Corporate Finance - Cost of Capital

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Question 1 of 4
Which of the following would be regarded as the riskiest form of debt capital? US Treasury bond Junk bond Triple-A rated corporate bond Correct. You will learn about the risk associated with different forms of debt capital in Topic 1, Cost of Debt Capital.

Question 2 of 4
What is the beta of a riskless security? 0 0.5 1 Correct. You will learn about beta in Topic 2, Cost of Equity Capital.

Question 3 of 4
True/False? The weighted average cost of capital can be calculated by taking the individual costs of debt and equity and weighting them by the market values of a companys total debt and equity. True False Correct. You will learn how to calculate the weighted average cost of capital in Topic 3, Weighted Average Cost of Capital (WACC).

Question 4 of 4
True/False? If a company is looking at a possible purchase of fixed assets for USD 1 million, and plans to borrow the entire amount at an after-tax interest rate of 6%, then the cost of capital for that purchase is 6%. True False Correct. You will learn about common pitfalls in the use of cost of capital in Topic 4, Cost of Capital Pitfalls. On completion of this tutorial, you will be able to: describe the risk/return nature of debt capital and the tax benefits to be derived from the use of debt as a financing tool explain the capital asset pricing model (CAPM) and how it is used to determine the appropriate cost of equity capital calculate the weighted average cost of capital (WACC) for a company describe the common pitfalls in the use of cost of capital

Prerequisite Knowledge Prior to studying this tutorial, you should have at least a basic knowledge of business performance measurement as described in the following tutorials: Corporate Finance Measuring Business Performance Free Cash Flow Corporate Finance Measuring Business Performance Economic Profit

Cost of Debt
What exactly is the cost of capital? The answer to this question has two parts. First, there is an explicit cost of capital, which is the cost of debt capital. Second, there is an implicit cost of capital the cost of equity capital, which we will look at in the second topic. The cost of debt capital is obvious to see as it appears as an expense on the income statement. It embodies a cost for both the time value of money, and for the risk the lender takes on in lending money to the borrower. That risk is that the lender may not receive the expected interest and/or principal in its entirety, or that it may not be received in a timely manner. In any case, the greater the risk, the higher will be the interest rate demanded by the lender to compensate for that risk. Therefore, there is a direct risk/return correlation associated with the cost of debt.

Risk/Return Nature of Cost of Debt

This graph shows how the cost of debt rises in line with the riskiness of the debt. On the far left hand side of the graph is a US Treasury security (for example, 10-year US T-bond). This security is considered to be riskless because the US government will always pay its debt obligations in full and on time. Even if the government has to resort to inflating the money supply to do so, a holder of this type of debt security can always be assured of receiving payments of interest and principal in a timely manner. Given that this security is riskless, the market demands a rate of 4.50% to compensate the lender for the time value of money plus any possible risk of inflation. As the risk of a debt security increases, the required interest rate to compensate for that additional risk also increases. On the far right hand side of the graph, the risk is so great that debt securities that fall within this section are sometimes called junk (also ref erred to as high yield debt). This junk debt can be so risky with regard to interest and principal payments that

even within a relatively low interest rate environment, borrowers may have to pay double-digit interest rates in order to obtain capital from this source.

Risk-free benchmark
In the US, the 10-year note is normally used as the benchmark risk-free asset since it is the most widely traded long bond. The 30-year bond was historically the risk-free benchmark prior to the suspension of new issues of 30-year Treasury bonds in October 2001. In February 2006, however, the US Treasury began re-issuing the 30-year bond and it may soon replace the 10-year bond as the risk-free benchmark.

Debt as a Financing Tool

Debt has a particular attribute that serves to reduce its actual cost to the borrower. That attribute is the fact that interest expense on borrowed funds is generally tax deductible. In effect, whenever a company borrows money, the government rebates a portion of that interest expense back to the company depending on the companys marginal tax rate. The following example illustrates this concept: Pre-tax Interest Rate = 8% Companys Marginal Tax Rate = 30%

The fact that interest expense is tax deductible can make debt a cost-effective means of obtaining capital in the marketplace.

