Part 4. Cost of Capital

Question 1

Cost of capital

Answer 1

The rate of return that suppliers of capital - lenders and owners - require as compensation for their contribution to capital.

The OC of funds for suppliers of capital; supplier of capital will not voluntarily invest in company unless its return meets or exceeds what supplier could earn elsewhere in investment of comparable risk.

Question 2

Component cost of capital

Answer 2

A cost (required rate of return) for a source selected becomes a component of company’s funding.

Marginal cost - what it would cost to raise additional funds for potential investment project.

Question 3

Weighted average cost of capital (WACC)

Answer 3

The marginal cost of capital (MCC), as it is the cost that a company incurs for additional capital.

Weights should represent the company’s target capital structure; its chosen proportions of debt and equity.

Question 4

Cost of debt

Answer 4

The cost of debt financing to a company when it issues a bond or takes out a bank loan.

Cost is equal to risk-free rate plus premium for risk.

Very risky company will have a higher cost to debt; and factors affecting level of investment are:

• profitability
• stability of profits
• degree of financial leverage

Question 5

2 methods to estimate before-tax cost of debt, rd:

Answer 5

1. Yield to maturity approach - the annual return that an investor earns on a bon if investor purchases bond today and holds it until maturity.

It is yield rd, that equates the PV of bonds promised payments to its market price.

2. Debt rating approach - we estimate the before-tax cost of debt by using the yield on comparably rated bonds for maturities that closely match that of companies existing debt.

Question 6

Issues in estimation cost of debt:

Answer 6

• estimating the cost of a floating rate security is difficult as the cost of this form of capital over the long term depends on not only current yields but future yields.
• debt with option like features - this affect the value of debt, such as a callable bond would have yield greater than similar noncallable bond of same issuer as bondholders want to be compensated for call risk associated with bond.
• nonrated debt - approaches for estimating synthetic debt rating based on financial ratio are imprecise as debt ratings incorporate not only financial ratios but also info about particular bond issue and issuer not captured in financial ratios.
• leases - a contractual obligation that can substitute for other forms of borrowing; so cost of lease should be included in cost of capital.

Question 7

Cost of preferred stock

Answer 7

The cost that a company has committed to pay preferred stockholders as a preferred dividend when it issues preferred stock.

Question 8

Features that affect preferred stock yield/cost:

Answer 8

• Call option
• Cumulative dividends
• Participating dividends
• Adjustable-rate dividends
• Convertibility into common stock

Question 9

Cost of equity

Answer 9

The rate of return required by a company’s common stockholders.

Increased through reinvestment of earnings (retained earnings) or issuance of new shares of stock.

2 methods of estimating cost:

1) Capital asset pricing model (CAPM)
2) Bond yield plus risk premium (BYPRP)

Question 10

Capital asset pricing model

Answer 10

The expected return on stock is the sum of risk-free rate of interest, Rf, and premium for bearing the stock’s market risk.

Question 11

Expected market risk premium E(Rm-Rf):

Answer 11

This is the premium that investors demand for investing in market portfolio relative to the risk free rate.

Question 12

Historical equity risk premium

Answer 12

A well-established approach based on assumption that realised equity risk premium observed over a long period of time is a good indicator of expected equity risk premium.

Requires compiling historical data to find the average rate of return for risk free rate in that country.

Question 13

Limitations of historical premium approach:

Answer 13

1. The level of risk of stock index may change over time.
2. The risk aversion of investors may change over time.
3. The estimates are sensitive to the method of estimation and historical period covered.

Question 14

Survey approach

Answer 14

Another approach to estimate equity risk premium.

Fine tune estimate of equity risk premium by adjusting it for specific systematic risk for the project.

Adjust specific systematic risk by multiplying market risk premium by beta to arrive at company’s or project’s risk premium; then add Rf to determine cost of equity within framework of CAPM.

Question 15

Bond yield plus risk premium approach

Answer 15

This is based on fundamental tenet in financial theory that the cost of capital of riskier cash flows is higher than less risky cash flows.

Question 16

Simple estimate of beta

Answer 16

This results from an OLS regression of the return on the stock on the return on the market.

Question 17

Actual values of beta estimates influenced by:

Answer 17

1. The choice of index used to represent the market portfolio.
2. The length of data period and frequency of observation.

Question 18

Pros of estimating beta:

Answer 18

• Accessibility of stock return data.
• Ease of use of estimating beta using simple regression.
• Availability of estimated betas on publicly traded companies from financial analysis vendors.

Question 19

How to estimate beta for thin traded non public companies:

Answer 19

• To base the beta estimate on betas of comparable companies that are publicly traded.
• Comparable company refers to those that have similar business risk, identified by industry classification systems such as GICS, ICB.
• Financial leverage can affect beta, an adjustment made if peer company has substantially different capital structure.

Question 20

Asset beta

Answer 20

When a peer company beta must be unlevered to estimate beta of assets, reflecting only systematic risk arising from fundamentals of industry.

It reflects the business risk of assets must be re-levered to reflect capital structure of company in question.

Question 21

Flotation cost

Answer 21

When company raises new capital, it generally seeks assistance of investment bankers, who charge the company a fee based on the size and type of offering.

Generally, higher in percentage terms for equity issuances that are perceived to be risker.

Debt and preferred stock; no FC incorporated as usually less than 1% value of offering, unlike equity issuance which is quite substantial.

Question 22

How to account for flotation costs?

Answer 22

• To directly incorporate into flotation costs into cost of capital.
• The flotation costs should be incorporated into valuation analysis as an additional cost.

Question 23

Cons of flotation cost method:

Answer 23

• FC are a cashflow that occurs at issue, affecting value of project only by reducing the initial cash flow.
• By adjusting cost of capital for FC, we apply higher cost of capital to determine PV of future cash flows.
• Meaning NPV of project < true NPV; otherwise profitable projects may get rejected when methodology is used.

Question 24

If most preferred method is to deduct FC as part of NPV, why highlight adjustment to cost of capital?

Answer 24

• It is often difficult to identify specific financing associated with a project - making adjustment for FC to cost of capital more useful if specific project financing cannot be identified.
• By adjusting the cost of capital for FC, it is easier to demonstrate how the costs of financing a company change as company exhausts internally generated equity and switches to externally generated equity.