Cost of Capital

1、S C H O O L O F M A N A G E M E N TAUDENCIA NantesEcole de ManagementInternational Master in ManagementCorporate Finance FIN691ProfessorTheodore SYRIOPOULOStsiriopaegean.grESTIMATINGTHE COST OF CAPITAL 3BackgroundnCash is not freeit comes at a price !nthe price is the cost to the firm of using inves

2、tors money cost of capital: return expected by investors for capital they supply4Backgroundnobjectives:nshow how to estimate the cost of capitalto be used in discounted cash flows models (valuation)ninvestors do not normally invest directly in projects but in firms that undertake projects5Background

3、nassume there are only 2 types of securitiesstraight bonds (loans)common shares6Backgroundnreturns expected from firms assetsmust be total of: returnsexpected by bondholders + returns expected by shareholdersweighted by respective contribution to financing of these assetsnWeighted Average Cost of Ca

4、pital (WACC)7Backgroundnunderstand:nhow to estimate the cost of debtnhow to estimate the cost of equity capitalnhow to combine the cost of different sources of financingto obtain a firms Weighted Average Cost of Capital8Estimating the cost of debt9Estimating the cost of debtnif a firm takes out a lo

5、an,the firms cost of debt interest rate charged by the banknif information is availablesolve valuation formula for investors required rate of return tt+1t+2TttDDD+2D1tTkkCoupon PMTCoupon PMTCoupon PMTCoupon PMTBond Price = +1+1+1+1+kkthis rate is the estimated cost of debt for the issuer10Estimating

6、 the cost of debtnexample:nSMC publicly issued a bond 5-year agonoriginal maturity = 10 years nbond will be repaid 5 years from nowncurrent / remaining maturity = 5 yearsnbond issue =at 90,000 trancesneach bond trance = $1,000nannual coupon = 8%ncoupon payment = $80nbond current market price = $1,08

7、0nbonds expected rate of return (yield to maturity) = SMC cost of debt11Estimating the cost of debtninterpretation:nan investor buying an SMC bond now & planning to keep it until maturitycan expect to receive from SMC:n$80 every year (coupon payment) for next 5-years remaining + $1,000 (principal am

8、ount) at the end of 5th yearnit holds in the bond market that:$1,080 = $80 / (1+ kD)1 + $80 / (1+ kD)2 + $80 / (1+ kD)3 + $80 / (1+ kD)4 + $1,080 / (1+ kD)5 kD = 6.10%kD = bondholders expected return = firms estimated cost of debt12Estimating the cost of debtninterpretation:Why ? this reflects inter

9、est rate cost SMC has to pay if it decided today to issue new bonds to investors (coupon rate is based on interest rate that was set 5 years ago when the bond was originally issued)13Estimating the cost of debtnif the firm has no bonds outstanding,its cost of debt can be estimated by addinga credit

10、risk spreadto the yield on government securities of same maturity Cost of debt = market yield on government bond + estimated credit risk spread14BOND RATINGMARKET YIELDSPREAD OVER GOVTGovernment 5.67%-AAA6.79%1.12% (112 basis points)A7.35%1.68% (168 basis points)BBB7.89%2.22% (222 basis points)BBB11

11、.96%6.29% (629 basis points)CCCexample of credit risk structure Credit Rating & Credit Risk Spreadinvestmentgrade bondsspeculativegrade bonds(junk bonds)1 bp = 0.01%nexample:market yield on government bond = 5.67%estimated credit spread on firm = 2.13%estimated firms cost of debt (kD) = 7.80%15Estim

12、ating the cost of debtnsince interest expenses are tax deductible,the AFTER-TAX cost of debt is relevantAFTER-TAX cost of debt = pre-tax cost of debt (1 marginal corporate tax rate)kD after-tax = kD pre-tax x (1 TR)16Estimating the cost of equity17Estimating the cost of equity:the Dividend Discount

13、Model (DDM)nbased on the Dividend Discount Model (DDM),the price of a share should be equal to: Present Value (PV) of stream of future cash dividends,discounted at the firms cost of equity (kE)S = DIV1/(1+kE)1 + DIV2/(1+kE)2 + + DIVN/(1+kE)N = = inft=1 (DIVt)/(1+kE)t kE = ?18Estimating the cost of e

14、quity:the Dividend Discount Model (DDM)nthe DDM cannot be use to solvefor the cost of equitynunless simplifying assumptionsregarding the dividend growth rate are made(e.g. constant dividend growth rate)in bonds we know expected coupon paymentsin stocks we do not know expected dividend payments19Esti

15、mating the cost of equity:dividends grow at a constant ratenfirms cost of equity sum of expected dividend yield + expected dividend growth rate nassume dividend firm is expected to pay next yearwill grow at a constant rate forever1E0DIVk =+gPdividend yield = next-year dividend (DIV1) / current share

16、 market price (P0)dividend yield1EDivS = kg20Estimating the cost of equity:how reliable is the DDM ?nfor vast majority of companies,the simplistic assumptions underlyingthe reduced version of the DDM model are unacceptablenan alternative valuation approach is needed the Capital Asset Pricing Model o

17、r CAPM21Estimating the cost of equity:Capital Asset Pricing Modelnthe greater the risk,the higher the expected returnnwhat is the nature of risk?nhow is it measured?nhow does it determine return expected by shareholdersfrom their investment? 22Risk & Return patternsinvesting equal amounts in the 2st