Leases
A lease can be thought of as a borrowing source, and so we need to address this financing vehicle as a form of debt capital. There are essentially two types of leases: Capital lease Operating lease

A capital lease transfers most of the risk of ownership of the asset to the lessee.

An operating lease is one in which the risk of ownership of the asset is primarily retained by the lessor.

Capital Lease
A capital lease is accounted for as if the asset had been purchased through the use of straight debt. The present value of the lease payments is recorded on the balance sheet as a fixed asset on the left hand side, and as debt capital on the right hand side. Because capital leases have characteristics similar to those of straight debt capital, the dollar amounts of these kinds of leases are counted as invested debt capital for purposes of free cash flow (FCF) or economic profit calculations. Again, since these leases are a form of debt capital, the cost of capital associated with this financing vehicle is equivalent to a companys cost of debt capital. Due to the debt equivalent nature of a capital lease, the interest expense associated with the lease payments should be added back when developing the net operating profit after taxes (NOPAT) statement for either FCF or economic profit purposes. This is in keeping with the concept of eliminating the impact of any financing related flows (including lease financing) from the NOPAT calculation.

Operating Lease
As such, operating leases do not appear on the financial statements of a company. The future lease payment obligations, however, are typically recorded in the footnotes of a companys financial statements. From an economic point of view, an operating lease allows a company to gain the use of an asset in exchange for future periodic payments to the owner of the asset. In that regard, an operating lease is similar to a straight debt obligation or to a capital lease, and will therefore have an impact on a companys investment capital and NOPAT. Impact on investment capital

Impact on NOPAT

Click each impact for details. When you have finished, click the Forward arrow to continue.

Impact on NOPAT
In order to properly reflect the impact that the operating lease payments have on NOPAT, we must calculate the implied interest expense embodied within the operating lease payments.

The best way to approximate what those implied interest expense amounts would be is to multiply the calculated present value of the operating lease (as mentioned above) by the cost of debt capital. The resulting figure (representing the approximated interest expense) should then be added onto NOPAT in order to keep the NOPAT figure on a pure operating (ex financing costs) footing. As with capital leases, the overall cost of debt capital can be used as the cost of capital associated with operating leases. This is in keeping with the idea that operating leases, along with capital leases, are really just different forms of borrowing, and therefore truly represent debt obligations from an economic point of view.

Debt Capital
Which of the following statements is true? The greater the risk, the lower will be the interest rate demanded by the lender. If the pre-tax interest rate is 10% and a borrowers marginal tax rate is 40%, then the borrowers after-tax interest expense is 6%. A capital lease is one in which the risk of ownership of the asset is primarily retained by the lessor. Correct.The after-tax interest expense is calculated as follows:

= 10% x (1 - 40%) = 10% x 60% = 6%

Cost of Equity
While the explicit cost of capital, as embodied in the cost of debt capital, is fairly straightforward, there is also an implicit cost of capital, which is the cost of equity capital.

The cost of equity capital does not appear anywhere on the traditional financial statements, and yet it is the more important and more expensive of the two major capital costs. It can also be thought of as an opportunity cost because investors have a universe of opportunities at their disposal with respect to where they invest their money. Because of this opportunity cost element, investors will have an expectation that they will be fairly compensated for having made an equity investment within a company. If an investor expects a company to earn X% on invested capital, and the company earns less than that, then the investor has lost value. Value has been lost because the investor could have, on average, earned that particular return for the same level of risk elsewhere in his universe of investment possibilities. Even though net income, or even cash flow, may have increased within the company, there has been a decline in value because that increase was simply not enough.

opportunity cost

In general terms, opportunity cost can be defined as the cost of anything in terms of alternatives forgone. For example, assume a firm plans to construct an extension to its current premises on land it already owns. The market value of the land should be included as part of the investment because, if the firm doesn't use it for the extension, then it could sell it, rent it, or use the land for some other purpose. The opportunity cost in this case equals the cash that could be realized from selling, renting the land, or so on. The opportunity cost in this case equals the cash that could be realized from selling or renting out the land.

