Reading 17: Cost of Capital

Page No. 153Date//Reading 7 0 Cost of CapitalcckIntroduction11Weight avg cost of capital (WACC) : The cost of debtandequity capital that finance a companys assetsCost of debt: After - tax Cost to the issuer d debt basedon the return debt Investors leg to fiancea6.Cost of equity : Return investor leg to own Co.i.e , the req return onequityWAcc is used by the Co. internaldecision makers to evaluate CapitalCost of+Cost ofinvestdebtEquityFor investors WACC is a critical inputto from valuationWACCWACC = Wdrd (1-t) + Wprp + wereFor FafutieDetermineng a company WACC is challenging becauseinvolves numerousComplex assumptions & Choices1.There is no "idal" method to calculateThe long g-term target Capital structure may not be thecurrent capital structerThe company marginal tax rate must be est.Forward wooking Page No. 154Date/ExQue RFR =8%Beta = 1.5YTM = 12 %Tax rate = 30%WeightEq=70 %ERP = 6%Weight Debt = 30%(Ke=8%+1.5x6%=17%Ked = 12% X (1-30%) = 8.4%WACC=70%x17%30%x8.4%= 14.42%CostofCapitalFactorsThecostsofdebt&equityCapitalareinfluenced by:Macro1Top - Down factors:ExternalorsystematicfactorsCapital AvailabilityMarket ConditionsLegal & regulatory considerations , country riskTax ridistion2BottomCompany specificupfactors:CompanyspecificorideasyncraticBiz or operating riskAssetfactornatureandSecurity FeaturesFinancialliquidityStrength&Secared debt, embeded option, PuttableprofifibilityMethodsUsedbondtoEstthecostofdebtThe methodsuseddependsonanumberoffactor2Type of debt :IstheCoYTMdebtprivatedebt!publiclytraded?Non-tradedor!BankAlease!Int RateRILL Page No 155Date//2 Debtliquidity:Howliquidormarketableisthedebt?3Credit rating : Doesthedebthaveacreditrating?4Debt Currency : In what currency is the debt denominatedEveryCurrencyhasitsownYTMyieldcurveExample:CostofdebtUsingMatrixPricingBrevis SolutionisatechproviderforthehealthcaresectorSunil Tilak, CFA is trying to est the cost of debt t whichrepresents30%ofbravisCapitalstructure.The6-yrBBrateddebt is thinlytradedTilakcollectsdata,shownnextonsimilarBB - ratedsecuritiesthat have liquid marketsCompanyMaturityCouponPriceEst the cots of debtSilva45%$99.454usingthematri XmethodDeso66%101.75Manfried77%110.0Listor78%$ 114YTMUsing ourCalculator t for Listor:5.16%PV = -114N=7PMT=8FV=100CPT1/4=&5.53%(of5.55.26%WethenConstructamatrixofmaturity&coupon5.53 %Coupon Rate2 bps per yrMaturity5%6%7 %8%Aug45.167.5.5%--6bps5.33 &7--5.26%5.53% in8345.39 % Page No. 1565342X0.002Date / /The avg yields for each maturity are then Calculated & used asest for those maturitiesFinally we use linear interpolation to determine the YTM fora6-yr bond as follows:-Interpolated yield = Yield shortt(Yield long - Yield short)(maturity - Mater(maturity - Maturity short )interpotedlong= 5.33% + (5.34 - 5.33)(6-4)C7 -4)= 5.33% + (0.02% x2)= 5.37 % AperYrApproach to Est ERPAnalysts est a company-specific ERP to calc re :le = Co cost of equity Capital=ECIG) + (Systematic market ERP + Co. IRP.MRP (ElRm ) Rf)Can be veThefocusin this reading is or est ERPUnfortunately t est ERP is difficult resulting in differinginvest" Condusions amy analysisMigh quality Input Page No. 157Date//Historical & Forward - Looking ApproachesTwo board approaches are used to est the ERP :Historyical (ex-post) approaches : Est the ERP using backwards-mean Rflooking historical data akback periodForward-looking (ex-ante) approaches : Uses forward - looking data basedonexpectations ForwardBe aware of the limitations of each and how theirconclusions