the equity price, RCthe conversion

rate and kCthe cost of the convertible. In this example we have:

£140 =+++

++

Solving for kC(by trial and error) gives about 5.5 per cent as the cost of the convertible

finance. Note that 5.5 per cent is an opportunity cost since:

lTower plc should be able to issue some more convertibles with similar terms and expect

to issue them at £140 per £100 nominal; or

lif the business were to buy back its own convertibles, for an investment of £140 it could

gain £11 (less tax) each year for five years and issue the shares for cash in five years

instead of using them to ‘redeem’ the loan notes. This would represent an annual return

of 5.5 per cent to Tower plc.

(1 +0.05)^5 ×£2.20 × 50

(1 +kC)^5

£11(1 −0.30)

(1 +kC)^5

£11(1 −0.30)

(1 +kC)^4

£11(1 −0.30)

(1 +kC)^3

£11(1 −0.30)

(1 +kC)^2

£11(1 −0.30)

1 +kC