From Individual Securities to Portfolios

Historically, the cost of equity capital was viewed in a straightforward risk/return manner. In other words, the greater the expected variability in the equity flows, the greater the return expected by the equity holders. This view held sway until the early 1970s, when the academic community offered a different perspective on equity risk. Rather than considering risk as something related to an individual security, risk was now considered in a portfolio context. Since investors had the capability of holding a large number of securities in a portfolio, the risk of any one individual security was of no concern. With a large enough portfolio of stocks, if any one stock exhibited a significant decline, that would probably be offset by another stock that had experienced a substantial increase. As a result, the important element in determining the risk of a stock was how its price moved within the overall portfolio. The methodology developed to determine this portfolio risk involved observing how the stock price of a given company moved over a long period of time in relation to a market portfolio of stocks, as embodied in a broad index of stocks such as the S&P 500. By graphing the relationship that existed for the returns on a given stock with respect to the returns on the

market portfolio, a trend line was created, and the slope of that trend line was called beta.

Beta
If a given stock also had a beta coefficient of 1.0, then that stock was considered to be as risky as the market portfolio. A beta of 1.0 would also signify that the stock was of medium or moderate risk, since its beta was equal to that of the market portfolio. Beta as a measure of stock risk is easily interpreted. If a stock has a beta of 1.0, then that indicates that for every 1% movement in the market portfolio (up or down), the stock, on average, would also move up or down by 1%.The stock would therefore be considered of equal risk to the market portfolio. If another stock had a beta of 1.4%, then for every 1% movement in the market portfolio (up or down), the stock would move up or down by 1.4%.The stock would be considered riskier than the market portfolio because of its greater relative movement compared to the market portfolio. Finally, if another stock had a beta of 0.7%, then for every 1% movement in the market portfolio (up or down), the stock would move up or down by 0.7%. The stock would therefore be considered less risky than the market portfolio because of its smaller relative movement compared to the market portfolio.

Beta & Cost of Equity

The graph above shows how beta relates to the cost of equity. Risk (along the x-axis) is defined in terms of beta, while rate of return is represented by the y-axis. As we mentioned earlier, a riskless security is defined as a US Treasury obligation. Because this security is riskless, it has a beta of zero. This intuitively makes sense since a Treasury security does not move in relation to the stock market. Its return is set based on its stated interest rate, and the principal amount will be returned at the stated time. As we take on more beta risk by moving to the right along the x -axis, the return that is required increases. At a beta equal to 1.0, we are at the risk level associated with the market portfolio. As can be seen from the graph, at this risk level the required return necessary to compensate an investor is higher than is required for the riskless security.

Market Risk Premium

The difference between the required return on the riskless Treasury security and the required return on the market portfolio is defined as the market risk premium (also known as the equity risk premium). In studying this differential historically over a long period of time, academics discovered that this number remained remarkably stable over the years. As a matter of fact, this number tended to gravitate to 6%, on average. This 6% number can be interpreted as the percentage premium that the market portfolio offered an investor for having taken on additional risk, compared to the return an investor

could receive on a long-term US Treasury security. For instance, in any given year, if the riskless security offered a return of 4%, then the market portfolio in that same year tended to offer a return of 10% (six percentage points higher). If, in another year, the riskless securitys return was 7%, the market portfolio return tended to equal 13% (again, six percentage points higher).

Early Expression of Market Risk Premium

One of the earliest expressions of the concept of the market risk premium came from the economist and philosopher John Stuart Mill in his 1848 publication, Principles of Political Economy. In writing about a farmer considering an investment in land, Mill proposes that: he will probably be willing to expend capital on it (for an immediate return) in any manner, which will afford him a surplus profit, however small, beyond the value of the risk, and the interest which he must pay for the capital if borrowed, or can get for it elsewhere if it is his own. Reference: Mill, J.S., Principles of Political Economy, Book 2 (Distribution), Chapter 16 (Of Rent), 1848

Capital Asset Pricing Model (CAPM)

Armed with the theory that the cost of equity capital for a company is related to the risk-free rate, the beta of a company, and the market risk premium, academics created what was called the capital asset pricing model (CAPM). The CAPM formula quantifies the cost of equity capital for a company as follows:

The formula states that the cost of capital for a company is equal to the risk-free rate of the long-term Treasury security plus an additional premium. That premium is related to the companys beta, multiplied by the market risk premium, which is assumed to be constant at 6%.

