Cost of Capital Factors
- Weighted Average Cost of Capital (WACC) represents the cost of debt and equity capital used by a company to finance its assets.
- Formula: WACC = wdrd(1 – t) + wprp + were.
- Determining WACC is challenging due to multiple calculation methods and the need for assumptions about the long-term target capital structure and marginal tax rate.
- Companies should aim for the optimal capital structure that minimizes WACC and maximizes shareholder wealth.
- A company’s cost of capital is influenced by the type of capital sought; debt typically has a lower cost than equity due to its lower risk.
- Top-down factors are systematic and reflected in the risk-free rate and Equity Risk Premium (ERP).
- Include capital availability, market conditions (interest rates, inflation), legal/regulatory environment (country risk, investor protections), and tax jurisdiction.
- Greater capital availability and favorable market conditions generally lead to lower costs of capital.
- Higher marginal tax rates decrease the after-tax cost of debt (assuming interest is tax deductible).
- Bottom-up factors are company-specific and reflected in the credit spread and beta.
- Include revenue, earnings, and cash flow volatility; asset nature and liquidity; financial strength, profitability, and leverage; and security features.
- Higher volatility and leverage increase the cost of capital.
- Tangible and liquid assets can lower the cost of debt due to collateral possibilities.
- Features embedded in debt (callability increases cost, putability and convertibility decrease initial cost) and equity (cumulative preferred decreases cost relative to non-cumulative) securities impact the cost of capital.
Estimating the Cost of Debt (rd)
- Methods depend on whether the debt is traded or non-traded, its liquidity, credit rating, and currency.
- Traded Debt: The Yield to Maturity (YTM) on existing straight debt (no embedded options) with a similar maturity can estimate the cost of new debt. Shorter-term, more liquid bonds might provide a more reliable estimate if the longest-dated bond is illiquid.
- Non-Traded Debt:
- If a credit rating exists, use the YTM of comparable-rated bonds with similar maturities (matrix pricing).
- If no rating exists, estimate a synthetic credit rating based on the company’s fundamental characteristics, such as Interest Coverage (IC) and Debt/Equity (D/E) ratios, and then use comparable-rated bond yields.
- The issuer’s overall credit rating may differ from the ratings of specific debt issues based on bond features.
- Bank Debt: Estimate the interest rate paid on new bank debt financing, considering amortization (amortizing loans typically have lower default risk and cost).
- Leases: The implied interest rate or rate implicit in the lease (RIIL) can be estimated from lease payments and the asset’s fair value. If RIIL is unknown, the incremental borrowing rate (IBR) (rate for a collateralized loan of the same term) can be used.
- International Considerations: Add a country risk premium (CRP) to the debt’s yield to account for economic, political, and exchange rate risks, often assessed relative to sovereign debt risk.
Estimating the Equity Risk Premium (ERP)
- Two broad approaches: historical (ex-post) and forward-looking (ex-ante).
- Historical Approach: Calculates ERP as the mean difference between a broad-based equity market index return and a government debt return (risk-free proxy) over a specific period.
- Key decisions: Equity index selection, time period (longer periods reduce standard error but may include less relevant data), mean type (arithmetic or geometric; geometric is less sensitive to outliers and better for terminal wealth), and risk-free rate proxy (short-term bill vs. long-term bond YTM; short-term is truly risk-free but duration mismatch exists).
- Assumes returns are stationary (future returns will resemble past returns) and markets are relatively efficient.
- Forward-Looking Approach: Uses current information and expectations to estimate ERP.
- Dividend Discount Model (DDM): ERP = E(D1/V0) + E(g) – rf, where E(D1/V0) is the expected dividend yield and E(g) is the expected earnings growth rate for the market index. Assumes constant growth rate leading to a constant P/E ratio.
- Grinold-Kroner Model: ERP = [DY + Δ(P/E) + i + g – ΔS] – E(rf), where DY is dividend yield, Δ(P/E) is the expected change in P/E, i is expected inflation, g is expected real earnings growth, and ΔS is the expected change in shares outstanding.
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