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Cost of Capital, Inside and Out

  • By Bryan Lapidus
  • Published: 9/10/2018

This is the first in a series of articles to introduce the key concepts and general applications of Cost of Capital for the corporate finance practitioner.

Cost of Capital is a term that encompasses several other, more technically precise terms that are used by corporate finance practitioners to help trade off risk-return. Cost of Equity is the CoC as applies to equity holders; Cost of Debt applies to debt holders; and the blended average, weighted by the ratio of equity to debt to other capital forms is the WACC, Weighted Average Cost of Capital.

Key assumption: Management is hired by investors/owners to manage their investment by running the company in a productive and ethical manner that satisfies their expectation of the amount of money they expect make given the risk they have accepted in the business.

It works this way:

From an external perspective, the CoC represents the equilibrium of risk and returns that an investor is willing to accept to put money into the company. For example, if the CoC is 12 percent, investors may be willing to put $100 on the expectation that they will receive $12 in return each year (on average, plus compounding principal); a company with a 15 percent return may offer the promise of more money but at additional risk.

The internal business manager knows that the owners/investors of the company expect this return, and so need to manage the business in a way that satisfies that return, or risk being fired or having the owners exit the company. Management will choose a mix of projects to grow the company to at least satisfy that return. The minimum acceptable level of returns for a portfolio becomes the CoC, the “bar” over which investments must hurdle, and is therefore known as the “hurdle rate.” The hurdle rate may be compared to the IRR for specific project to determine which should be accepted.

THE TERMS OF THE WACC

The formula for WACC is relatively straight forward, but the challenge lies in the assumptions, especially within the cost of equity. Keep in mind that the WACC derives from the external market perspective brought in-house. The basic formula is as follows:


WACC = (Cost of Equity * % of Capital) + (Cost of Debt * % of Capital) + (Cost of Other * % of Capital)  



The % of Capital is simply the share of that component divided by Total Capital:

  • Value of Equity/Value (Equity+Debt+Other)
  • Value of Debt/Value (Equity+Debt+Other)
  • Value of Other Capital/Value (Equity+Debt+Other)

Cost of Equity = Risk Free Rate + Beta * (Market Risk Premium)

DefinitionRate of return equity investors require to make an investment in a firm

Terms

Definition

Usage

Risk Free Rate An asset without risk of default, highly liquid and trustworthy.

Example: US Government Treasuries, due to presumed security and ability to print more money to meet debt obligations. The duration of the security should match the duration of the investment, i.e., 2-year, 10-year or 30-year bonds.

Beta Variance (volatility) of a company's returns relative to the variance of the market

Calculated by most data brokers (Bloomberg, Google Finance, Yahoo Finance, etc.). For unlisted companies, it is best to find a market proxy that is a similar company in the market.[1] Inside a company, different betas may be used for business lines or markets with different risk profiles.

Market Risk Premium,
calculated as (Rm-Rf)
The extra return required for investors to choose to invest in the market (Rm) over a risk-free asset (Rf). 

The precise number to use here is a subject of tremendous debate and varies by country. To simplify, I recommend this site.

Beta * the Risk Premium really means the expected return relative to the market. Once you have decided to be an equity investor, it is assumed that you have a diversified portfolio, or “the market portfolio.”[2] The beta is how a company correlates to the market. Therefore, the investment is a company’s expected return relative to the market’s expected return.

Cost of Debt = Interest Rate * (1-tax rate)

Definition: Cost to the firm of borrowing funds

Terms

 Definition

Usage

Interest Rate:  Blended rate of various debts, revalued at market rates. Should reflect market trading rates if available.  If not, accounting (historical) rates may be applied as a proxy.  Large corporations will have multiple debts (bonds of different maturities, notes, etc.) This can be calculated as the interest rate paid divided by debt from the most current financial statements.
 Tax Rate The tax rate most likely to be used in the future. Without specific information, the effective tax rate is a good proxy.  Apply (1-tax) because interest is tax deductible, and we want to measure cash flows rather than accounting income. [3]

   

The Cost of Other

DefinitionOther capital raised by the firm

In addition to debt and equity, there are other types of capital that may be integrated into the capital structure. If the value of the other capital is small, the impact of the WACC will also be small.  “Preferred stock” is the most frequently used in this category, and is a “hybrid” security with aspects of both debt and equity. The formula for including this in the WACC is Preferred Dividend Rate / (Equity+Debt+Other).

[1] The formula requires the use of a “levered” beta, meaning one that reflects the debt/equity ratio of the company. Most data services provide levered betas. If you think your company will be changing its debt/equity ratio, as in the case of a levered buyout, you would want to unlever the existed beta, then re-lever it at the targeted debt/equity ratio.

[2] Why is this? It is for the same reason that you don’t put all your eggs in one basket. A portfolio of one stock is more volatile than a portfolio of 10 stocks. The non-correlated factors will move idiosyncratically and lower the aggregate risk. “The Market” is the maximum number of stocks, therefore the maximum diversified risk. 

[3] The 2018 Tax Cut and Jobs Act changed details about the tax shield of interest expense. For most businesses, the amount of interest shielded is 30 percent of EBITDA through 2021, and 30 percent of EBIT thereafter, exclusive of interest income. Businesses with annual revenue below $25 million over the previous three years are exempt.
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