CAPM and Cost of Equity Capital

Assume the following: Risk-free rate = 5.5% Market risk premium = 6% Company beta = 1.3

According to the CAPM, what is the companys cost of equity capital? Input your answer correct to two decimal places. %

Incorrect. The CAPM formula quantifies the cost of equity capital as follows:

Click the Back arrow to try again.

Using the CAPM in Practice

The CAPM formula is:

Calculating the cost of equity capital for a company using the CAPM methodology is relatively easy to do. The risk-free rate on long-term US Treasury securities is easily obtained from any one of a number of sources, including publications such as the Wall Street Journal and Financial Times. The market risk premium is assumed to be constant at 6%. For companies that are publicly traded, company betas can be obtained from various sources such as Ibbotson or Value Line, or from Wall Street investment houses such as Merrill Lynch, Goldman Sachs, and Morgan Stanley.

If a company is not publicly traded, how can we proceed with using the CAPM? If a particular company is privately held, or not publicly traded, a direct beta for that company will not exist. In that case, a proxy for beta will need to be developed. A simplistic way to do that is to look at publicly traded peer companies or competitors for the particular company in question. We can then take an average of the betas for those companies and use that average as a proxy for the particular companys beta. While not a perfect solution, this approach will prov ide a reasonable approximation for beta.

Levered & Unlevered Beta

A more sophisticated way to determine a private companys beta is to recognize that company betas are really made up of two components. These components reflect a companys business risk and its financial (debt) risk. The business risk component (or unlevered beta) is a function of the kind of industry a company is in, and the type of products or services the company sells. It captures the risk of a companys operations without regard to financial risk. The more a companys industry, or products and services, causes its stock to move in relation to the market, the greater the companys unlevered beta will be, and the other way around. The second component, for financial risk, considers the amount of debt a company has in its capital structure. The greater the proportion of debt a company has in its overall capital structure, the greater the risk to the equity holders that the companys debt obligations will not be covered by business operations. This financial risk, therefore, adds to the overall business risk that a companys equity holders must bear. The sum of a companys business risk (unlevered beta) and financial risk yields a companys total equity risk, or levered beta. This levered beta is ultimately the beta that is of paramount importance since it reflects both kinds of risks (business and financial) that a company faces.

Relationship Between Levered & Unlevered Beta

A company that is privately held will need to rely on proxy measures for its beta. Peer/competitor companies can be used to approximate what a specific companys beta might be. However, while the business risk (unlevered beta) for all companies within a specific industry may be reasonably similar, the financial risk that each of those companies has taken on may cause their levered betas to vary markedly from one another. The way we can address this issue is to calculate unlevered betas using the following equation:

A cursory look at the above equation gives an indication as to how unlevered and levered betas can differ depending on the level of debt versus equity in a companys capital structure. Debt/Equity = 0%

Debt/Equity = 100%

Click each value to learn more. When you have finished, click the Forward arrow to continue.

Debt/Equity = 0%
If there is no debt whatsoever in a companys capital structure, the term within the parentheses will reduce to 1, and the levered and unlevered betas will be the same. This can be seen from the following:

Debt/Equity = 100%
If we assume that the debt to equity ratio is equal to 100%, then the equation changes as follows:

BetaL = BetaU x (1 + 100% x (1 - t)) BetaL = BetaU x (1 + (1 - t))

Using a debt to equity ratio of 100%, and assuming a marginal tax rate of 30%, the relationship between the levered and unlevered beta is: BetaL = BetaU x (1 + (1 - 30%)) BetaL = BetaU x (1 + (70%)) BetaL = BetaU x (1.70) BetaL/ (1.70) = BetaU The unlevered beta in this example can therefore be determined by starting with the levered beta and dividing by 1.70.