18、ocks same average return which is now risklessdiversification helps reduce riskreturns of 2 hypotheticalperfectly negatively correlated stockswith same average return23Diversification reduces RISKna major implication of holdinga diversified portfolio of securities (or projects) risk of a single stoc

19、k can be broken-down into 2 components:nunsystematic or diversifiable risknsystematic or non-diversifiable risk24Diversification reduces RISKnunsystematic or diversifiable riskcan be eliminated through portfolio diversificationincludes company-specific factorse.g.:new product discovery(positive effe

20、ct)factory destruction(negative effect)25Diversification reduces RISKnsystematic or non-diversifiable riskcannot be eliminated through portfolio diversificationincludes market-specific factorsaffect the entire economy (instead of only the firm)e.g.change in economys growth rate,inflation rate, inter

21、est rates26Diversification reduces RISKnfinancial markets will not reward unsystematic riskbecause it can be eliminated through diversification at practically no cost27Diversification reduces RISKnthus:only risk that mattersin determining therequired return on a financial assetis the assets systemat

22、ic riskrequired rate of return on a financial assetdepends only on its systematic risk28Systematic vs. Unsystematic RiskNumber of assets(securities / projects)Systemic (market ) Risk Diversifiable (specific) RiskTOTAL RISK = Systematic (market) Risk + Diversifiable (specific) Risk Portfolio RISK29Me

23、asuring Systematic Riskwith the BETA coefficientna firms systematic risk usually measuredrelative to the market portfoliomarket portfolio = portfolio containing all of the assets in the worldnsystematic risk of a stock is estimated bymeasuring sensitivity of its returnsto changes in a broad stock ma

24、rket indexe.g. S&P500 index this sensitivity factor is calledthe stocks beta coefficient30Monthly stock returns: SMC vs. S&P 500graph shows how beta of SMCs stock (b=1.05) was estimated by plotting SMCs stock returns vs. S&P500 returns over last 5 years;slope of characteristic line measures beta2000

25、31Beta coefficients of US stock sampleTexas Instrument1.60AT&T1.00Black & Decker Corp.1.50Bayer AG1.00Maytag Corporation1.50McDonalds0.90Navistar International1.45Dow Chemical 0.90Intel Corporation1.35Shell Transport & Trading0.90World Com, Inc.1.35Smithkline Beecham0.80US Airways1.35Boston Beer0.80

26、United Air Lines1.20Walgreen0.80IBM1.20TotalFinaElf0.80Hewlett Packard Company1.20Coca-Cola Co.0.80LVMH Moet Hennessy LV1.20New York Times, Co.0.80U.S. Home & Gardens, Inc.1.20Merck & Co., Inc.0.70Bank of America Corp.1.15Chevron Corporation0.70American Express Corp.1.15Diageo PLC0.70General Motors1

27、.10American Water Works Co.0.40Air Gas1.05Consolidated Edison Co.0.4032s 1 aggressive stock behaviourvs. market portfolio s 1defensive securitiess 142CAPM to estimate firms cost of equityassume:ngovernment bond yield =5.8%nSMCs beta =1.06nmarket risk premium =6.2%nmarket portfolio return =?KE, SMC =

28、 5.8% + (6.2%) x 1.06 = 12.37%43Estimation of cost of equity with CAPMLondon Stock Exchange5.1% x (6.2% x 0.44) = 7.8%0.44RetailingMarks & Spencer5.1% x (6.2% x 0.60) = 8.8%0.60DistributionInchcape5.1% x (6.2% x 0.94) = 11.0% 0.94TelecommunicationsBritish Telecom5.1% x (6.2% x 1.15) = 12.2%1.15Pharm

29、aceuticals Smithkline Beecham5.1% x (6.2% x 1.3) = 13.2%1.30AirlineBritish AirwaysEstimate Cost of Equity with the CAPMBeta CoefficientIndustryCompanySource: DatastreamGovernment Bond Rate = 5.1%Market Risk Premium = 6.2%(November 2000)44Cost of Capital45Estimating a firms Cost of CapitalnWhat is th

30、e firms cost of capital?nminimum rate of return the firm (project) must generatein order to meet the return expectationsof its suppliers of capital (shareholders debtdholders)46Estimating a firms Cost of Capitalnassuming that the firm is financed bydebt + equityna firms cost of capital is:Weighted A

31、verage Cost of Capital (WACC)= weighted average of (cost of debt + cost of equity) weights = relative shares (proportions) of debt + equity used in financing the firms assets47Weighted Average Cost of Capital WACC = k D(1 Tc) + kEDE + DEE + DWACC = Weighted Average Cost of CapitalkD = cost of DebtkE

32、 = cost of EquityTc= corporate tax rateD = DebtE = Equity48The Firms Cost of Debt & EquitynCost of debt can be estimated using:nbond valuation formulancredit spread approachnask the banknrelevant cost of debt is the after-tax cost of debtnCost of equity can be estimated using:nCapital Asset Pricing

33、Model (CAPM)when there are no available share prices,the average beta of proxy firms is used49Firms WACC calculations: SummarynStep 1:estimate relative proportion of debt & equity(SMC: 40.5% debt)nStep 2:estimate the firms after tax cost of debt(SMC: 4.02%)nStep 3:estimate the firms cost of equity (SMC: 12.37%)nStep 4:calculate the firms WACC (SMC: 9%) WACC = discount rate the firm should use when making investment decisions50WACC estimationStep 1:Estimate the firms relative proportions of debt (D) and equity (E) financing:DEE + DE + D