are affected by estimation errorHistorical Approach to Est ERPAnalysts must make decisions regarding these fourchoices :TProxy for mikEquity Index : Broad - based, market - value - weighted indexesare typicallychosen (eg S&P 500 , + MSC ERFE)2 Est time period : Shorter data period may be noisier yetmore representative of current environment.expated 1-Prediod retur r3Mean measule : Arithmetic (easier) vs geometric (better)ERPTERPterminal wealth4Proxy for the RfR : Short - term govt debt (ey T-bill rate)or YTM on a long-term govt bond (GEPJ)When useitwillERPSTLTyield Page No.158DateTForward - Looking Approachesforward-lookingapproachisbasedonexpectationsforecoAFirfinancialvariablethataffectfuture CFTheseestlookingestorareoftenforwardex-antecalledestIrThree Forward - looking Est" methods about :-Survey-based-est:" experts"theirexpectationsAskingofCapitalBiasedtowardrecentmarketsmarketDivdiscmodels:ERP=E(Dr)+E(g)-RfVo(Repurchasesnew)Gordon growth modelofissuesnewAinAV.shareMacroeconomicmodeling:Grinold - KronermodelusesfivefactorsERP=(PLE)+i+G+AS1-E(if)influtionGDP Towth rute=ItYTM (nominal*MethodstoEstReqReturnonEquity\ t YEM Real T1]DDMr= Dit -g2BondyieldplusRisk plembuild-upmethod3]Risk-basedmodelCAPMFFEstlegrateofreturnforprivateorinternationalCoaddsfuther Complexity1 DOM :We can estaforward-lookingERPbyapplyingtheConstantgrowth DDMusedearlierExample -plaiyCurrentshareprice=P.=€100Expected future div = D1 = €3Expected(perpetual)growthratediv=g=2%in -ERP 11 Req RetuinRfPage No. 159Date / /(04)+g€3re=+2%E100=0.05 or 5 %2BondyieldplusRiskprem(BYPRP)approach1Equit > Debt more Risky)EstCoreturnas:?Debt CostthanareqonequityequityTe=Id+RP= YTM t Subjective etcId=CompanyCostofdebt(proxiedbyYTMonLTD)RiskequityrelativetocodebtRP =prem3Risk - basedmodels:102Fama-Frenche-factormodel:-theyTe=sftBERP+ B2 SMB+B3HMLCAPMsizeStyleSMB=sizefactormeasuredbymarketCapitalizationbet"bookvalue&HML = relationshipequityvalueFive - Factor Fama French model+B,+B2SMB+B3HML+B4RMW+BCMAERPRMWCMR=Invest=profitabletyfactorfactor Page No.160Date / /Ex Est Cost of Equity using DDMCogenics Inc is expected to pay a div of $4 at the end ofDiv are expected to grow at a constant rate of 4% per yrfirst yrThe current Cogenics stock price is $100Based on this data , + calc the cost of equity for CogenicsBetagenics Inc is expected to pay a div of $1.5 T $2 + $25 &$3 at the end of each of the next four Dis yr respectively. beThe Current betagenics stock price is $50 , & expected toD.Based on this data, Calc the cost of equity for Betagenics$60 p4 at the end of four yr.sol" :-For betagenics we need to Solve for le in the following ofTe = $1.5 + $2$2.5$3+60++(It's)(1+()(1+re)3(Ltre)"On our 0 0 Calc(Fo = -50 ; (01 = 1.5 ; CO2 =2 i CO3 =2.5 (04 = 63CPT IRR = 8.78%Coste of equity Page No. 161Date//Ex: BYPRPCompany LMN has bounds with 15yr to maturity a couponof8.2% & price of 101.70Ananalyst est that the additional risk assumed from holdingthefirm equity rather than bond justifies a risk prem of3.8%Calcthecostofequityusing the bond -yield - plus - risk -premapproach15Sol" Using TVM Keys : PV = -101.7 , N = = 15 PMT = 8.2 FV=100CPT 1/48.0%Cost of equity=+3.87.=11.87Ex: Fama - French Five-Factor ModelFactor RftBetaRisk PremCalc the cost of equity for fultonMarket1.13.2%Corp given the following info: :Size0.21.3%Value-0.32%The current RfR is 2.17.Profitability0.184.27.Invest" style0.52.4%Solle = 2.1%+(1 x x 3.2%)+(0-2x 1.3%)+ (-0.3 X 2%)t(0.18 x 4.27.)