Cost of Capital

The Cost of Capital Issues

Key issues:

What do we mean by cost of capital How can we come up with an estimate?

Preliminaries
1. Vocabulary--the following all mean the same thing: a. Required return b. Appropriate discount rate c. Cost of capital (or cost of money) d. Hurdle rate

Cost of Capital Sources of Finance to a Co

The various Long term sources of finance available to a Company are: Equity Debt Preference capital Retained earnings

Cost of Capital Debt versus Equity

* Fixed claim * Residual claim * High priority on cash * Lowest priority on cash flows flow * Tax deductible * Not tax deductible * Fixed Maturity * Infinite life * No management control * Management control

Debt

Hybrid (Combination of debt & equity)

Equity

Cost of Capital What it is? Cost of capital to a company is the minimum rate of return expected by the providers of funds. It is the rate of return that a company has to offer finance providers to induce them to buy and hold a financial security. Hence, it is the minimum acceptable return on any current average risk project under consideration today. The cost of capital is an opportunity cost--it depends on where the money goes, not where it comes from.

Significance of Cost of Capital

Evaluating Investment Decisions Designing Debt Policy

Performance Appraisal

Valuing a share

Calculating the cost of capital

Firms perspective Thinking: What is the cost, in terms of return, necessary to induce purchase and retention shares

Shareholders perspective

Thinking: Am I getting a return appropriate for the risk, when compared with other investments

Rate of Return
Financial Manager: What is the minimum rate of return on projects we must produce to satisfy shareholders

Cost of Capital Why it is Important?

Invest in projects that yield a return greater than the minimum acceptable rate of return (hurdle rate)--Investment Decision Choose a financing mix that maximizes the value of the firm (minimizes the CoC) and matches the assets being financed-Financing Decision If there are not enough investments that earn the minimum required rate, return the cash to the owners of the firm--Dividend Decision OBJECTIVE: MAXIMISE the VALUE of the FIRM

Cost of Capital Computation of CoC

Cost of Capital is the weighted average cost of each source of finance. It depends upon: (a) The cost of each component of financing (b) The proportion of each source in total funds Cost of capital is the cost of each component weighted by its relative book/market value

WACC k e ( E / D E P ) K d ( D /( D E P ) K p ( P / E D P )

Cost of Capital Cost of Equity

Cost of equity is the return that investors require to make an equity investment in a firm Approaches to estimating cost of equity - Capital Asset Pricing Model (CAPM)

- Dividend Discount Model (DDM)

Cost of Equity CAPM

Some of the risk in equity investment is firm specific (nonsystematic risk) and some of the risk is borne by everyone in the market (all investments) and is referred to as systematic or market risk Firm specific risk can be diversified, so the market compensates us only for the non diversifiable (systematic) risk Using CAPM, we can estimate the cost of capital for a firm by estimating its beta, the return on the risk-free asset and the market portfolio Beta is a relative measure of risk. It is the amount of volatility our stock adds to the volatility of the market portfolio For a given systematic risk level, the firm should earn the risk free return plus beta times the market risk premium

Cost of Equity CAPM

E ( Re ) R f ( E ( Rm ) R f )
Expected Return Beta

Risk Premium

Risk Free Rate

Cost of Equity
CAPM:Computation of Risk Free Rate (Rf)

Risk free asset is one for which the investor knows the expected returns with certainty. Default Rates and Reinvestment Rates The cash flows on a project and the discount rate used should be defined in the same terms. Risk less rate used should match the time horizon of cash flows being analyzed If cash flows are in dollars, the discount rate has to be a dollar discount rate & the risk free rate has to be a dollar rate

Cost of Equity
CAPM:Risk Free Rate (Rf)

GSec Rate

Cost of Equity CAPM: Computation of Beta ()

Beta of an investment is the risk that the investment adds to a market portfolio Approaches to estimating Beta Historical Market Beta-historical data on market prices for individual investments Fundamental Beta-fundamental characteristics of investments

Cost of Equity CAPM: Computation of Beta ()

Historical Market Beta-Regression of returns on stock against market returns Stock index used as a proxy for market portfolio R squared-provides an estimate of the proportion of the risk of a firm that can be attributed to market risk; the balance (1-R squared) can be attributed to firm specific risk. Issues in calculating historical beta: Length of the estimation period Choice of return interval Choice of market index

Cost of Equity CAPM: Computation of Beta ()

Fundamental Beta-fundamental characteristics of business Beta of a firm is determined by three variables: The type of business the firm is in: the more sensitive a business is to market conditions, the higher its beta Degree of operating leverage: High fixed cost relative to total costhigh operating leverage. High operating leverage, high beta Degree of financial leverage: High financial leverage, high beta Beta of an unleveraged firm (unlevered beta) is determined by the type of business and operating leverage. Also called asset beta. Beta of a leveraged firm (levered beta) is determined by the riskiness of business & its financial leverage It is expected that firms that face high business risk should be reluctant to take on financial leverage

Cost of Equity CAPM: Computation of Beta ()

Estimation of fundamental beta Identify the business in which the firm operates Estimate the average unlevered betas of other publicly traded firms that are primarily into these businesses Take the weighted average of the unlevered beta, using the proportion of firm value as the weights. If values are not available use operating income or revenues Estimate the current market value of debt and equity of the firm & use this debt equity ratio to estimate a levered beta.

