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2015, Study Session #11, Reading # 36

COST OF CAPITAL
WACC
MCC
TCS
IOS

=
=
=
=

Weighted Avg. Cost of Capital


Marginal Cost of Capital
Target Capital Structure
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.

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 companys TCS.
 Examine trends or statements by management regarding capital structure
policy to infer TCS.
 Use avg. of comparable companies CS as TCS.

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SYS
FC
IB
CF
MP
PS
DDM

= Sovereign Yield Spread


= Flotation Cost
= Investment Banker
= Cash Flows
= Market Price
= Preferred Stock
= Dividend Discount Model

2015, Study Session #11, Reading # 36

2.3 Applying the Cost of Capital to Capital Budgeting & Security Valuation
 Companys 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 companys WACC if systematic risk of project is above or
below the companys risk.
 NPV = PV of inflows (discounted at projects cost of capital) PV of outflows.
 If we are using the companys 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

3.1.1 Yield-to-Maturity Approach

3.1.2 Debt-Rating Approach

 Yield that equates PV of


bonds promised payments to
MP.
 YTM assumes reinvestment at
YTM.

 Used when MP of debt is not


available.
 Before-tax cost of debt = yield on
comparably rated bonds for
maturities closely matching
those of companys debt.
 Important consideration debt
ratings are ratings of debt issue
itself.

3.2 Cost of Preferred Stock


 Cost of nonconvertible, non-callable PS =  =

3.1.3 Issues in Estimating the Cost of Debt


3.1.3.1 Fixed-Rate Debt versus Floating-Rate Debt
Estimating cost of floating rate debt is difficult
(depends on current & future yield).
3.1.3.2 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.

 Cost to pay preferred stock holders as preferred dividend.

 =   
 =    

 = 
   
 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.
Where

3.1.3.3 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.

3.1.3.4 Leases
If company uses leasing as source of capital, the
cost of leases should be included in cost of
capital.

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2015, Study Session #11, Reading # 36


3.3 Cost of Common Equity
Company may increase common equity through earnings reinvestments or issuance of new shares.
3.3.1 Capital Asset Pricing Model Approach
   =  +     
Where
 = 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)2 +----------  (factor risk premium)j.
Equity risk Premium

Historical ERP Approach

DDM Based 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.

Survey Approach

+

 Ask panel of finance experts for their


estimates & take mean response.
 Adjust ERP for particular project or
company by adjusting its systematic risk.

Where
= next year dividend
= current market value
g = growth rate.

= dividend yield.

    Is dividend yield plus growth in


dividend.
 ERP is difference b/w    & RfR.

3.3.2 Dividend Discount Model Approach


 =


+ 


Growth rate estimation

Through published source or vendor

Sustainable growth rate


  = 1   
   !
Where ROE = return on equity.
 Assume constant capital structure.

3.3.3 Bond Yield plus Risk Premium Approach


  =  + Risk premium
Where
 = before-tax cost of debt.
 Risk premium capture additional risk of stock relative to its bonds.

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2015, Study Session #11, Reading # 36

4. TOPICS IN COST OF CAPITAL ESTIMATION


4.1 Estimating Beta & Determining a Project Beta
 can be estimated through market model regression (companys
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 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 companys & adjusting it for financial leverage differences.
Comparable company company with similar business risk.
Asset (unlevered) after removing effects of financial leverage.
adjustment for capital structure of company or project (lever the asset to arrive equity )

  =  "

  =  $%1 + 1  &'

(We assume debt has no market risk)

Steps in Pure-Play Method

Step I

Select the comparable

Step II

Estimate comparables beta

Step III
Unlever the comparables beta

Step IV

Lever for projects financial risk

4.2 Country Risk


 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.


 
= ( )

 *    
+
.


 *     
,
 -

    - 


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2015, Study Session #11, Reading # 36

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 companys 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+
 0


 = /
1+
 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 cant 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.

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