Topic 5: Cost of Capital

Topic Overview
Lesson 5.1
5.1.1 Weighted Average Cost of Capital
5.1.2 The Cost of Debt Capital
5.1.3 The Cost of Debt Capital using the
Yield to Maturity
5.1.4 Debt Ratings
5.1.5 The Cost of Debt Capital using the
Debt Rating Approach
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5.1.1 The Weighted Average Cost of Capital
 In Topic 5 we will focus
on Net Present Value
as the most accurate
and reliable decision rule
for project evaluation
THE COST OF CAPITAL AS A DISCOUNT RATE
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NPV…
The discount rate…
requires us to discount
future cash flows using
an appropriate discount
rate
should be the firm’s cost of capital
The cost of capital
is the cost the firm pays
to the providers of the
capital used by the firm
to fund its investments
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5.1.1 The Weighted Average Cost of Capital
 Consider again the simple balance sheet we
looked at in Topics 1 and 3:
THE FIRM’S CAPITAL STRUCTURE
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 The relative combination of debt, equity and
other securities issued by a firm (i.e. the right
hand side of the balance sheet) is called its
capital structure
Assets Liabilities & Equity
Current assets Debt
Long‐term assets Preference shares
Ordinary shares
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5.1.1 The Weighted Average Cost of Capital
 In order to arrive at a single value to use as
a discount rate, we need to determine the
total cost of capital for the firm
 This will be the firm’s average cost of capital
 In order to take into account the particular
capital structure of each firm, it needs to be a
weighted average cost of capital (WACC)
 The weights will reflect the importance of
each source of capital in the capital structure
SIMPLE AVERAGES & WEIGHTED AVERAGES
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5.1.1 The Weighted Average Cost of Capital
 We could calculate the weights for the WACC
using one of two different sets of values:
BOOK VALUES AND MARKET VALUES
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 Since the cost of capital is to be used to make
decisions about the future, we should always
use market values to determine the weights
Book values
Market values
The historical cost of the debt
and equity securities as shown
on the balance sheet
The current value of the
securities that investors would
be prepared to pay for them
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5.1.2 The cost of debt capital
 The cost of debt capital, such as a bond, is
not the coupon rate – this reflects interest
rates at the time the debt was issued
 The cost of debt capital is the interest rate
that the firm would have to pay to refinance
its debt at current market prices
 In the case of bonds, It is their yield to
maturity, which is the return or yield an
investor would receive if he or she bought
the firm’s bonds and held them to maturity
WHAT IS THE COST OF DEBT CAPITAL?
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5.1.2 The cost of debt capital
 The cost of debt capital is a function of two
things:
 The general level of interest rates
– The higher the general level of interest
rates, the greater the opportunity cost; the
greater the return investors will require to
invest in the debt rather than something else
 The risk of the firm that has issued the debt
– The riskier the firm, the greater the rate of
return required by investors
WHAT DETERMINES THE COST OF DEBT?
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5.1.3 The cost of debt capital – yield to maturity
 If the firm’s debt is traded in a liquid market
(e.g. a bond market) the cost of debt is the
discount rate that equates the present value
of the future cash flows with the current price
of the bonds – this is called the yield to
maturity
 If there are multiple future cash flows, this
can only be done using trial an error, a
financial calculator or a spreadsheet – you
are not required to do this in this subject.
YIELD TO MATURITY
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5.1.4 The cost of debt capital – debt rating approach
 If there is no reliable market price for a firm’s
bonds, an alternative approach is to assume
that the cost of debt is similar to the cost of
debt of a firm with a similar debt rating
 Debt ratings are issued by firms such as
Moody’s, Standard and Poor’s and Fitch,
and are based on a firm’s risk of default
 If two firms are of similar risk, we assume
that their cost of debt (if they had to
refinance their debt) would be similar
HOW CAN WE ESTIMATE THE COST OF DEBT?
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In default
5.1.4 The cost of debt capital – debt rating approach
Example of debt ratings:
DEBT-RATINGS
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Investment
grade
Speculative
grade (junk)
S&P
AAA
To
BBBBB+
to
C
D
Fitch
AAA
to
BBBBB+
to
CCC
D
Moodys
Aaa
to
Baa3
Ba1
to
Ca
C
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5.1.4 The cost of debt capital – debt rating approach
Analysts estimates of debt risk premiums:
DEBT-RATINGS
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S&P Cost of Debt Credit Spreads
AAA 3.0% 0.50%
AA 3.2% 0.70%
A 3.4% 0.90%
BBB 3.6% 1.10%
BB 3.8% 1.30%
B 4.0% 1.50%
CCC 4.2% 1.70%
CC 4.4% 1.90%
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5.1.4 The cost of debt capital – debt rating approach
 The amount of interest paid to debt-holders
is not the effective cost of debt to the firm,
because debt is tax deductible
 The effective, or after-tax, cost of debt, is:
THE AFTER-TAX COST OF DEBT
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where rD = the before-tax cost of debt
TC = the corporate tax rate
1  D C r T (13.3)
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Topic Overview
Lesson 5.2
5.2.1 The Cost of Preference Shares
5.2.2 The Cost of Ordinary Shares
using the Constant Dividend
Growth Model
5.2.3 The Cost of Ordinary Shares
using the Capital Asset Pricing
Model
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5.2.1 The cost of equity capital
 Preference shares normally pay a fixed
dividend
 The infinite stream of dividends therefore
constitutes an perpetuity
 If we know the price of the preference shares
we can rearrange the formula for the price of
a preference share (which is based on the
formula for the present value of a perpetuity)
to solve for the discount rate
THE COST OF PREFERENCE SHARES
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5.2.1 The cost of equity capital
 Hence, the formula for the cost of preference
shares is:
THE COST OF PREFERENCE SHARES
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where rP = the cost of preference shares
DivP = the preference share dividend
PP = the preference share price
P
P
P
P Div
r
 P (13.4)
P
P
r Div
P
 
