2013, Study Session #11, Reading # 37 COST OF CAPITAL 1. INTRODUCTION

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1 COST OF CAPITAL 1 WACC = Weighted Avg. Cost of Capital MCC = Marginal Cost of Capital TCS = Target Capital Structure IOS = Investment Opportunity Schedule YTM = Yield-to-Maturity ERP = Equity Risk Premium DDM = dividend discount model 1. INTRODUCTION Cost of capital is important in investment decisions for management & investors. If return is > cost of capital, company has created value. Cost of capital estimation requires assumptions & estimates. Company must estimate project-specific costs of capital. SYS = Sovereign Yield Spread FC = Flotation Cost IB = Investment Banker CF = Cash Flows MP = Market Price PS = Preferred Stock DDM = Dividend Discount Model 2. COST OF CAPITAL Cost of capital rate of return the suppliers of capital require as compensation (opportunity cost of funds). Marginal cost cost to raise additional funds for potential investment projects. Cost of capital for entire company is WACC which is also referred MCC. WACC = w r 1 t + w r + w r where w = proportion of debt r = before tax cost of debt t = marginal tax rate, = proportion of preferred & common equity respectively., = &. 2.1 Taxes & Cost of Capital In many jurisdictions interest on debt financing is a deduction to arrive at taxable income. Estimating the cost of common equity capital is more challenging than the cost of debt capital and conventional preferred equity (no stated & fixed payment). Two methods for estimating cost of equity are: Capital asset pricing model. Dividend discount model. No tax adjustment in cost of equity (payment to owner is not tax deductible). 2.2 Weights of the Weighted Average Ideally uses in project or company proportion of each source of capital that company use. Target capital structure capital structure that a company is striving to obtain. Analyst use several approaches for estimating target capital structure as: Assume current capital structure represents company s TCS. Examine trends or statements by management regarding capital structure policy to infer TCS. Use avg. of comparable companies CS as TCS.

2 2 2.3 Applying the Cost of Capital to Capital Budgeting & Security Valuation Company s MCC may as additional capital is raised, & returns as company makes additional investments represented by IOS. Optimal capital budget amount of capital raised and invested at which marginal cost of capital is equal to marginal return from investing. Upward or downward adjustment to company s WACC if systematic risk of project is above or below the company s risk. NPV = PV of inflows (discounted at project s cost of capital) PV of outflows. If we are using the company s WACC to calculate project NPV, we assume: Project has same risk as avg. risk project of company. Constant TCS throughout useful life. If free cash flow to firm, use weighted avg. cost of capital for company valuation. If free CF to equity, use cost of equity to find PV of these CF. 3. COST OF THE DIFFERENT SOURCES OF CAPITAL 3.1 Cost of Debt Yield-to-Maturity Approach Debt-Rating Approach Issues in Estimating the Cost of Debt Yield that equates PV of bond s promised payments to MP. YTM assumes reinvestment at YTM. 3.2 Cost of Preferred Stock Cost to pay preferred stock holders as preferred dividend. Cost of nonconvertible, non-callable PS = = = = = Used when MP of debt is not available. Before-tax cost of debt = yield on comparably rated bonds for maturities closely matching those of company s debt. Important consideration debt ratings are ratings of debt issue itself. Dividend on Ps is not tax-deductible. Certain number of features (e.g. call option, cumulative dividends etc) affect cost of PS & hence require adjustment Fixed-Rate Debt versus Floating-Rate Debt Estimating cost of floating rate debt is difficult (depends on current & future yield) Debt with Optionlike Features Cost of debt is difficult to determine if debt has optionlike features (call, put etc). Analyst can make market value adjustments to YTM for options Nonrated Debt If company does not have rated bonds, synthetic debt rating based on financial ratios is used, it ignores information on bond issue & issuer Leases If company uses leasing as source of capital, the cost of leases should be included in cost of capital.

