Cost Of Capital The cost of capital is a term used in the field of financial investment to refer to the cost of a company's

funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities". !" #t is used to evaluate new pro$ects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmar% that a new pro$ect has to meet. &or an investment to be worthwhile, the expected return on capital must be greater than the cost of capital.

Weighted average cost of capital

The '()) methodology, as defined below, is a widely accepted method for calculating the cost of capital. #t is understood by both the finance community and the industry, and is consistent with the methodology used by many regulators. The '()) for a company is a weighted average of the cost of debt and the cost of equity, with the weightings determined by the relative levels of debt and equity in the company's asset base* '()) + )ost of ,ebt x -earing .)ost of equity x (! / -earing) The tax burden, to which operators are sub$ect to, due to the leverage effect that they cause, should be considered when calculating the weighted average cost of capital. Therefore, the post/tax '()) is* '()) + )ost of ,ebt x (! 0 t) x -earing . ()ost of equity) x (! / -earing) 'here, t is the tax rate.

The weighted average cost of capital (WACC) of a firm simply refers to how much, on average, it costs the firm to raise money. That is, it is the average rate that the firm must pay on any new capital that it raises. The importance of the WACC is in its relation to the evaluation of projects. The basis of determining WACC is to determine the costs of each of the individual sources of long term financing for the firm, weight those costs by the degree to which the firm uses the different sources, and simply add up the weighted costs.

This e uation is the same as saying! WACC " (percent of the firm that is e uity) times (cost of e uity) plus (percent of the firm that is debt) times (cost of debt)

Uses rATIONALE
WACC can be used as a hurdle rate against which to assess ROIC(return on investment capital) performance. It also plays a ey role in economic value added (!"A) calculations. Investors use WACC as a tool to decide whether to invest. #he WACC represents the minimum rate of return at which a company produces value for its investors. $et%s say a company produces a return of &'( and has a WACC of ))(. #hat means that for every dollar the company invests into capital* the company is creating nine cents of value. +y contrast* if the company%s return is less than WACC* the company is shedding value* which indicates that investors should put their money elsewhere. WACC serves as a useful reality chec for investors. #o be blunt* the average investor probably wouldn%t go to the trouble of calculating WACC because it is a complicated measure that re,uires much detailed company information. -onetheless* it helps investors now the meaning of WACC when they see it in bro erage analysts% reports. #he WACC is useful in determining how a company gains its capital. Is it financing itself through debt or e,uity. #he WACC helps answer that ,uestion. Computing WACC offers insight into a company%s ability to ma e returns upon its investments and* hence* money for investors. #he WACC is often used by internal management to steer the company toward beneficial* moneyma ing pro/ects and away from losing ones.

3.2 The gearing ratio

The weighting used in the '()) formula is the company's gearing. The gearing is a measure of the ratio of debt to company value (the latter being equivalent to the sum of debt (,) and equity (1)) and is defined as* -earing + DE D

+
There are a number of ways to determine the gearing level, each with a direct effect on the cost of capital* a) 2ased on boo% values* the gearing is calculated using the accounting value of the company's debt and equity. This is a transparent method, easy to chec% and audit. The downside with the use of boo% value is that it is not forward/loo%ing and does not reflect the company's true economic value. 2esides, boo% values are dependent on the operator's strategic and accounting policy and so they may vary substantially with changes in the accounting principles, provided general accounting rules are respected3 b) 2ased on mar%et values* the gearing can be calculated on the basis of the observed mar%et value of the company's debt and equity, namely its mar%et capitalisation, which in theory will reflect the true economic value of the company's capital structure. The mar%et value of equity can be obtained by multiplying the number of shares with their current price. The mar%et value of debt can be difficult to obtain directly since besides bonds firms generally have other forms of non/traded debt, such as ban% debt. 4owever, boo% values can be converted into mar%et values by treating the entire boo% debt as one coupon bond.5 This coupon bond would be valued at the current cost of debt for the company. 4owever, the problem with the use of mar%et values is that they are dependent on several mar%et factors, namely volatility, investors' expectations and speculation and so they can be sub$ect to serious fluctuations, negatively affecting mar%et stability. (v)

Determining the Costs of Financing #n order to determine the WACC, the costs of the individual sources of long term financing there are four sources of capital! $) %ebt &) 'referred (toc) *) Common (toc) +) #nternally generated funds (retained earnings)

Debt is money the company borrows and has to pay interest on, $ust the same as we might borrow money from the ban%. The company will then have to pay interest each year which will be a set percentage of the amount they have borrowed. They need to ma%e these repayments no

matter what, whether they ma%e a profit or not. 4owever the amount of debt doesn6t increase over time li%e the value of the company does.