+(0.5X 2.4%)Thus the Cost of equity for Fulton Corp is Te= 7.2% Page No (62DateICost of Equity for Private CompanyPrivate company are often smaller & less mature CAPM than publicSince they have no market price data, the & Famamodelsare not suitable to apply to provide co.Illiquididity and the lack of transparency (i.e no sec filingsdisclosures) increase the investement risk of private Co.Appropriate Risk Prem for a piem Co include :Size Prem (SP)0IMPIndustry Risk Prem (IP)0 Specific Company risk prem ( SCRP) : A general Risk- premCovering unique risk of the private company suchasKey person risk l geographical location risk t etc which areSdifficults to diversity awayFactors Affecting SCRPQualitative FactorsQuantitative FactorsLower Corporate goverance qualityHigher leverage & Volatilitylarge proportion of intangiblesin dicate higher risk.in total assets.Poor Competitive standing inthe industryMang" without adequate Skill& experience.Geographical ConcentrationCustomer Concentration, or supplier concentrationAll indicate higher fisk Page No. 163Date//Build-up Approach-Starts with the risk-free rate and adds the equity risk premFatther risk premia for size 7 industry & company - specificChara cteristics are added Public needed.Req Reton onRey Return=If + ERP IP+ SP + + SCRPPublic size industry(c daySimilar t but uses beta of a group of peer Companies (industry BExpanded CAPM ApproachReq Return = of + Speer ERP + SP tt SCRPSCRP depends on:liquidQuantitative factors :- Industry corporate goverance quality t assetnature & type, customer and supplier Concentration / geographicalConcentration competitive position in the industry & mang" quality.Quantitative factors:- Operating & financial leverage earningsvolatility & predictability& CF volatityFC in costInternational ConsiderationstructureCost of Equity for emerging MarketsEmerging market risk rey additional prem.There are alternative way to est theseprems- Country - spread model- Country risk rating model Risk Piem bet devleifed market 4 emerging marketsPage No. 165= bond yield - bond yield(devloped)(emergency)Date/Country- - Spread model / Country Risk Rating modelThe country-spread model est a country risk prem (CRP) (alsocalled Country spread prem) for a specific emerging marketThe est equity risk plem then becomes :ERPemerging market = ERP developed + x CRP1for LaurtyBCountry Risk Pien= exposure of the CO to the local ecoWe can use Sovereign yield spread as an est of CRPHowever, diff in legal & market environment Complicatethe use of just yield spread for CRP.Damodaran ratio recommended adj the sovereign yield spread by themarkets of Standard deviation of the Country equity & bondCRP = Sovereign Yield Spreadxequity)Extended CAPMbundG CAPM uses a global market index to est the ERP Fatherthan using only a local market indexmarket Because the of low correlation bet developed & emergingt beta Coefficient usingais usually quite low ( or even -ve)global market proxyunder estimatedTo overcomes this a second factor represent the local market issometimes includes- Though the availibility of reliability market index data is aConcern in many emerging markets Page No 165Date / /Example1CAPM is a 2- factor model t based on1. A global market index leg MSCI All country world)2. A wealth -weighted index in a foreign currencyIndexEcre) = if + Ba E (rgm) -r + $ Bc E(rc) -r]use this if laily not availBG = Sensitivity to the global market inde K1gm = global market returnBc = Sensitivity to the foreign Currency indexTc = Foreign Curry index return