3 3 3.3 Cost of Common Equity Company may increase common equity through earnings reinvestments or issuance of new shares Capital Asset Pricing Model Approach = + = return sensitivity of stock i to changes in market return. = expected return on market = expected market risk premium. (MRP) Selection of appropriate rate guided by duration of projected CF. Expected MRP is the premium that investors demand for investing in market portfolio relative to. Multifactor model (factors that may be other sources of priced risk). = + (factor risk premium), + (factor risk premium) (factor risk premium) j. Equity risk Premium Historical ERP Approach DDM Based Approach Survey Approach Realized ERP is a good indicator of expected ERP. Use historical data for avg. return of market portfolio & avg. RFR. Limitations Stock index risk level may change over time. Investor risk aversion may change. Sensitive to method of estimation & historical period covered. = + = next year dividend = current market value g = growth rate. = dividend yield. Is dividend yield plus growth in dividend. ERP is difference b/w & RfR. Ask panel of finance experts for their estimates & take mean response. Adjust ERP for particular project or company by adjusting its systematic risk Dividend Discount Model Approach = + Growth rate estimation Through published source or vendor Sustainable growth rate = 1 ROE = return on equity. Assume constant capital structure Bond Yield plus Risk Premium Approach = + Risk premium = before-tax cost of debt. Risk premium capture additional risk of stock relative to its bonds.

4 4 4. TOPICS IN COST OF CAPITAL ESTIMATION 4.1 Estimating Beta & Determining a Project Beta β can be estimated through market model regression (company s stock return against market return). Estimation period, periodicity of return interval, selection of appropriate market index, use of smoothing technique & adjustments for small-capitalization stocks are important considerations for β estimation. Business risk risk related to uncertainty of revenues. Operating risk operating cost structure risk. Financial risk uncertainty of N.I & net CF due to use of financing. Pure Play Method Using comparable publicly traded company s β & adjusting it for financial leverage differences. Comparable company company with similar business risk. Asset (unlevered) β β after removing effects of financial leverage. Β adjustment for capital structure of company or project (lever the asset β to arrive equity β) = (We assume debt has no market risk) = Steps in Pure-Play Method Step I Step II Step III Step IV Select the comparable Estimate comparable s beta Unlever the comparable s beta Lever β for project s financial risk 4.2 Country Risk β does not capture country risk for companies in developing countries. Adjust cost of equity (using CAPM) by adding a country spread to MRP. Country Spread (country equity premium) types Sovereign Yield Spread Diff. b/w govt. bond yield in that country (denominated in developed market currency) & Treasury bond yield of similar maturity bond in developed market country. If country has credit ratings but no equity markets, the expected rate of return is found by estimating reward to credit risk for a large sample of countries (which have both credit ratings and equity markets) & apply this ratio to countries without equity markets. =

5 5 4.3 Marginal Cost of Capital Schedule Cost of different sources of capital as more capital raised (result in MCC schedule). Debt incurrence test may restrict a company s ability to incur additional debt of same seniority. Company can deviate from target capital structure, MCC may increase. = 4.4 Flotation Costs Floatation cost fee charged by I.B based on size & type of offering. Debt & preferred stock ignore flotation cost (quite small amount). Flotation cost may be substantial in equity issuance. View about Flotation Cost Incorporate into cost of capital Incorporated into valuation analysis as an additional project cost FC in Monetary terms = + FC as % applied against price per share = + 1 f = % flotation cost as a% of issue price Adjustment to CF in valuation computation (e.g. consider initial outflow in NPV calculation). Preferred over cost of capital adjustment method. Incorrect approach adjust PV of FCF by a fixed %, not initial CF. Found in text book because: Useful if specific project financing can t identified Demonstrate how costs of financing change when company switches from internally generated equity to external equity. 4.5 What Do CFOs Do? A survey of CFOs revealed the following: CAPM is most popular method for estimating cost of equity & popular in publicly traded companies. Dividend CF model to estimate cost of equity is used by limited no. of companies. Majority use single company cost of capital with some type of risk adjustment for individual projects.

Financial Planning and Control. Semester: 1/2559

Financial Planning and Control Semester: 1/2559 Krisada Khruachalee Master of Science in Applied Statistics, Master of Science in Finance, Bachelor of Business Administration (Cum Laude), Finance and Banking