Cost of Capital

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Definition:

1: the opportunity cost of the funds employed as the result of an investment decision1; 2: The implicit (interest paid on debt) and explicit cost (expected return on equity) of the capital raised by the company2

Different Types of Capital

Equity
Hybrid Capital with properties of debt and equity: eg: Preference Shares, Convertible debt

Debt

Expected return by Capital appreciation & Dividend

Future return uncertain and not promised. But expectation of a return exists

providers of capital Interest payments

A fixed rate of interested promised

Capital appreciation, Dividend, Interest

Cost of Capital
(Used to discount future cash flows to arrive at value) If a company has not debt (is all equity financed), its cost of EQUITY is its Cost of Capital When companies have multiple sources of capital, its cost of capital is its Weighted Average Cost of Capital In capital budgeting, you use project specific cost of capital not the companys cost of capital for decision making because

This is

Risk involved in different projects would be different!

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Sources: 1) http://wordnetweb.princeton.edu/perl/webwn?s=cost of capital 2) GraduateTutor.com

In valuation, you must discount at the appropriate level of risk

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Weighted Average Cost of Capital

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Capital Structure: How much Debt vs. Equity?

Debt
A fixed rate of interested promised Hybrid Capital with properties of debt and equity: eg: Preference Shares, Convertible debt Return, Partly promised Partly based on Performance

Equity
Future return uncertain. But expectation of a return exists

When companies have multiple sources of capital, its cost of capital is its Weighted Average Cost of Capital
The cost of each type of capital is weighted according to the its proportion. Proportion of the capital uses is based on current market values. After tax cost of debt Weight of debt Cost of equity Weight of equity

WACC =

rd x (1- T) x
T= Marginal tax rate

D D+E

re x

E D+E

Cost of equity Do equity investors get a promised rate of return? No! Then why would they invest money in a company? .. Equity investors expect a return on investment. This expected return is the cost of equity. The cost of equity can be estimated in a multiple ways: 1 Capital Asset Pricing Model 2 Market Implied Premium 3 Arbitrage Pricing Model Fama French Three Factor 4 Model

(1-T) is the adjustment made to capture the interest tax shield (value created due to the taxability of interest paid) Cost of debt: What do you pay in return for borrowing money? Interest on money borrowed! Cost of debt is the effective market interest rate on debt. Or the Yield To Maturity which is the rate an investor gets if he/she bought this bond and held it to maturity.

Capital Asset Pricing Model (CAPM)

CAPM: re =
rf
Risk free rate of return

r f + e x ( r M - r f )

This is the rate of return you would get when investing in a totally risk free asset. While there is theoretically no totally risk free asset, the US treasury bonds are considered to be the closest to a risk less asset. The return from US treasury bonds is considered the risk free rate of return.
Note: use short (long) term T-bill rates for short (long) term projects

rM

Market rate of return

This is the rate of return you would get when investing in the entire market. You can use the historical return from the S&P 500 as an estimate of market rate of return. In class this is often given to students. This is the reward you get for taking the risk involved in investing in the market. It is the return you get more than the risk free rate of return. Market risk premium = market rate of return - risk free
Note: you could be given the market risk premium or the market return. If given the market return, you will need to compute the market risk premium ( rM - rf ). The market risk premium is historically between 7%-10%.

( rM - rf )

Market risk premium

or Beta

Beta is the responsiveness of a stocks price to the changes in the market. This will be given to you or estimated.

Market Implied Premium

r=

Dividend(next year) + Dividend Growth Rate Price today

Assuming constant growth rate in dividends.

Arbitrage Pricing Theory (APT)

3

APT: r = A + b1 x (rfactor1) + b2 x (rfactor2) + b3 x (rfactor3)..+ noise

The APT theory assumes that each stocks return is a linear function of a variety of factors. It does not specify the factors but examples include interest rate, GDP, inflation, oil prices, etc.

Fama Frenchs Three Factor Model (TFM) TFM: r = rf + bmarket x (rmarket factor) + bsize x (rsize factor) + bbook-market x (rbook-market factor)
The TFT theory assumes that each stocks return is a linear function of a the market, its size and book to market ratio.

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Sources: 1) http://wordnetweb.princeton.edu/perl/webwn?s=cost of capital 2) GraduateTutor.com

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Beta or
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Definition: (finance)

1: is a number describing the correlated volatility of an asset in relation to the volatility of the benchmark that the asset is being compared to. 1; 2: A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.2

Different Types of Betas

Equity Beta
Used to compute Cost of equity in CAPM

Asset Beta
Used to compute Equity beta

Portfolio Beta
Weighted average of individual betas in portfolio

Debt Beta
Assumed to be zero in class settings

Equity Beta
Statistically From the Slope

Beta is the responsiveness of a stocks price to the changes in the market. The beta of an individual stock can also be computed as
Individual Stocks Beta = Covariance of stocks return vs market return Standard deviation of market return

An Individual stocks beta can also be estimated from the slope of the fitted line plotting the stocks return (y-axis) vs. markets return (x-axis).
stock return

Beta = Slope =

Change in Y Change in x

market return

Note: Remove outliers for better results. Remember we are assuming that the nature of the business hasnt changed.

Levering Industry If a company is a private company, we will not have prior market data to estimate beta or it as above. Therefore, we use comparable public companies date to estimate asset Comparable beta and then compute equity beta as follows. company beta 1. Find comparable pure play (companies with only one line of business) in the same business. 2. Estimate their Equity Beta (statistically or from the slope: above methods) 3. Since they will have different leverage structures, we first un-lever their Equity Beta to get their Asset Beta.

A =

d x D + e x E D+E D+E

(If d is assumed to be zero, then we get)

Or A =

d x D + e x E D+E D+E

4. Get the average of these pure play companies to get the Industry Beta. We assume that this will be the beta of any company/project in this business. 5. Since un-levered Industry Beta assumes no debt, we re-lever the Industry Beta with the actual level of debt to get our Equity Beta
(If d is assumed to be zero, then we get)

e= A - d x

D x D+E D+E E

Or e= A - d x

D x D+E D+E E

Beta is a measure of volatility and therefore traits that reduce volatility reduce beta
Business with steady cash flow have lower betas. Higher fluctuations occur in the following: Cyclical companies Growth firms Luxury goods markets Companies with a higher proportion of fixed costs have higher operating leverage. This causes more volatility of cash flows and so causes higher betas

Nature of Business

+
Operating Leverage

Asset Beta
(industry)

+
(debt)

Equity Beta

Companies with more debt (financial leverage) will have higher betas.

Financial Leverage

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Sources: 1) http://wordnetweb.princeton.edu/perl/webwn?s=cost of capital 2) GraduateTutor.com

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