Corporate Finance - Cost of Capital

12:45 pm

Cost of Capital
CFAI Reading 37

Intro

• If a company returns at less than the rate it borrows at it actually destroys value
• Cost of capital must be estimated, and this is difficult
• Rough measure of risk
• Companies should evaluate each project on its own cost of capital; in practice they use one cost of capital throughout, and add/subtract based on project's relative risk to typical project

Cost of Capital

• Rate of return that supplier of capital (bondholders and owners) require as compensation
• Also equates to the suppliers' opportunity cost of capital - they will not willingly invest unless it is good enough return for risk
• We are concerned with marginal - what it would cost to raise additional funds
• WACC
• WACC = WdRd(1-t) + WpRp + WeRe
• Taxes
• After tax cost of debt ex. debt rate is 6% and rate is 40%, effective rate = 6% (1-.4) = 3.6%
• Two ways to estimate Re
• CAPM
• Dividend Discount Model
• Weights
• Should use the target capital structure the company is trying to attain
• If you don't explicitly know the target, 3 options:
• Assume current weight IS target (baseline)
• Examine trends in cap structure or statements by mgmt to infer target
• Use averages of comparables (unweighted, arithmetic mean - can also use wtd average to give more weight to bigger cos)
• Transform D/E into a weight by dividing D/E by (1 + D/E)

Applying Cost of Capital

• Marginal cost of capital (MCC) might rise as capital is raised, whereas returns to opportunities may decrease (Investment Opportunities Schedule)
• Optimal capital structure is where MCC intersects IOS
• For an average project, cost of capital is WACC
• Riskier projects should have ad hoc higher WACC and vv
• Using WACC to evaluate a project assumes project has same risk as average risk project of the company and the project will have constant target capital structure throughout its life
• Security valuation
• If cash flows are to all suppliers of capital, use WACC
• If cash flows are strictly to owners (FCFE) use Re

Cost of Debt

• YTM Approach
• Equates annual return if investor buys today and holds to maturity - use financial calculator and don't forget to do semi annual, and then multiply rate by two
• Debt Rating Approach
• Use yield on comparably rated bonds for maturities that closely match that of company's existing debt
• Remember to consider other factors like seniority/collateral - debt ratings are of the issue itself
• Sometimes called evaluated pricing or matrix pricint
• Issues
• Fixed vs. floating - might have to forecast future interest rates
• Debt with call/conversion/put options - callable (option for issuer) will have greater yield, buyer put option will have lower yield
• If company already uses calls/puts and will continue in future, just use this rate
• Adjusting for other approaches is beyond the exam
• Nonrated debt - might not have debt, or rates available; synthetic ratings might be available but these are rough at best
• Leases - if company uses leasing as a source of capital, should include this in the cost of capital

Cost of Preferred

• For nonconvertible, noncallable: P = D / r  and r = D / P
• D is dividend, r is cost of preferred stock
• NOT tax deductible
• If has option features, must adjust (use markets or other approaches again outside scope of exam)

Cost of Common Equity

• CAPM
• Er = Rf + beta * (Rm - Rf)
• Use matching t-bill for project life in years
• Multifactor model
• Er = Rf + B1 (factor risk premium) + B2 (factor risk premium) + ... on and on
• Idea is that CAPM might not capture all relevant risks
• Estimating MRP
• Historical Equity Risk Premium Model
• Use a whole market cycle, examine markets
• Limitations: level of risk of a stock index may change over time, risk aversion of investors may change over time, estimates are sensitive to methods of estimation and period covered
• Dividend Discount Model
• P = D1 / (r - g)
• r = D1/P + g      solve this for the whole index
• Then subtract Rf to get ERP
• Survey Approach
• Just ask people - one US survey found ERP was 5.5 to 7.0%
• Dividend Discount Model Approach (for estimating Ke)
• P = D1 / (r - g)
• Re = D1/P + g
• Must estimate next dividend and growth rate
• Growth
• Use published forecast OR
• Sustainable growth rate = plowback ratio * ROE
• Bond Yield plus Risk Premium Approach
• Re = Rd + risk premium
• Can estimate risk premium using historical spreads between stock/bond yields

Estimating Beta and Determining Project Beta

• Issues: estimation period, daily/weekly/monthly (periodicity), selection of index, smoothing technique, small cap stocks
• Private company beta estimation is difficult
• Beta is impacted by business risk (sales/operating risk) and financial risk
• Sales risk impacted by elasticity of demand, cyclicality, competition
• Operating is impacted by fixed vs. variable cost - higher fixed is riskier
• Financial risk - greater use of debt financing to produce cash flows is riskier
• Pureplay Method - same industry and a single line of business
• Using comparable public company and adjusting for leverage differences
• Must first unlever the beta of the public co - this gives 'asset' beta
• Then relever beta to arrive at estimate of equity beta for project or company of interest
• Unlevered = Levered / [1 + (1 - t) * D/E]

Country Risk

• Simplest estimate is sovereign yield spread
• Difference in yield of govt bond in the country, denominated in developed country, and the yield on the bond in the developed country
• But too coarse generally
• More refined: take this and then multiply by [sdev(equity index) / sdev(sovereign bond mkt in terms of developed mkt currency)]
• Note - this is the likely testable approach
• Can also use country credit ratings to get expected ERP for countries with debt ratings but no equities markets - use comparable countries that DO have equities markets to estimate reward to credit risk measures and then apply it to subject country

Marginal Cost of Capital Schedule

• As mentioned before the cost of capital rises as you raise more due to covenants, provisions, leverage etc. - might have to issue equity which is even pricier than debt
• Also deviation from ideal capital structure is an issue but in practice capital issuance is lumpy
• Generally the schedule has step-up points called break points - you can issue a lot at the same cost, then it jumps up
• Break points for debt and equity:
• Divide break amount by target D/V or E/V to get total capital raised

Flotation Costs

• Fees to bankers
• Usually quite small for debt so not included in cost of capital
• But can be big for equity
• One view is to account for this in Ke
• Ke = (D1 / P (1 - f)) + g
• f is percent of share that issuance cost is
• But this doesn't work...reduces initial project cash flow
• Alternative way: adjust cash flows in valuation computation
• Be sure to note whether flotations costs are tax deductible
• We still see the first way in practice a lot because it is hard to identify what specific financing is going to project, and it is easier to show how projects change when you go from using internally generated equity to using external equity financing

What do CFOs do

• Most popular for Ke is CAPM
• Few companies use dividend cash flow model
• Public cos are more likely to use CAPM than private
• Majority use a single WACC in evaluating projects, but a large portion apply some type of risk adjustment for individual projects

End

2:30 pm

1.75 hrs