Calculating Beta
Assume the following information about a company:

Estimated unlevered beta Debt to equity ratio

0.45 60%

Marginal tax rate 30% What is the appropriate levered beta for this company? Input your answer correct to two decimal places.

Incorrect. The levered beta can be calculated using the following formula:

Click the Back arrow to try again.

What is Weighted Average Cost of Capital (WACC)?

In order to properly reflect the cost of capital for a company that has both debt and equity in its capital structure, we need to calculate a weighted average cost of capital (WACC). This is accomplished by determining the percentage of a companys overall capital structure consisting of debt and the percentage consisting of equity. The overall capital structure is quantified using market value, and the debt and equity components are also quantified using market values for each, as follows:

As can be seen from the above equations, the weightings for debt and equity use the market values for both debt and equity in developing the percentages.

Weightings for WACC

Although weightings for debt and equity use the market values for both debt and equity in developing the percentages, even for publicly traded companies, the market value of debt may not be readily available. If that is the case, then as a proxy for market value, the book value of debt can be used. While clearly not as accurate as market value would be for calculating a weighting factor, book value is nonetheless a reasonable proxy for market value. This is because if a company is maintaining a particular debt to equity capital structure, then as old debt, with a current market value that is either greater than or less than book value, matures, it is constantly being replaced with debt whose book value and market value are one and the same at issuance. Thus there is a built-in mechanism that tends to move the market value of debt back to book value, making the use of book value reasonable for weighting purposes. The market value of equity can also be problematic if a company is not publicly traded, and therefore does not have a published value. Again, as with debt, a proxy needs to be used. In this case, we can look at peer companies or competitors that are publicly traded for guidance. One approach would be to look at the multiples to current FCF at which those public companies are currently trading. If, for instance, the average market multiple for those

companies is 11 times their current FCF, then as a proxy, the company can presume that its equity market value approximates 11 times its current FCF. The point to bear in mind is that we are not trying to attain exactitude with these proxy approaches for either debt value or equity value. Rather, we are trying to develop reasonable weightings that will ultimately permit us to calculate the WACC.

Difficulties in Calculating WACC

Despite appearing relatively easy, problems can arise in calculating WACC. Apart from the issues described in relation to using proxies for the market value of debt and equity, difficulties can also arise where a company issues more than one class of share. For example, common stock may be issued with restricted or no voting rights or, occasionally, may be redeemable. Furthermore, companies may issue different types of preferred stock, such as cumulative, participating, or convertible preferred stock.

Weightings of Debt and Equity

The overall capital structure is quantified using market value, and the debt and equity components are also quantified using market values for each, as follows:

WACC Formula
The WACC is calculated by applying the weighting on debt to the cost of debt and the weighting on equity to the cost of equity:

Example: Weighting (Debt) Weighting (Equity) Cost of Debt (after-tax) Cost of Equity WACC = (40% x 4.5%) + (60% x 13%) WACC = 1.8% + 7.8% = 9.6% In this example, 9.6% would be the weighted average cost of capital that would be compared to a companys return on investment in order to determine whether value has been created or 40% 60% 4.5% 13%

not. It is also the rate that would be used to discount future expected flows from future investment opportunities.

Example of Calculation for Cost of Equity Capital

Risk-free rate = 6.4% Market risk premium = 6% Company beta = 1.1 Cost of equity = 6.4% + (1.1 x 6%) = 6.4% + 6.6% = 13%

Example of WACC calculation

Example: Weighting (Debt) = 40% Weighting (Equity) = 60% Cost of Debt (after-tax) = 4.6% Cost of Equity = 13%

WACC = (40% x 4.6%) + (60% x 13%) WACC = 1.8% + 7.8% = 9.6%

Question on WACC
A company has common stock with a market value of USD 6 million and a cost of 12% per annum. It has debt with a market value of USD 4 million and a cost of 8% per annum. What is the companys WACC? Input your answer correct to two decimal places. %

Incorrect. The WACC is calculated as follows:

Click the Back arrow to try again.