3.3 The cost of debt The cost of debt reflects the cost the company has to sustain in order to get capital to finance its activity, either from financial institutions or through loans from other companies. #t corresponds to the weighted average of the costs of the various long/run loans of the company and it is strongly correlated to the current interest rate's level, the company's financial capacity and ris% and even to the country's fiscal policy. The cost of debt can be calculated using accounting data or the current loan boo% in order to derive the interest rate the company registers in its accounting boo%s. This is a transparent method, easy to audit, and that considers the costs the company actually paid. ( factor to be considered in calculating the cost of debt is to loo% at the firm6s credit ratings as an indication of borrowing costs. (nother method to ascertain the cost of debt is to calculate an efficient borrowing level. This could be done where firms over borrow or borrow at too high a rate and therefore the level of debt and associated interest cost are ad$usted bac% to an efficient level by the regulator so that the firm is not rewarded for this financial decision. (nother method to estimate the cost of debt is the following* )ost of ,ebt + 7is% &ree 7ate . )ompany 8pecific ,ebt 9remium The ris% free rate is analysed in more detail in chapter :.; of this document. The company specific debt premium increases with the company's gearing reflecting the company's higher financial ris%, considering that more cash flow needs to be generated in order to meet interest payments. #t can be obtained by observing published credit ratings : that specialist credit rating agencies assign to that company. (lthough it is more complex to calculate, this approach ensures that the cost of debt is forward/loo%ing and, therefore, avoids transitional effects, such as temporary holdings of debt

Equity is usually money obtained from selling shares in the company. (n investor will give the company money in return for a share of the company itself. The company is not usually obliged to ma%e any interest payments on this capital, but most will pay dividends to their shareholders depending on the profit they have made in a particular period. The shareholder also benefits from the value of the company (and hence the value of their shares) increasing over time.
Cost of Equity The second main component of the '()) formula is the cost of equity . 1conomic theory has developed different approaches to calculate the cost of equity, for example the )apital

(sset 9ricing <odel ()(9<), the ,ividend -rowth <odel (,-<). These models share a common assumption about how investors ma%e financial decisions* investors are assumed to be able to reduce total ris%s by holding diversified portfolio.

3. Different !ethodologies to calculate the cost of equity

3.4.1 The dividend growth model

The most common version of the ,-< assumes that a company will pay a dividend that grows at a constant rate over time, independent of any shoc% that might hit the economy. The cost of equity using the simplest ,-< version is* Re + D= (! . g) > P= . g 'here* Re + )ost of equity D= + The dividend paid at time ?ero P= + The current price of companies6 shares g + The expected growth rate of dividends

Capital Asset Pricing Model Capital Asset Pricing Model (CAPM) #he Capital Asset 0ricing 1odel (CA01) is one method of determining the appropriate discount rate in business valuations. #he CA01 method derives the discount rate by adding a ris premium to the ris 2free rate. In this instance* however* the ris premium is derived by multiplying the e,uity ris premium times 3beta*4 which is a measure of stoc price volatility. +eta is published by various sources for particular industries and companies. +eta is associated with the systematic ris s of an investment. One of the criticisms of the CA01 method is that beta is derived from the volatility of prices of publicly2traded companies* which are li ely to differ from private companies in their capital structures* diversification of products and mar ets* access to credit mar ets* si5e* management depth* and many other respects. Where private companies can be shown to be sufficiently similar to public companies* however* the CA01 method may be appropriate.
The commonly used formula to describe the )(9< relationship is as follows*

7equired (or expected) 7eturn + 7& 7ate . (<ar%et 7eturn / 7& 7ate)@2eta &or example, let's say that the current ris% free/rate is ;A, and the 8B9 ;== is expected to return to !5A next year. Cou are interested in determining the return that Doe's Eyster 2ar #nc (DE2) will have next year. Cou have determined that its beta value is !.F. The overall stoc% mar%et has a beta of !.=, so DE2's beta of !.F tells us that it carries more ris% than the overall mar%et3 this extra ris% means that we should expect a higher potential return than the !5A of the 8B9 ;==. 'e can calculate this as the following*

7equired (or expected) 7eturn + 7equired (or expected) 7eturn +

;A . (!5A / ;A)@!.F "#.3$

'hat )(9< tells us is that Doe's Eyster 2ar has a required rate of return of !G.HA. 8o, if you invest in DE2, you should be getting at least !G.HA return on your investment. #f you don't thin% that DE2 will produce those %inds of returns for you, then you should consider investing in a different company. #t is important to remember that high/beta shares usually give the highest returns. Ever a long period of time, however, high beta shares are the worst performers during mar%et declines (bear mar%ets). 'hile you might receive high returns from high beta shares, there is no guarantee that the )(9< return is reali?ed.

