Finance Essentials: Cost of Capital

Cost of Capital Overview
Cost of capital is the rate of return that suppliers require as compensation for their contribution to capital; if suppliers believe the opportunity costs of funds can earn a higher return elsewhere, they would decide to not invest. The ultimate underlying goal is to have your cost of equity greater than your cost of capital. Weighted Average Cost of Capital (WACC) is referred as the Marginal Cost of Capital (MCC) because it is the cost the company incurs.
 
If we choose to use a company’s WACC in the calculation of the NPV, we assume that the project has (1) the same risk as the overall average-risk for all other company projects and (2) will have a constant target capital structure throughout its useful life. WACC or MCC corresponding to the average risk of the company, plays a role in the capital budgeting decision based on NPV. Formula for WACC = wdrd(1-T)+ wprp+were; where d is debt, p is preferred stock, and e is equity. In relation to taxes, taxable interest would reduce cost of capital.
 
Capital Structure is the ratio of a company’s debt to equity. The target capital structure is the capital structure that a company is striving to obtain. People often estimate the target structure by either assuming the company’s current capital structure at market value weights,  examine trends, estimate by using statements from management, and/or using averages of comparable companies. When applying the cost of capital to capital budgeting, a company’s WACC may increase as additional capital is raised, whereas returns to a company’s investment opportunities are generally believed to decrease. On a graph, with (1) amount of new capital being the x axis and (2) cost/return on the y axis, the WACC curve is believed to be upward sloping, while marginal returns are believed to be downward sloping. The optimal capital budget is the intersection of both curves; which represents the optimal debt-to-equity ratio that maximizes value.
 
Costs of Different Sources of Capital
Cost of debt (rd) can be determined by the following two methods: (i) Yield to Maturity, which is the annual return that investors earn on a bond if held to maturity; or (ii) Debt-Rating Approach, which is the estimation based by using the yield on a comparably rated bond that closely matches that of the company’s existing debt. The more preferable choice to determine cost of debt would be yield to maturity.
 
Cost of Preferred Stock: It is the cost that a company has committed to pay preferred stockholders as a preferred dividend. For non-callable preferred stock with a fixed dividend rate, the cost would equal the dividend over the price. Do note that there are special features such as call options, cumulative dividends, participating dividends, or convertibility of common stock in which we must make appropriate adjustments for.
 
The most common and preferable way to determine cost of equity is the Capital Asset Pricing Model (CAPM). When using CAPM to estimate the cost of equity, we typically estimate beta relative to an equity market index. Market premium estimate is the Market Return – Risk Free Rate (“Rm”-“Rf”), which is also an estimate of an equity risk premium (ERP). Other ways to determine the cost is are the Multifactor Model (alternative to CAPM, which incorporates factors that may be other sources of price risk, including macroeconomic and company specific factors). Basic idea behind multifactor is that CAPM beta may not capture all the risks.
 
There are other several ways to estimate ERP (for CAPM it was the Market Risk Premium) which are:
(i) Historical equity risk approach, which is Rm – Rf
(ii) DDM approach where re= (D1/P0) + g, where we rearranged the constant growth model to get r by itself. To estimate growth rate, one can (a) use a forecasted growth rate from a published source or (b) use a sustainable growth rate where g = (1-D/EPS)ROE where the retention ratio is (1-D/EPS);
(iii) Bond Yield plus Risk Premium approach is based that the cost of capital of riskier cash flows are higher than that of less risky cash flows (typically 3 – 5%);
(iv) Survey approach, asking a panel of finance experts for their estimates and take the mean response.

Additional Topics in Estimating Beta
Estimating beta and determine project’s beta: Beta estimates are sensitive to the method of estimation and data used which includes factors such as (i) estimation period, (ii) periodicity of the return interval, (iii) selection of an appropriate market index, (iv) use of a smoothing technique (analysts adjust historical betas to reflect tendency of betas to revert to 1), and (v) adjustments for small-cap stocks (exhibit greater risks/returns relative to large caps). Beta does not appear adequate enough to capture country risk for companies in developing countries, therefore, analysts often calculate CAPM by adding a country spread market risk premium. For instance, if ERP of the CAPM was 4% and the country risk premium was 3%, we would measure the beta sensitivity as the sum of both; simplest estimate of the country spread is the sovereign yield spread. Beta is affected by the systematic components of business and financial risk.
 
Business Risk is related to the uncertainty of revenues (sales risk) and operating risk (attributed to the company’s operating cost structure). Sales risk is affected by the elasticity of demand of the product, revenues and the structure of competition in the industry. Operating risk is affected by the relative mix of fixed and variable operating costs (greater the fixed to variable costs, greater the uncertainty). Financial risk is the uncertainty of net income and net cash flows attributed to the use of financing that has a fixed cost (i.e. debt and leases). Greater fixed financing relative to variable, the greater the financial risk.
 
Estimating a beta using the pure play method requires using a comparable publicly traded company’s beta and adjusting it for financial leverage differences. Pure play allows for a more top-level industrial view for systematic risk. Steps are:
(1) Select the comparable,
(2) Estimate the comparable beta,
(3) Unlever the comparable beta
(4) Lever the beta for the project’s financial risk. Ultimately, we must first, estimate the unlevered beta by estimating the asset beta for the comparable company: βU = βof comparable / (1/(1+(1-tcomparable)(Dcomparable/Ecomporable)). Then, levered beta for the project is βL = βU * (1/(1+(1-tproject)(Dproject/Eproject))
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