B1=u (1+(1-t)(D/E)

Cost of Equity CAPM:Computation of Risk Premium (Rm)

Risk premium measures the extra return that would be demanded by investors for making a risky investment Historical risk premium Implied Equity Premium Risk premium varies across countries

Cost of Equity CAPM:Computation of Risk Premium (Rm)

Historical premium-premium earned by risky investments in the past Defining the time period Implied risk premium-Forward looking risk premiums Expected dividends next period = Required return on Equity-Expected growth rate Based on the PV of dividend growing at a constant rate forever Assumption-Overall market prices stocks correctly

Cost of Equity CAPM

Estimating the cost of equity: Expected return = risk free rate + Beta * Expected risk premium

E(Re) = Rf + (E(Rm)-Rf)
If the risk free rate is 7.00%, Risk premium is 5.50%, beta is 1.01, estimate the cost of equity

Cost of Equity DDM

Estimates the cash expected to be paid to shareholders Most theoretically correct of-all approaches Hard to use in practice

Many firms dont pay dividends Dividends may be volatile Many firms dont increase dividends in line with earnings Some models substitute earnings for dividends or other simplifying assumptions

Cost of Equity DDM

Cost of equity under DDM is the shareholders required rate of return which equates the present value of expected dividends with the market value of shares. Current stock value = PV of future dividends

P0

D1 D2 D .... 2 (1 k e ) (1 k e ) (1 k e )
ke

Dividends expected to be maintained at the same rate

D1 P0 ke

t 1

D1 P 0

Cost of Equity DDM

Constant Growth Model: dividends are expected to grow at a constant rate `g Cost of equity is equal to dividend yield + expected dividend growth rate

r = (D1/P0) + g
D1 = expected dividend per share next year Div0(1+g) r = required return g = expected dividend growth rate P0 = price of the stock today The current market price of a cos share is Rs.90, current year dividend 4.50, if dividends are expected to grow at a rate of 10%, calculate the shareholders required rate of return

Cost of Equity DDM

Where does `g come from?

Using Historical Growth model

g ( Dt / D0 )
Year 2000 2001 2002 2003 2004 2005

1 t

As per this model the future growth rate in dividend is expected to be based on past dividend growth
Dividend 4.5 5.0 6.0 7.5 12.5 15.0 Growth 11% 20% 25% 67% 20% 29% (AM)27% (CAGR)

Average growth rate

Cost of Equity DDM

Where does `g come from?

Using Historical Growth model G = (Pet)(ROE)

As per this model the future growth rate in dividend is expected to be based on the proportion of earnings reinvested back into the company and its RoE. If ROE is 12% & retention ratio is 40%, G=12%*40% = 4.8%

Cost of Equity DDM: Two Stage Growth Model

This model is based upon two stages of growth, an extraordinary growth phase that lasts for `n years, and a stable growth phase that lasts forever after n.
Extraordinary growth rate g each year for n years Stable growth rate gn forever

Cost of Equity DDM: Two Stage Growth Model

Present value of an equity share = present value of dividends during extraordinary phase + present value of terminal price.
Div t Pn P0 t (1 k e ) n t 1 (1 k e ) Div n 1 Where P n Divt = expected dividend per k e share g n in year t
n

Ke = required rate of return Pn = price at the end of year n Gn = growth rate forever after year n Example: Price of a share is 134, D0 is 3.50. Expected to grow at 15% over six years and 8% forever

Cost of Equity DDM: Two Stage Growth Model

Present value of an equity share = present value of dividends during extraordinary phase + present value of terminal price.
Div t Pn P0 t (1 k e ) n t 1 (1 k e ) Div n 1 Where P n Divt = expected dividend per k e share g n in year t
n

Ke = required rate of return Pn = price at the end of year n Gn = growth rate forever after year n Example: Price of a share is 134, D0 is 3.50. Expected to grow at 15% over six years and 8% forever

Cost of Capital Cost of Retained Earnings

Are retained earnings free of cost? Cost of retained earnings is the rate of return on dividends forgone by equity shareholders. Cost of equity is taken as cost of retained earnings

Cost of Capital Cost of Debt The cost of debt is the rate at which you can borrow from the market currently. It reflects:

default risk level of interest rates in the market

Approaches to estimating cost of debt are:

Yield on the instrument calculated from the market price, coupon and maturity, can be used as cost of debt-looking up to the ytm on a bond outstanding from the firm Ratings and associated default spread

Cost of Capital Cost of Debt

Yield on the instrument calculated from the market price, coupon maturity, can be used as cost of debt-looking up to the ytm on a bond outstanding from the firm Cost of debt is the rate which equates the current market price with the PV of future cash flows on the debt instrument

