STUDY UNIT 4 - COST OF CAPITAL
3.1 Cost of Capital
The minimum return that investors require in order to invest in the organisation.
3.2 Sources of Finance
Equity: Through issuing of ordinary shares which gives the investor a stake
in the business
Debit: Contain carrying provisions with regards to interest rate, security
and repayment and may contain restrictive covenants which usually limit
level of risk to which the company is exposed
3.3 Relationship between Risk and Return
The choice between debt or equity depends on:
o Return: Debt is cheaper than equity
o Risk: Debt is riskier than equity
o Control: Debt has less impact on the control of a company than equity
Cost of finance is dependent on
o The prevailing risk-free rate of return (Rf)
o The reward investors demand for the risk they take in advancing funds
to the firm
Risk-Free Rate of Return (Rf)
• It is the minimum rate required by all investors whose returns are certain
and is also called the return on treasury bill or the return on government
gilts (gilt-edged securities)
• It includes compensation for inflation i.e. it is a nominal or money rate
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, Return on Risky Investments – Equities
• Equity shareholders are paid only after all other commitments have been
met, the order of priority is:
o Secured lenders
o Legally-protected creditors such as tax authorities
o Unsecured creditors
o Preference shareholders
o Ordinary shareholders
Equity shareholders face the greatest risk as level of risk depends on:
o The volatility of company earnings
o The extent of other binding financial commitments
Required Return = Risk-Free Return + Risk Premium
3.4 Components of the Cost of Capital
3.4.1 Cost of new debt (Kd)
• Refers to interest charged on loans
• Loans are of two categories:
o Term loans at a negotiated rate – the quoted rate is related to the
market rate currently charged for similar loans
o Debentures (bonds) at a coupon rate – the rate is determined in terms
of the discount or premium on par value at the time of sale
o Formula 𝑲𝒅 = I(1 –t)
Kd = the cost of capital
I = interest rate payable
t = the marginal tax rate
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3.1 Cost of Capital
The minimum return that investors require in order to invest in the organisation.
3.2 Sources of Finance
Equity: Through issuing of ordinary shares which gives the investor a stake
in the business
Debit: Contain carrying provisions with regards to interest rate, security
and repayment and may contain restrictive covenants which usually limit
level of risk to which the company is exposed
3.3 Relationship between Risk and Return
The choice between debt or equity depends on:
o Return: Debt is cheaper than equity
o Risk: Debt is riskier than equity
o Control: Debt has less impact on the control of a company than equity
Cost of finance is dependent on
o The prevailing risk-free rate of return (Rf)
o The reward investors demand for the risk they take in advancing funds
to the firm
Risk-Free Rate of Return (Rf)
• It is the minimum rate required by all investors whose returns are certain
and is also called the return on treasury bill or the return on government
gilts (gilt-edged securities)
• It includes compensation for inflation i.e. it is a nominal or money rate
1|Page
, Return on Risky Investments – Equities
• Equity shareholders are paid only after all other commitments have been
met, the order of priority is:
o Secured lenders
o Legally-protected creditors such as tax authorities
o Unsecured creditors
o Preference shareholders
o Ordinary shareholders
Equity shareholders face the greatest risk as level of risk depends on:
o The volatility of company earnings
o The extent of other binding financial commitments
Required Return = Risk-Free Return + Risk Premium
3.4 Components of the Cost of Capital
3.4.1 Cost of new debt (Kd)
• Refers to interest charged on loans
• Loans are of two categories:
o Term loans at a negotiated rate – the quoted rate is related to the
market rate currently charged for similar loans
o Debentures (bonds) at a coupon rate – the rate is determined in terms
of the discount or premium on par value at the time of sale
o Formula 𝑲𝒅 = I(1 –t)
Kd = the cost of capital
I = interest rate payable
t = the marginal tax rate
2|Page
