RiskandReturn: Debt Cost of Capital

FINC361 Fall2016
Professor Mahdi Mohseni

Cost of equity
Recall:
For an individual stock:
Volatility = Systematic risk + Diversifiable risk
1. Diversifiable risk: No premium should be attached to it!

Investors should not be compensated for risk that can be

diversified away at no cost

2. Systematic risk: A premium should be attached to it!

Diversification has its limits; one cannot diversify all risks by

creating portfolios. The un-diversifiable risk has to be borne by
investors and they require compensation for bearing that risk.

At the firm-level, systematic risk is measured by beta ()

Cost of equity:
Implementing the CAPM formula
Formula:

E (ri ) = rf + i (E (rMkt ) rf )

Hence, we need:
1. Risk-free rate

YTM (annual rate) on US Treasury bonds with longterm maturity to reflect long term use of firm assets

2. Estimates for:

1. (E (rMkt ) rf ) : Market risk premium

2. i : Firm i' s beta

Beta
Measures the co-movement of a security with the market
Mathematically:
Volatility of i that is common with the market

Mkt
i

SD(Ri ) Corr (Ri ,RMkt )

=
SD(RMkt )

Cov(Ri ,RMkt )
Var (RMkt )

Given that definition, what should be the beta for:

1. The market portfolio
2. The risk-free investment
3. An individual stock

What is the critical ingredient in this case?

Big picture

1. Largest source of financing:

2. 2nd largest source of financing:

Internal cash flows!

Debt!

Ways to raise external financing

1. Fixed claim on cash flows

1. Residual claim on cash flows

2. Higher priority

2. Lowest priority

3. Tax deductible

3. Not tax deductible

4. Finite maturity

4. Infinite life

5. Gives little say over the business

DEBT
Bank debt
Leases
Commercial paper
Corporate bonds

HYBRID
SECURITITES
Convertible debt
Preferred stock
Etc.

5. More say over the business

EQUITY
Common stock
Warrants (options
issued by the firm)

Bond vs. Stocks

1. Bonds:
Fixed obligations
The payment scheme is known precisely when the bond is
issued. Typically, the cash flows are the following:
A.
B.

Coupons (usually twice a year)

Principal repayment (at maturity)

2. Stocks:
Residual claim on the firm
No guaranteed payments for the investor
Dividends if all goes wellonce workers, suppliers, taxes and
bondholders have been paid!
Dividends are at the discretion of management

Bonds
1. What are they?

Debt instruments

Issued by governments and large corporations

2. Who buys them?

Investors of all kinds

Pension funds, insurance companies, hedge funds, private investors, etc.

3. Why are they issued?

To raise external capital

4. Trading?

A. Initial issuance (primary market):

Bond is sold off to the public with help of investment bankers

Proceeds go to the firm

B. After bond is issued (secondary market):

Bond can be traded among investors
Proceeds go to seller of the bond

PART I: BOND PRICING

Investor:
Price paid today = PV(all future cash flows)

Typical timeline:

2. Principal repayment
(face value)

+$CPN
+$FV
1. Annuity

Timeline

Time 0


Price
you pay
today

Maturity:
Year N

Term of the bond

Bond Pricing

Price = Present value(all bond cash flows)

1. Annuity
2. One final payment

Formula:
P = CPN

1
1
FV
1

y
(1 + y ) N
(1 + y ) N

What is the discount rate y?

Part II: COST OF DEBT

Yield to Maturity (YTM)
Suppose current price P of bond is observed
YTM is the discount rate such that

P= PV(Bond cash flows)

Solving for YTM = Solving for Internal rate of return (IRR)

Risky bonds
1. "Risk-free" debt

U.S. government Treasury Bills (T-Bills)

Reasoning:

U.S. government can always reissue more debt

Strong legal system + strong economy
Can always raise enough funds through taxes

YTM for T-Bills is set by the Fed

YTMs for long term government bonds are set by the market

2. Risky debt

I. Non-U.S. government debt

II. Corporations
Risk of default

Failure to meet their debt obligations

Require a risk premium to compensate investors

Higher YTM

Higher risk: Higher YTM!

Take two bonds of same maturity (say 10 years)

1. US government Treasury yields about 3%
2. Risky (Junk bonds) yield 5%
2% spread
It reflects the risk premium investors want as compensation for bearing more risks

Risk premium (spread)

changes over time

The required compensation (spread) changes over time

as investors reassess their risk tolerance and views on
the assets they invest in
In times of crisis, spreads jump up

Spread changes over time:

More recent examples
Europe has found
again some peace of
mind since The
Draghi speech.
whatever it takes
Massive bond buying
(like QE in the US)

A real-life example of a bond issue: Manchester United

Raised in 2010 about $800m through bond issue!

1. YTM at issuance (Jan 2010): 9.125%
2
2.
YTM one year later (Jan 2011): 7.70%
More than 1% drop in required rate of return for bond
Lower risk premium required by investors due to
improvements in the teams performance over the year!

Bond rating agencies

Neutral third-party experts
Two biggest players: Moodys and Standard & Poors (S&P)
Their business: Rate the credit worthiness of most bond issues
Who pays them for this service?
The firms issuing bonds
Do you see a conflict of interest?

Rating downgrade Higher cost of debt Higher WACC

Firms try to avoid downgrades

Credit ratings:
Opinions that matter!
Investment
grade

Speculative
grade
junk

Agencies issue opinions on debt instruments (bonds)

These ratings matter a lot: Many investors (e.g. pension funds)
have statutes that limit them in what bond they can invest in
Investment grade cutoff

Banks have risk capital put aside as a function of rating of debt

It explains in part the mortgage-backed securitization bubble

CAPM applied to bonds

Bonds from major companies rarely default
Common assumption: = 0

E ( rbond ) =rf + bond ( E ( rMkt ) rf ) =rf

That implies that the return on bonds is equal to

the risk free rate

But:
The yield-to-maturity on a bond is often
higher than the yield on government bonds

CAPM applied to bonds

Most bonds actually have > 0
In practice, it is estimated again according to
bond ratings:
By Rating A and above
Avg. Beta
<0.05

BBB
0.1

BB
0.17

B
0.26

CCC
0.31

Assume BB rated bond

According to CAPM:

E ( rBBbond ) =
rf + BBbond ( E ( rMkt ) rf

= rf + 0.17 *(Market risk premium)

Recap: Discount rates

Discount rate

1. Cost of equity:

= Opportunity cost of capital

= Expected return for taking same risk
= Hurdle rate

E (ri ) = rf + i (E (rMkt ) rf )

: Measure of exposure to systematic risk

2. Cost of debt:

E (rbond ) = rf + bond (E (rMkt ) rf

1. Yield-to-Maturity (YTM) for debt with comparable risk

and maturity
2. CAPM applied to bonds