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outstanding； giving each remaining shareholder a larger percentage ownership
of the pany。 This is usually considered a sign that the pany’s
management believes its share price is undervalued。 Other reasons for
buybacks include pu。。ing unused cash to use； raising earnings per share
and obtaining stock for employee stock option plans or pension plans。
HYBRIDS
A number of financing methods straddle the debt and equity boundary。
These try to mitigate taking a bit more risk for the potential of a bit more
return than would be usual with debt financing。 But they also limit the
upside that might be expected from pure equity； which would retain all of
any increase in value from the outset：
。 Convertible preference shares operate like preference shares； in that
their holders rank before ordinary shareholders for dividend payment；
Finance 69
or return of funds in the case of failure。 They also have the option； at
some specified date in the future； to convert to ordinary shares and so
enjoy all of any increase in value。
。 Mezzanine finance has one or all of these characteristics： It ranks a。。er
other forms of debt； but before equity； for any payout in the event of a
business failing； it pays higher； o。。en significantly higher； interest than
other debt； it can be held for up to 10 years； it can be converted into
ordinary shares。 It is popular with VCs for management buyouts。
Grants
Government agencies at both national and local government level as well
as some extra…governmental bodies such as the EU offer grants； effectively
free or nearly free money in return for certain behaviour。 It may be to encourage
research into a particular field； stimulate innovation or employment or
to persuade a pany to locate in a particular area。 Grants are constantly
being introduced （and withdrawn）； but there is no system that lets you
know automatically。 You have to keep yourself informed。
Business Link （businesslink。gov。uk 》 Finance and grants 》 Grants
and government support） has advice on how to apply for a grant as well
as a directory of grants on offer。 Microso。。 Small Business Centre （
microso。。/uk/businesscentral/euga/home。aspx） has a European Union
Grant Advisor with a search facility to help you find which of the 6；000
grants on offer might suit your business needs。 Grants。Gov （grants。
gov） is a guide to how to apply for over 1；000 federal government grants in
the United States。
COST OF CAPITAL
A business needs to keep track of how much it is paying for the capital it
uses； as that is the minimum hurdle rate for any investment it may make。
Also； it needs to be aware that if new money being raised is more costly
than that already in the business； it will only be profitable if it raises the
hurdle rate for new projects accordingly。
Cost of debt
This can be very straightforward。 If a pany takes out a bank loan at a
fixed rate of interest of say； 8 per cent； then this is the cost before any tax
relief。 Taking tax relief at 40 per cent into account； the net cost of debt es
down to 4。8 per cent。 In the case of a public offer for bonds or debentures；
the rate of interest which has to be paid on new loans to get them taken up
by investors at par can be regarded as the cost of borrowed capital。
70 The Thirty…Day MBA
Cost of equity
Put simply； the cost of equity is the return shareholders expect the pany
to earn on their money。 It is their estimation； o。。en not scientifically
calculated； of the rate of return that will be obtained both from future
dividends and an increased share value。
Dividend valuation model
One approach to finding the cost of equity is to take the current gross
dividend yield for a pany and add the expected annual growth。
Example
For example； XYZ plc has forecast payment of a gross equivalent dividend
of 10p on each ordinary share in the ing year。 The pany’s shares
are quoted on the Stock Exchange and currently trade at ￡2。00。 Growth of
profits and dividends has averaged 15 per cent over the past few years。 The
cost of equity for XYZ plc can be calculated as：
Cost of equity capital = Current dividend （gross） ％ ＋ Growth rate ％
Current market price = （￡0。10 × 100） ％ ＋ 15％ = 20％ = ￡2
With this method； dividends are assumed to grow in the future at the
constant rate achieved by averaging the last few years’ performance。
Capital asset pricing model （CAPM）
Before turning to the next method； we need to clarify some aspects of risk。
There are two broad types of risk：
。 Specific risk： This applies to one particular business。 It includes； for
example； the risk of losing the chief executive； the risk of someone else
bringing out a similar or be。。er product； or the risk of labour problems。
Shareholders are expected not to want pensation for this type of
risk as it can be diversified away by holding a sufficient number of
investments in their portfolios。
。 Systematic risk： This derives from global or macroeconomic events
that can damage all investments to some extent and therefore holders
require pensation for this risk to their wealth。 This pensation
takes the form of a higher required rate of return。
A slightly more plicated approach to the cost of equity tries to take the
systematic risk element into account。 It is known as the capital asset pricing
model or CAPM for short。 Put simply； CAPM states that investors’ required
rate of return on a share is posed of two parts： a risk…free rate similar
Finance 71
to that obtainable on a risk…free investment in short…term government
securities； and an additional premium to pensate for the systematic
risk involved in investing in shares。
This systematic risk for a pany’s shares is measured by the size of its
beta factor。 A beta the size of 1。0 for a pany means that its shares have
the same systematic risk as the average for the whole market。 If the beta is
1。4 then systematic risk for the share is 40 per cent higher than the market
average。 A pany’s share beta is applied to the market premium that is
obtained from the excess of the return on a market portfolio of shares over
the risk…free rate of return。 The formula to calculate cost of equity capital
using CAPM is：
Ke = Rf ＋ B（Rm – Rf）
Where： Ke = cost of equity； Rf = risk…free return； Rm = return on market
portfolio of shares and B = beta factor。
Example
If the risk…free rate of return is 5。5 per cent and the return on a market
portfolio is 12 per cent； then for a pany with a beta of 0。7 for its ordinary
shares calculate its cost of equity。
Ke = Rf ＋ B（Rm – Rf）
= 5。5％ ＋ 0。7（12％ – 5。5％）
= 10。05％
Of the two methods described for finding the cost of equity for a pany；
the la。。er CAPM method is the more scientific。 Ideally； the risk…free and
market rates of return should reflect the future； but current rates of return
are used as substitutes。 Beta factors measure how sensitive each pany’s
share price movements are relative to market movements over a period of
a few years。
The weakness of CAPM is that it assumes all investors are rational and
well informed； that markets are perfect and that there is an unlimited supply
of risk…free money。 There are even more plex models for calculating the
cost of equity capital； but none are without their critics。
Weighted average cost of capital
Having identified the cost of equity and the cost of borrowed capital （and
that of any other long…term source of finance such as hire purchase or mortgages）；
we need to bine them into one overall cost of capital。 This is
primarily for use in project appraisals as justification of those that yield a
return in excess of their cost of capital。
72 The Thirty…Day MBA
An average cost is required because we do not usually identify each
individual project with one particular source of finance。 Because equity and
debt capital have very different costs； we would make illogical decisions and
accept a project financed by debt capital only to reject a similar project next
time round when it was financed by equity capital。 Generally businesses
take the view that all projects have been financed from a mon pool
of money except for the relatively rare case when project…specific finance
is raised。 The weightings used in the calculations should be based on
the market value of the securities and not on their book or balance sheet
values。
Example
Assume your pany intends to keep the gearing ratio of borrowed capital
to equity in the proportion of 20 ： 80。 The nominal cost of new capital
from these sources has been assessed； say； at 10 per cent and 15 per cent
respectively and corporation tax is 30 per cent。 The calculation of the overall
weighted average cost is as follows：
Type of capital Proportion （a） A。。er…tax cost （b） Weighted cost （a × b）
10％ loan capital 0。20 7。0％ 1。4％
Equity 0。80 15。0％ 12。0％
13。4％
The resulting weighted average cost of 13。4 per cent is the minimum rate
that this pany should accept on proposed investments。 Any investment
that is not expected to achieve this return is not a viable proposition。 Risk
has been allowed for in the calculation of the beta factor used in the CAPM
method o