Evaluating Investments
When using the cost of capital for evaluation purposes, we must be careful not to fall into the trap of thinking that if a specific financing is going to be used for a planned purchase of an asset (for example, a piece of machinery), then the cost of capital for that investment opportunity is just the cost of that specific financing vehicle. For example, if a company is looking at a possible purchase of fixed assets for USD 1,000, and plans to borrow the entire amount at an after-tax interest rate of 4.6%, then the cost of capital for that purchase is not just the 4.6% related to the specific borrowing for that investment. Whenever an investment is made within a company, the owners of the company (the shareholders) always have a stake in that investment, irrespective of the actual explicit financing that is used at that particular time.

Evaluating Investments
The fallacy of looking only at the particular financing that is used at a point in time to judge an investment can be seen in a scenario whereby a company purchases a piece of equipment for USD 1,000 with borrowed funds with an after-tax cost of debt of 4.6%. It then purchases another piece of equipment for USD 1,000 with internally generated (equity) funds with a cost of 12.4%. If the company were to evaluate both investments based upon the specific financing used at the time, then it would evaluate the first investment using a 4.6% hurdle rate and the second investment using a 12.4% hurdle rate. The company would be using different hurdle rates for both investments, even though the two pieces of equipment might be exactly the same, with exactly the same risk and exactly the same expected future cash flows! This is clearly illogical. The proper way to evaluate both investments would be to use the weighted average cost of capital. If, for instance, the WACC was equal to the 9.6% amount we calculated in our earlier example, then this is the discount rate that would be applied to both investment opportunities; we ignore the actual financing that was engaged in for each investment.

Evaluating Investments
An alternate way of conceptualizing the idea of ignoring the specific financing when evaluating an investment is to consider that once an investment is made and it is placed on the balance sheet, it is impossible to look at the debt and equity on the right hand side of that balance sheet and specifically assign particular pieces of debt and equity to particular assets. The only thing we can say in looking at a balance sheet is that the entire right hand side of the balance sheet (the debt and equity) supports the entire left hand side of the balance sheet (the assets). Therefore, when an asset is purchased and appears on the balance sheet, we should say that the financing of the asset, in general, is in proportion to the overall market value weighting of debt and equity that exists on that balance sheet.

Is WACC a Suitable Discount Rate?

In practice, it can be hard to identify the exact cost of capital a company faces. Moreover, the future cash flows of an investment will usually be unknown and, as a result, the effect on the opportunity cost of equity finance will be uncertain. The WACC might be a suitable discount rate if the following hold: The WACC reflects the firm's long-term future capital structure and capital costs. The cost of capital to be applied to investment evaluation reflects the marginal cost of new capital.

These assumptions can be justified if it is believed that the capital structure of a company changes only very slowly over time, so that the marginal cost of new capital would be roughly equal to the weighted average cost of current capital. If this view is correct, then by

undertaking investments that offer a return in excess of the WACC, a company will increase the market value of its common stock in the long run. This is because the excess returns would provide surplus profits and dividends for the shareholders. The arguments against using the WACC as the cost of capital for investment appraisal are based on criticisms of the assumptions that are used to justify it. Clearly, new investments undertaken by a company might have different business risk characteristics from the company's existing operations. As a consequence, the return required by investors might go up (or down) if these new investments are undertaken, because their business risk is perceived to be higher (or lower).

Cost of Capital and Financing of Project

Why is it not a good idea to assume that the cost of capital for a particular project will be related to the specific financing used for that project? The cost of the specific project financing is always lower than the companys existing WACC. The cost of the specific project financing is always higher than the companys existing WACC. It may lead to a misallocation of resources. Correct. Both debt and equity holders have a stake in all projects undertaken by a company. That stake is determined by the existing weighting of debt and equity in the capital structure of the company. To use only a debt cost of capital on some projects and an equity cost of capital on others would seriously understate or overstate the cost of capital hurdle rate. This could lead to a misallocation of resources within the company, and is thus to be avoided.