The Cost of Capital
The Cost of Capital Eva R. Porras
Eva R. Porras 2011 Softcover reprint of the hardcover 1st edition 2011 978-0-230-20183-5 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6-10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted her right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2011 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin s Press LLC, 175 Fifth Avenue, New York, NY 10010. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave and Macmillan are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN 978-1-349-30003-7 ISBN 978-0-230-29767-8 (ebook) DOI 10.1057/9780230297678 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress. 10 9 8 7 6 5 4 3 2 1 20 19 18 17 16 15 14 13 12 11
To my father
Contents List of Tables List of Figures List of Abbreviations Acknowledgements Preface ix x xi xiii xiv Introduction 1 1 A General Introduction to Risk, Return, and the Cost of Capital 6 The relevance of the cost of capital 6 The relationship between risk and return 9 Historical evidence 15 Market efficiency and return 22 Portfolio risk and return 24 The time value of money and investment criteria 30 Cash flows: Free cash flows, Equity cash flows 34 Summary 41 2 The Components of the Cost of Capital and Alternative Models 43 Risk, return, and the cost of capital 43 The weighted average cost of capital (WACC) 55 Summary 92 3 Problems in Using the Models 94 Problems in using the models to price risk: An introduction 94 The CAPM 97 The Gordon or constant growth model 116 The Subjective or risk premium model 118 From cost of equity to cost of capital 119 Summary 120 Appendix: A more detailed analysis of the CAPM 121 4 Caveats 131 WACC, average risk and the divisional cost of capital 131 Flotation costs 140 Cost of capital and inflation 142 Risk premiums for non-traded stocks 150 vii
viii Contents Specific concerns for regulated industries 153 Stock options 157 Convertible stock 160 Taxation 161 Summary 162 5 Country Risk 165 Country risk premiums 165 Sovereign credit ratings 166 Modelling country risk 169 Summary 192 6 The Optimal Capital Structure 193 The theory of optimal capital structure 194 Empirical evidence 201 How to estimate the optimal capital structure 204 How to effect changes in capital structure 217 Summary 222 Conclusion 225 Notes 230 References 234 Further Reading 237 Index 239
Tables 1.1 Historical evidence, USA 1926 to 2005 18 1.2a Long-term debt yields and spreads over Treasury 21 1.2b Corporate long-term debt yields and spreads over Treasury 21 1.3 Diversification and risk 29 1.4 Discounted payback period 31 2.1 Average return estimation 47 2.2 Covariance estimation 47 2.3 Standard deviation estimation 48 2.4 Beta examples and their meaning 50 2.5 Betas in three sectors 76 2.6 Estimating dividend growth 78 3.1 Sovereign default risk and country risk premium 101 3.2 A sample of historical returns 104 3.3 Equity risk premiums, USA (1926 87) in percentages 105 4.1 ACMA project 132 4.2 Beta for ACMA division 137 4.3 Real versus nominal cash flows 149 5.1 Comparative ratings by three agencies 170 5.2 Country equivalency ratings 172 5.3 Country and total equity risk premium 185 5.4 Cash flow estimation 191 6.1 EPS and ROE 206 6.2 Tax savings 206 6.3 EPS and ROE additional equity versus additional debt scenario 207 6.4 EPS and ROE additional equity versus additional debt scenario 207 6.5 Estimating the firm s free cash flows 209 6.6 Interest coverage ratio and rating 210 6.7 Company value and leverage 212 6.8 Estimate the cost of equity CAPM 213 6.9 WACC and company value for different debt levels 213 6.10 Optimal capital structure 217 ix
Figures 1.1 The normal distribution 17 1.2 The efficient frontier 28 1.3 Portfolio diversification 29 2.1 Correlation 46 2.2 Regression line 50 2.3 Reward-risk ratio 51 2.4 Reward-risk ratio for two investments 53 3.1 Historical returns and standard deviation, US 1926 1996 96 3.2 Beta for J. P. Morgan U.S. equity relative CCMP index 112 3.3 Beta for J. P. Morgan U.S. equity relative SPX index 113 3.4 Beta for Citigroup U.S. equity relative SPX index 1 113 3.5 Beta for Citigroup U.S. equity relative SPX index 2 114 3.6 Beta for Citigroup U.S. equity relative CCMP index 114 3.7 Heteroscedasticity and homoscedasticity 128 4.1 Security market line and project risk 132 4.2 Security market line (SML) 135 4.3 Normal curve 154 4.4 Skewness 155 5.1a Colombia government bond 10 year yield 177 5.1b United States government bond 10 year yield 178 6.1 The effect of financial leverage 205 6.2 The cost of capital for various levels of debt 214 6.3 Firm value and WACC for different leverage levels 216 x
Abbreviations AM APBO APT APV B-S CAPM CDO CDS CEO CF CFO CPI CRP DCF DJIA DPP EBIT EBT ECF EMH EPS ERP EU FCF FCFE FCFF Fed FV GAAP GDP GLS IMF IRR IRS LBO LIBOR M&M Apparel manufacturing Accumulated post-retirement benefit obligations Arbitrage pricing theory Adjusted present value Black and Scholes Capital asset pricing model Collateralized debt obligations Credit default swaps Chief executive officer Cash flows Chief financial officer Consumer price index Country risk premium Discounted cash flow Dow Jones Industrial Average Discounted payback period Earnings before interest and taxes Earnings before taxes Equity cash flow Efficient market hypothesis Earnings per share Equity risk premium European Union Free cash flows Free cash flow to equity Free cash flow to the firm US Federal Reserve System Future value Generally accepted accounting principles Gross domestic product Generalized least squares International Monetary Fund Internal rate of return Internal Revenue Service Leveraged buyout London Interbank Offered Rate Modigliani and Miller xi
