Chapter 10 • Cost of capital estimations and the discount rate
assess the cost of capital, it is the future cost that we are interested in. The third
assumption, relating to risk, perhaps needs a comment. We know from a combination
of intuition and casual observation of real life that the required rate of return/cost of
capital depends partly on the level of risk surrounding the cash flows of the invest-
ment project concerned. It is not appropriate, therefore, to use a WACC based on a
past involving investment projects of one risk class as the discount rate for invest-
ments of an entirely different class.Calculation of WACC
Hazelwood plc is financed by:
(a) 1 million ordinary shares (nominal value £1 each), which are expected to yield a dividend
of £0.10 per share in one year’s time; dividends are expected to grow by 10 per cent of
the previous year’s dividend each year; the current market price of the share is £1.80
each; and
(b) £800,000 (nominal) loan notes, which pay interest at the end of each year of 11 per cent
(of nominal) for three years, after which the loan notes will be redeemed at nominal value.
Currently the loan notes are quoted in the capital market at £95 (per £100 nominal).
The corporation tax rate is 30 per cent.
What is the business’s WACC?Example 10.4First we must find the cost of each of the individual elements.
(a)Ordinary shares. Here we can apply the Gordon growth model (see equation (10.7),
page 280):Cost of equity, kE=+10%=15.6%, say 16%
(b)Loan notes. We must use our IRR-type trial and error here. We have the equivalent of an
investment project where an investment of £95 now will bring in interest of £11 (less tax)
that is, £7.70 net, at the end of each of the next three years plus £100 at the end of the
third year.
The discount rate that will give a zero NPV looks as if it is below 10 per cent. Try
8 per cent:Year Cash flow Discount factor Present value
££
0 (95.00) 1.000 (95.0)
1 7.70 0.926 7.1
2 7.70 0.857 6.6
3 107.70 0.794 85.5
4.2£0.10
£1.80Solution