Estimating the Cost of Capital
Content
Estimating the Cost of Capital What is the cost of capital (WACC)? An opportunity cost If a manager accepts a project, funds are not available for other proposed uses. Investors have significant capital market opportunities; their choosing one specific company over another implies a favorable risk/return assessment of that company (and its projects) over the other opportunities. The cost of capital provides the relevant benchmark: unless the firm (run by managers) earns more than its cost of capital it does not create value for investors. Sources of long-term Capital
Long-Term Capital Long-Term Debt Preferred Stock
Common Stock
Retained Earnings
New Common Stock
The weighted average cost of capital (WACC) WACC = wdKd(1-T) + wpKp + wcKs wd + wp +wc =1.00 The w’s refer to the firm’s capital structure weights. (we believe they should be target, not historical and market, not book). The K’s refer to the cost of each component. We believe they should be marginal (current or forward looking), not historical. Cost of Debt We frequently look at current yield to maturity on existing debt and/or consult with our investment banker to find our likely cost (yield) of newly issued debt. Tax adjustment because of tax deductibility of interest. Relatively straight forward estimation with little controversy or ambiguity. Cost of Preferred Stock We frequently look at current yield on existing preferred and/or consult with our investment banker to find our likely cost of newly issued preferred stock. Not that many firms use preferred: mostly public utilities because it is cheaper than equity but for regulatory purposes counts as equity; some financial institutions and firms with control issues. Relatively straight forward estimation with little controversy or ambiguity. Cost of Equity Most difficult conceptually to estimate. Largest component of vast majority of firms in terms of proportion of market value capital structure. Most important to equity investors. While we teach in intro course three calculation methods (CAPM, Dividend Growth model and bond yield plus a premium), most important (and most difficult to estimate) is market driven CAPM. The SML from CAPM ri = rRF + (rM – rRF) bi ri is the required return of return of the stock rRF is the risk free rate (to be discussed) rM is the required rate of return of the market bi is the beta of the stock = Cov(ri,rm)/σ2(rm)—to be discussed; bi may be division or project risk (to be discussed) (rM – rRF) is the market risk premium (to be discussed)
The Risk Free Rate of Return 90-day T-Bills most consistent with received theory; they protect against interest rate movements. 10 to 30 year T-Bond rates more reflective of capital budgeting projects WACC used for. Most companies use a rate of about the life of the project. Beta Estimation Should be future beta; no such estimates exist so we use historical beta. Beta is a function of index used and frequency and length of observation The more time periods, better statistical reliability, but increases use of stale data. Shortening observation period from monthly to weekly or data gives more observations, may create nonnormal data and introduces much noise. rM theoretically includes all risky assets and is therefore unobservable Beta estimates for the same company will consequently be different with monthly vs weekly vs daily data and with different number of years of observation. Thus WACC will be different with different betas May need to use beta of another firm for project in new industry firm not in: pure play beta Market Risk Premium Issue is how much is expected market return greater than risk free rate of return. Large reliance on historical data Issue of arithmetic versus geometric mean returns—arithmetic seems to be preferred. Wide range of estimates…likely from 3 to 9 percent Risk-adjusting WACC The calculated WACC is suitable for a firm’s “average risk” capital budgeting project. For above or below average risk projects WACC should be adjusted—failing to do so ignores that obtained capital must earn that return commensurate with its risk and not doing so may over allocate capital to risky projects and under allocate it to less risky projects. While this seems more concrete on divisional basis, it should occur within a division. This issue can create massive internal political issues. New division may create a new WACC
Long-Term Capital Long-Term Debt Preferred Stock
Common Stock
Retained Earnings
New Common Stock
The weighted average cost of capital (WACC) WACC = wdKd(1-T) + wpKp + wcKs wd + wp +wc =1.00 The w’s refer to the firm’s capital structure weights. (we believe they should be target, not historical and market, not book). The K’s refer to the cost of each component. We believe they should be marginal (current or forward looking), not historical. Cost of Debt We frequently look at current yield to maturity on existing debt and/or consult with our investment banker to find our likely cost (yield) of newly issued debt. Tax adjustment because of tax deductibility of interest. Relatively straight forward estimation with little controversy or ambiguity. Cost of Preferred Stock We frequently look at current yield on existing preferred and/or consult with our investment banker to find our likely cost of newly issued preferred stock. Not that many firms use preferred: mostly public utilities because it is cheaper than equity but for regulatory purposes counts as equity; some financial institutions and firms with control issues. Relatively straight forward estimation with little controversy or ambiguity. Cost of Equity Most difficult conceptually to estimate. Largest component of vast majority of firms in terms of proportion of market value capital structure. Most important to equity investors. While we teach in intro course three calculation methods (CAPM, Dividend Growth model and bond yield plus a premium), most important (and most difficult to estimate) is market driven CAPM. The SML from CAPM ri = rRF + (rM – rRF) bi ri is the required return of return of the stock rRF is the risk free rate (to be discussed) rM is the required rate of return of the market bi is the beta of the stock = Cov(ri,rm)/σ2(rm)—to be discussed; bi may be division or project risk (to be discussed) (rM – rRF) is the market risk premium (to be discussed)
The Risk Free Rate of Return 90-day T-Bills most consistent with received theory; they protect against interest rate movements. 10 to 30 year T-Bond rates more reflective of capital budgeting projects WACC used for. Most companies use a rate of about the life of the project. Beta Estimation Should be future beta; no such estimates exist so we use historical beta. Beta is a function of index used and frequency and length of observation The more time periods, better statistical reliability, but increases use of stale data. Shortening observation period from monthly to weekly or data gives more observations, may create nonnormal data and introduces much noise. rM theoretically includes all risky assets and is therefore unobservable Beta estimates for the same company will consequently be different with monthly vs weekly vs daily data and with different number of years of observation. Thus WACC will be different with different betas May need to use beta of another firm for project in new industry firm not in: pure play beta Market Risk Premium Issue is how much is expected market return greater than risk free rate of return. Large reliance on historical data Issue of arithmetic versus geometric mean returns—arithmetic seems to be preferred. Wide range of estimates…likely from 3 to 9 percent Risk-adjusting WACC The calculated WACC is suitable for a firm’s “average risk” capital budgeting project. For above or below average risk projects WACC should be adjusted—failing to do so ignores that obtained capital must earn that return commensurate with its risk and not doing so may over allocate capital to risky projects and under allocate it to less risky projects. While this seems more concrete on divisional basis, it should occur within a division. This issue can create massive internal political issues. New division may create a new WACC