Bn C1 C2 B ......... B0 is amount is amount realized per2debenture (or market price) 0 n ( 1 k ) ( 1 k ) ( 1 k ) d d d Bn is redemption price per debenture. Debt trading at Par, Premium, Discount

Cost of Equity
CAPM:Risk Free Rate (Rf)

Ratings and associated default spread

Cost of Capital Cost of Debt

Cost of debt of companies whose debt is not traded and is not rated

Evaluate recent borrowing history Estimating a synthetic rating Once we get the cost of debt we adjust the explicit cost obtained for the tax effect
After tax cost of debt kd = Before tax cost of debt kd (1 - t)

Cost of Capital Cost of Preference Capital

The cost of preference capital is the rate at which you can raise this capital from the market currently.
Pn Div1 Div2 P ......... 0 2 n Irredeemable preference share (1 k ) ( 1 k ) ( 1 k ) p p p
Div Cost of preference share is not adjusted for taxes because K p P0 preference dividend is paid after the corporate taxes have been paid

Cost of Capital Weightage of Sources of Finance

Book Value Weights: Value of Equity, preference & debt as given in balance sheet Market Value Weights: No. of shares/debentures outstanding times the current market price

Book Value Weights Vs Market Value Weights

Cost of Capital Computing Cost of Capital

What is the Cost of Capital for a firm which proposes to make 100000 of investment in a project by raising the money from the following source Debt 400000 Retained Earning 200000 Equity 300000 Preference capital 100000 The cost of each source of finance is estimated to be: ke 14% kp 11% kd 7%

Cost of Capital Flotation cost & Cost of Capital

Flotation Cost - legal fees, administrative expenses, brokerage, underwriting commission.

These costs are one time costs incurred at the time of raising finances.

Adjust the cash flows for the flotation costs

Can you apply the firms cost of capital i.e. the hurdle

rate to all investments considered by a firm? What

will happen?

Analysis of Risk

Type of Risk

Examples

Firm can mitigate by Taking large no. of projects

Investor can mitigate by Portfolio Diversification

Effect on Analysis Diversifiable

Project Specific

Estimation mistakes. Product/ Location Unexpected Response/ New Product Change that affects all companies Currency changes Political Changes Interest Rate/ Inflation

Competitive

Acquiring Competitors Diversifying

Investing in Equity of Competitors Holding a diversified portfolio Country diversified portfolio

Diversifiable but not for small private firms Diversifiable but not for small private firms Not diversifiable except for International companies

Industry

International

Investing in multiple countries

Market / Macro

Cost of Capital Project Cost of Capital

Cost of capital for firm vs cost of capital for project Single business: project risk similar with the business-cost of capital of firm can be used as cost of capital of project Multiple businesses with different risk profiles-cost of capital of firm cannot be used as cost of capital of project Estimating cost of equity-Rf, , Rm Estimating cost of debt-comparable cos, stand alone project Assess whether the added benefits of analyzing each project individually exceeds the cost of doing so

Cost of Debt and Debt Ratio

Project Characteristics Cost of Debt Debt Ratio

Project is small and has cash flow characteristics similar to firm

Project is large and has cash flow characteristics different from the firm Stand alone project

Firms cost of debt

Firms debt ratio

Cost of debt of comparable firms

Average debt ratio of comparable firms

Cost of debt for project

Debt ratio for project

Assume that a company is considering three projects-A,B and C, having identical outlays. The expected return on investment in Project A is 22%, B 18% and C 19%. WACC for the firm is 20%. Which project satisfies the base criterion and will be accepted? If further analysis reveals that Project C is almost risk less, while project A is highly risky. Project B is of average risk. The perspective betas for the projects A, B and C are 3, 1 and 0.80 respectively. If the market rate of return is 11% and risk free rate is 5%, the project cost of capital will be A-23%, B-11% and C-9.8%. Would your selection change?

When a firm has businesses with very different risk profiles, different investments can have different costs of equity and capital. What is the relationship between the firms cost of equity and capital and its projects costs of equity and capital? The firms costs of equity and capital should reflect the weighted average of the costs of equity and capital of all of the different businesses that the firm operates in, which the weights depending upon the contribution they make to firm value

Cost of Capital
Estimating Beta for firm from Project betas
In 2003, General Motors had three divisions: GM Automotive, Aircraft division and GM Acceptance Corp. The betas of each division and their market values are given below. What is the beta for the entire corp. Division Beta Market Value Automotive 0.95 $22269mn Aircraft 0.85 $2226mn GMAC 1.13 $15812mn In 2004, GM acquired Electronic Data Systems for $2000mn. Its beta is 1.25 How does this acquisition affect the beta of GM?

Cost of Capital
Factors Affecting WACC

Non Controllable - Interest rate, market risk premium Controllable - Capital Structure, Dividend & Investment Policy

Cost of Capital
CoC: Points to Remember

Use the current cost of raising capital

Use the target capital structure to determine the weights for the WACC