17 - Cost of Capital : Advanced Topics Flashcards
weighted average cost of capital
Top-down (i.e., external or macro) factors include:
Capital availability.
Market conditions.
Legal and regulatory considerations, country risk.
Tax jurisdiction.
Bottom-up (i.e., company-specific) factors that affect the cost of capital include:
Business or operating risk.
Asset nature and liquidity.
Financial strength and profitability.
Security features.
Publicly Traded Debt - Estimating Cost of Debt
If the company’s debt is publicly traded, the yield to maturity for the longest maturity straight debt outstanding is generally the best estimate of the cost of debt.
Non-Traded/Thinly Traded - Estimating Cost of Debt
If the company’s debt is not traded or is thinly traded, we can use matrix pricing to consider the yields on traded securities with the same maturity and credit ratings.
If the debt is not credit rated, then financial ratios of the company such as interest coverage (IC) ratio or financial leverage (D/E) ratio may be used to infer a credit rating for that debt.
Leases—and specifically, finance (i.e., capital) leases—can be used to estimate the cost of borrowing
rate implicit in the lease (RIIL)
implied cost of capital in a lease
rate implicit in the lease (RIIL) can be estimated as the IRR of
PV of lease payments + PV of residual value = Fair value of leased asset + Lessor’s initial direct cost
incremental borrowing rate (IBR)
the rate on a new secured loan over the same term
country risk rating (CRR)
reflects risks related to economic conditions, political stability, exchange rate risk, and the level of capital market development
Country Risk Premium
The excess of the median interest rate for that country relative to the benchmark country rate determines the country risk premium
The required return on equity security i can be calculated as:
two types of estimates of the equity risk premium
historical estimates and forward-looking estimates.
Historical Estimates of the Equity Risk Premium
consists of the difference between the historical mean return for a broad-based equity market index, and a risk-free rate over the same period.
A weakness of the historical approach Historical Estimates of the Equity Risk Premium
assumption that the mean and variance of the returns are constant over time - equity risk premium actually appears to be countercyclical—it is low during good times and high during bad times
may suffer from survivorship bias
Forward Looking Estimates of the Equity Risk Premium
use current information and expectations concerning economic and financial variables
There are three main categories of forward-looking estimates
survey-based estimates,
dividend discount model estimates, and
estimates from macroeconomic modeling.
Survey Estimates for ERP weakness
tend to be biased toward recent market returns.
dividend discount model for ERP
ERP = E(dividend yield) + g − rf
re = (D1/V0) + g
Macroeconomic Models for ERP
use the Grinold-Kroner (2001) model to illustrate a macroeconomic model.
Grinold-Kroner Model (2001)
‘g’ (the capital gains yield, CGY) formula - For the Grinold-Kroner Model (2001)
estimating expected inflation formula
Several approaches to estimating the required rate of return on equity
DDM
Bond-Yield-Plus–Risk-Premium Method
build-up approaches
Risk Based Model - CAPM
MultiFactor model - (Fama and French)
and risk premium models.
DDM for measuring cost of equity
For an individual company, cost of equity is dividend yield plus capital gains yield.
Bond-Yield-Plus–Risk-Premium Method for measuring cost of equity
adds a risk premium to the yield to maturity (YTM) of the company’s long-term debt.
capital asset pricing model (CAPM)
required return on stock = risk-free rate + (equity risk premium × beta of stock)
Multifactor Models for measuring cost of equity
The general form of an n-factor multifactor model is:
required return = rf + (risk premium)1 + (risk premium)2 + … + (risk premium)n
where:
(risk premium)i = (factor sensitivity)i × (factor risk premium)i
Multifactor vs CAPM
Multifactor models can have greater explanatory power than the CAPM (which is a single-factor model).
Fama–French Models for measuring cost of equity
A five-factor Fama–French model for measuring cost of equity
Appropriate risk premiums for a private company include
size premium (SP),
industry risk premium (IP), and
specific company risk premium (SCRP).
Factors Affecting specific company risk premium (SCRP)
Qualitative factors:
Quantitative factors
There are two approaches to estimate the cost of equity for private companies
expanded CAPM and build-up approach.
Expanded CAPM Approach for measuring cost of equity for Private Companies
Build-Up for measuring cost of equity for Private Companies
The estimated equity risk premium for international companies
sovereign yield spread
the difference in yields of emerging market government securities relative to developed market benchmark security
Damodaran recommended adjusting the sovereign yield spread by the ratio of standard deviation of the country’s equity and bond markets:
international CAPM (ICAPM)
