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Session 6 and 7. Cost of Capital - Part I

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Session 6 and 7. Cost of Capital - Part I

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navyajoshi881
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Session 6 and 7.

The Cost of Capital


PGP, IIM INDORE
Discount rate
•Opportunity cost of capital: The return investors could earn on alternative investments of
equal risk
•An appropriate rate that reflects the time value of money and riskiness of cash flows
• The denominator in the NPV
• Risk: Likelihood that we will receive returns that are different from the returns we expect

•The terms discount rate, minimum required return, and cost of capital – used interchangeably
Company and Project Costs of Capital
Weighted Average Cost of Capital
◦ Traditional measure of capital structure, risk and return
! #
◦ 𝑊𝐴𝐶𝐶 = ∗ 𝑘𝑑 ∗ 1 − 𝑡 + 𝑘𝑒
" "
◦ V = D+E
◦ Because interest expense is tax-deductible, we multiply the cost of debt
by (1 – TC).
Weights in WACC
Note on Weights in WACC
•Market value weights
•Target Capital Structure Ratios
• Weights should represent the long-term target capital structure (if the same is known)

•Consistent rates to be used in deriving cost of equity and WACC


Cost of Debt
Jet Airways’ Interest cost
•By middle of 2018, Jet Airways was cash strapped.
• Delayed paying salaries to select categories of staff, senior management, engineers and pilots, since Aug 2018
• The sector was facing head winds due to increase in crude oil prices and the weakening of INR
• Jet Airways had lost its market share to low-cost carriers like Indigo
•ICRA downgraded Jet Airways rating from BB to B in Oct 2018.
• BB is moderate level of default risk. B is high risk of default
•ICRA downgraded the rating again in Dec to C.
• C is very high risk of default
•ICRA downgraded the rating again in Jan 2019 to D.
• Instruments with this rating are in default or are expected to be in default soon.
•Since March 2017, it went through 7 rating downgrades
•Cost of Borrowings was around 12 to 13% for year ending March 2018.
Cost of Debt
•Expected return on a long-term debt obligation of a credit quality that corresponds to the
capital structure ratios built into the WACC Formula
•The interest rate likely to be charged on new debt.
•Find the yield on the company’s debt, if it has any.
•Find the bond rating for the company and use the yield on other bonds with a similar rating.
• Default spread (also called credit spread or bond spread)
• kd = Rf + Default spread
• Example - Company debt outstanding (non-traded) – USD 500 mn, and it has debt rating of A+. The
prevailing default spread on A+ rated securities is 1.07% and the risk-free rate is 3.96%. Then the cost of
debt for this company is 5.03%
Rating Spread Yield Broader Classification
Aaa/AAA 0.69% 4.65%
Aa2/AA 0.85% 4.81%
A1/A+ 1.07% 5.03%
Investment Grade
A2/A 1.18% 5.14%
A3/A- 1.33% 5.29%
Baa2/BBB 1.71% 5.67%
Ba1/BB+ 2.31% 6.27%
Ba2/BB 2.77% 6.73%
B1/B+ 4.05% 8.01%
B2/B 4.86% 8.82%
B3/B- 5.94% 9.90% Non-investment Grade
Caa/CCC 9.46% 13.42%
Ca2/CC 9.97% 13.93%
C2/C 13.09% 17.05%
D2/D 17.44% 21.40%

Ref. https://pages.stern.nyu.edu/~adamodar/ and https://ycharts.com/indicators/10_year_treasury_rate


10 Year Treasury Rate is at 3.96% in Jan 2024. Modifications by the presenter for class discussion. Standard assumptions apply.
Cost of equity
The Cost of Equity Capital
•From the firm’s perspective, the expected return is the Cost of Equity Capital:
•𝑘𝑒 = 𝑅! + 𝛽 𝑅" − 𝑅!
•To estimate a firm’s cost of equity capital, we need to know three things:
• Rf - Risk-free rate,
• 𝑅! − 𝑅" : Market risk premium
• 𝛽 - Company beta
Cost of equity: CAPM
•Marginal investor: An investor that is most likely to trade next, generally well-
diversified.
• The only risk that she perceives in an investment is risk that cannot be diversified away (i.e,
market or non-diversifiable risk)
• The only risk for which she earns a risk premium: systematic risk
Example
•Suppose the stock of Stansfield Enterprises, a publisher of PowerPoint presentations,
has a beta of 1.5. The firm is 100% equity financed.
•Assume a risk-free rate of 3% (YTM on Long-term Govt. Bond) and a market risk
premium of 7%.
•What is the appropriate discount rate for an expansion of this firm?
•𝑘𝑒 = 𝑅$ + 𝛽 𝑅% − 𝑅$
•𝑘𝑒 = 3% + 1.5 7%
•𝑘𝑒 = 13.5%
Risk free rate
•Risk free: actual return = expected return
• No default risk
• No reinvestment risk

•Returns on Government Security


• Yield to Maturity on a long-term Treasury bond

•Long-term for a going concern, else the maturity should meet the projected cash flow period
• Match the duration of the analysis to the duration of the risk-free rate
• Alternate argument: CAPM is a period model, hence use T-bill rate. T-bills are zero beta.

•Debate between using T-bill rate or Treasury bond rate


Market risk premium
•Risk Premium:
• Measures “extra returns” for making an average risk investment rather than risk-free investment.
• Function of risk aversion of an investor
•Estimating Risk premium:
• Common Approach: Estimate historical premium
• Time period used: Estimation as back as 1926, 50 yrs, 20 yrs, 10 yrs
•Equity market risk premium in Jan 2024*
• USA – 4.6%, India – 7.81%
•Mistake to avoid: Historical data for market returns, and current long-term bond
yield for estimating the MRP

*https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html
Estimation of Beta
•Market Portfolio - Portfolio of all assets in the economy. In practice, a
broad stock market index, such as the S&P 500, is used to represent
the market.
•Beta - Sensitivity of a stock’s return to the return on the market
portfolio.
Determinants of Beta
•Determinants of Beta:
• Type of business – cyclical / non-cyclical, operating leverage, financial leverage
•Highly cyclical stocks have higher betas.
◦ Empirical evidence suggests that automotive firms, luxury products, fluctuate with economic cycle.
◦ Food / Staples, beverages, tobacco, FMCG, household and personal products, power generation, other
utilities, etc. - are less dependent on the business cycle.

•Operating Leverage – To be discussed in the next session


A numerical Example: WACC
Example: International Paper
— The beta is 0.82, the risk-free rate is 3%, and the market risk premium
is 8.4%.
— Thus, the cost of equity capital is:

ke = Rf + b × ( Rm – Rf)

= 3% + 0.82×8.4%

= 9.89%
Example: International Paper
•The yield on the company’s debt is 8%, and the firm has a 37% corporate tax rate.
•The debt to value ratio is 32%
E D
WACC = × ke + × kd ×(1 – T)
E+D E+D

WACC = (0.68 × 9.89%) + (0.32 × 8% × (1 – 0.37)) = 8.34%

•8.34% is International Paper’s cost of capital.


•It should be used to discount any project where one believes that the project’s risk is equal to the
risk of the firm as a whole
Reference
•Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2015). Principles of corporate finance. Tata
McGraw-Hill Education.

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