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5.2.2-3 The cost of equity capital
 There are two ways
to estimate the cost
of ordinary shares:
THE COST OF ORDINARY SHARES
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CAPM
CDGM
Capital Asset
Pricing Model
Constant Dividend
Growth Model
Based on the formula to
calculate share price with
constant dividend growth
1
E
E
P Div
r g


    E f i Mkt f r  r  β E R  r (12.6)
1
E
E
r Div g
P
  
(13.5)
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Topic Overview
Lesson 5.3
5.3.1 Calculation of the Weighted
Average Cost of Capital
5.3.2 Project Evaluation using the WACC
5.3.3 Evaluation of the Acquisition of
another Firm
5.3.4 Evaluation of Projects in Multidivisional
Firms
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5.3.1 The weighted average cost of capital
 The formula for calculating the WACC
(based on debt, preference and ordinary
shares) is:
CALCULATING THE WACC
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where rE = the cost of ordinary shares
rP = the cost of preference shares
rD = the before-tax cost of debt
TC = the corporate tax rate
E, P and D are the respective weights
% % 1  % (13.6) WACC E P D C r  r E  r P  r T D
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5.3.2 The weighted average cost of capital
 We have said that a firm would normally use
its WACC as the discount rate to determine
the NPV of a project
 If the NPV of a project is positive, it will
generate more cash (in present value terms)
than is needed to meet the cost of capital,
and hence will increase the value of the firm
 However, there are certain key assumptions
we are making when we use the WACC in
this way
PROJECT EVALUATION USING THE WACC
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5.3.2 The weighted average cost of capital
PROJECT EVALUATION USING THE WACC
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Assumption No. 1
We assume that the risk
of the project is
equivalent to the
average market risk of
the firm’s investments
Average risk
 The cost of capital is
determined by the
risk of the investment
from the point of view
of investors – i.e. the
risk of the firm
 It is only appropriate
to use the WACC for
a project that has the
same level of risk of
the company’s
existing projects
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5.3.2 The weighted average cost of capital
PROJECT EVALUATION USING THE WACC
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Assumption No. 2
We assume the firm
maintains a constant
ratio of debt to equity
as it raises new capital
to finance projects
Constant debtequity
ratio
 The WACC is based
on the firm’s current
debt-equity ratio
 The level of debt, or
leverage, impacts on
the risk of the firm
 If this is to change,
the WACC will no
longer reflect the true
cost of capital for
new projects
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5.3.2 The weighted average cost of capital
PROJECT EVALUATION USING THE WACC
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Assumption No. 3
We assume that the
main effect of leverage
is the tax deductibility of
interest – i.e. that there
are no other effects
Limited leverage
effects
 With very high levels
of debt, there are
other factors, such as
financial distress
costs and bankruptcy
costs, which impact
on the risk of the firm
 The calculation of the
WACC assumes that
these factors are not
significant at current
debt levels
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5.3.3 The weighted average cost of capital
 If a firm is planning to acquire another , it is
likely that the risks associated with the
newly-acquired business will differ from the
risks of the firm’s existing investments
 It would not be appropriate to use the firm’s
existing WACC (which is based on the risks
of its current investments) as the discount
rate to determine the NPV of the acquisition
 It should use the new business’s WACC,
which is based on that business’s risks
COST OF CAPITAL FOR A NEW ACQUISITION
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5.3.4 The weighted average cost of capital
 If a large firm has a number of divisions
operating in different industries, and the risk
of these divisions varies, it not appropriate to
use the overall WACC for the firm to
evaluate projects within those divisions
 It in necessary to determine a cost of capital
appropriate to each division
 For example, one could estimate the beta for
firms operating within each industry to
calculate a cost of capital for each industry
DIVISIONAL COSTS OF CAPITAL
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