xii Abbreviations MBS MICAPM MRP MSCI NASDAQ NI NPV NYSE OLS PBO PI PP PPP PV ROE S&P 500 SEC SIC SML WACC Mortgage-backed securities Modified international capital asset pricing model Market risk premium Morgan Stanley Capital International (equity index) National Association of Securities Dealers Automated Quotation Net income Net present value New York Stock Exchange Ordinary least squares Projected benefit obligation for pensions Profitability index Payback period Purchasing power parity Present value Return on equity Standard & Poor s 500 Index Securities and Exchange Commission Standard Industrial Classification Security market line Weighed average cost of capital
Acknowledgements This book is the product of the efforts and experience of many people who in different ways have contributed towards its development. First, I would like to thank all the professors who donated their energy and time to my education. It was their persistence and dedication which instilled in me a love for the subject of finance. As a professor myself I have been gratified by the interest my students have shown in the subject of the cost of capital. The sharing of our common business experiences as directors and entrepreneurs helped us recognize the cost of capital as an area where competitive advantages can be achieved by becoming more effective and efficient managers. These advantages can also be gained when making financial decisions in our own private sphere. I therefore want to thank all the students who openly discussed the personal and professional challenges they faced, and who with their questions planted the seeds for this work. I need to give very special thanks to Renée Takken and Lisa von Fircks of Palgrave Macmillan. They already know the many reasons for my gratitude. I extend this recognition to my family who exercised their patience through the many months it took to finish this work. Finally, I want to thank my very generous colleague Dr. Roderick Martin who read every page of the manuscript and made so many good comments and suggestions. Of course, any mistakes or textual errors are and remain my sole responsibility. xiii
Preface On the executive programmes in finance that I teach, the cost of capital is one of the subjects that raises the most interest. There are several reasons for this. One is that managers within small and medium size companies dedicate enormous amounts of energy, time and resources to managing the left-hand side of the balance sheet. For example, most people in the business community are aware of models that exist to help them determine the optimal amount of cash or inventory that should be kept in the balance sheet (or warehouse) to reduce unnecessary stocks that consume valuable resources. Nevertheless, for various reasons, fewer managers have equivalent knowledge of how to think about and mix the different sources of capital needed to purchase the assets the company requires to ensure its growth and well-being. In other words, the right-hand side of the balance sheet often remains a mystery or is treated as given. Much the same holds true for personal financial management. I have met very few people outside the finance profession who have a real understanding of how to manage their personal wealth and of the true risks they incur when choosing the composition of their personal investment portfolios. Since enormous gains are to be achieved from efficiency in managing the costs and risks of financial resources, this book explains the concepts, formulae, theory and thinking related to these cost of capital and capital structure questions, and is designed to serve the following three main purposes: 1. A comprehensive reference for business managers. 2. An introductory text on cost of capital for academic courses and practitioners. 3. A reference for the general reader who wishes to understand the relationship between the return to be obtained from different investments and the risk they take on when they adopt various positions. Our aim is to give readers the educational and practical background to put them in command of theory, applications and practice in all the issues related to the subjects addressed within these pages. This work is not written as a textbook, but rather as a story book in which financial terminology, concepts and formulae are explained in simple terms and illustrated with graphs, pictures and examples that a xiv
Preface xv non-expert can easily follow. The chapters treat the subject with different degrees of depth. The story is introduced in a very general way, to provide an intuitive approach to the subject. However, as we move from one chapter to the next, concepts are developed more profoundly, and models are explained in a more detailed manner. Although some of these subjects appear complex, the problems confronted in modern financial or personal wealth management are equally challenging, so a good knowledge base is therefore required. Also, since consensus has not been reached on many of the subjects developed here, an effort is made to present the issues clearly, reflecting the various points of view, and a range of positions on controversial issues. The story of the relationship between risk, return and the cost of financial resources to businesses and individuals is put in context by relating it to the needs of investors, the companies with projects to undertake, the requirements of each sector, historical evidence and the theories developed to explain choices and behaviour. In summary, we have attempted to write a text that spans financial theory, the empirical tests of that theory and its applications to real-world financial problems; we hope the book is also entertaining and easy to read.