Cost of equity
)ost of equity + 7is% free rate of return . 9remium expected for ris% )ost of equity + 7is% free rate of return . 2eta x (mar%et rate of return/ ris% free rate of return) 'here 2eta+ sensitivity to movements in the relevant mar%et* 'here* Es The expected return for a security Rf The expected ris%/free return in that mar%et (government bond yield) s The sensitivity to mar%et ris% for the security RM The historical return of the stoc% mar%et> equity mar%et (RM-Rf) The ris% premium of mar%et assets over ris% free assets. The ris% free rate is ta%en from the lowest yielding bonds in the particular mar%et, such as government bonds. (or required rate of return for investors) can be calculated with the "dividend capitali?ation model", which is

The ris% free rate&rf'

The ris% free rate is the expected return on an asset, which bears in theory no ris% at allI, i.e. whose expected returns are certain. #n practice, it is not possible to find an investment that is free of all ris%s. 4owever, freely traded investment/grade government bonds can generally be regarded as having close to ?ero default ris% and ?ero liquidity ris%.

The ris% pre!iu!

The mar%et ris% premium represents the additional return over the ris%/free rate that investors require as compensation for the ris% they expose themselves to by investing in equity mar%ets. #t is essentially a measure of investors6 appetite for ris%
What Does Beta (ean) ( measure of the volatility, or systematic ris%, of a security or a portfolio in comparison to the mar%et as a whole. 2eta is used in the capital asset pricing model ()(9<), a model that calculates the expected return of an asset based on its beta and expected mar%et returns.. (lso %nown as "beta coefficient".

(v) *) Common (toc)! The main method used to calculate a cost of e uity capital for common stoc)!

2) Preferred Stock:

'referred stoc) is li)e a cross between debt and e uity as it is e uity that re uires a fi,ed dividend payment. The cost of preferred e uity is simply defined as the dividend yield on the stoc).

-et!

dp" fi,ed annual preferred dividend. 'p"price of preferred rp"cost of preferred e uity

rp =

dp 0p

.ote that it is actually the net issuing price that should be used in this e uation. That is, the price of the preferred stoc) net of any flotation costs that would have to be incurred in order to issue new shares.

4.Cost of retained earnings !ost of internal e"#it$

Jote that retained earnings are a component of equity, and therefore the cost of retained earnings (internal equity) is equal to the cost of equity as explained above. ,ividends (earnings that are paid to investors and not retained) are a component of the return on capital to equity holders, and influence the cost of capital through that mechanism.

In order to calculate a weighted average cost of capital there are a few pieces of information that we need to know: TheWd= The proportion of the financing taken on by debt (amount of capital taken from loans/initial investment)

The Wp d! The proportion o the inancing ta"en pro#ided $% pre erred stoc" (a&o'nt o capital ta"en ro& pre erred stoc"(initial in#est&ent) The We! The proportion o the inancing pro#ided $% e)'it% (a&o'nt o capital raised $% ne* e)'it%(initial in#est&ent) The a ter ta+ ,d! The cost o de$t + ( -. ta+ rate) or the interest rate that the $an" re)'ires The ,p d! di#idend(share price The ,e! /(r)0 1eta (Mar"et /is" Pre&i'&)

The initial in#est&ent The ta+ rate We are no* a$le to calc'late the WACC *hich !

Wd(Kd)(1-t)+(Wpfd)(Kpfd) +(We)(Ke)
ere is a numerical e!ample: We want to start a company that re"uires an initial investment of #$%%&%%%' (ur company that will manufacutre plastic shower caddies will re"uire use of all #$%%&%%%' We are able to take out a loan of #)*&%%% from a local bank+ #*%&%%% by issuing common stock to family& friends& and professors+ and #)*&%%% of preferred stock to a generous alumna of , -' There is an ./ interest rate on our loan+ and we agreed to pay our alumna 0/ return' We do some research and see that a company who only manufactures plastic shower caddies has a beta of '.* with no outstanding debt' (ur risk free rate is 1'1/ and market risk premium is 0'0/' The ta! rate is 2%/' What is our re"uired return on our investment that we will use to find a present value of our company& in other words& our W3--4

2OLUTION3
Wd= )*&%%%/$%%&%%% = ')*

We! 456555(-556555 ! 74 Wp d! 846555(-556555 ! 784 ,d! 759 ,e! 75::0794(75;;) ! 7-5 ,p d! 75;
5ow we can substitute into our e"uation: W3--= (')*)('%.)($6'2)7('*)('$)7(')*)('%0)

WACC! 75-:0754075-4 ! 75<= ! <7=>

When finding a rate of return for an individual pro8ect& we must remember that W3-- is only appropriate for an individual pro8ect when its risk is e"ual to the risk of the company as a whole' If there is added or subtracted risk to the firm from the pro8ect& the re"uired return must be ad8usted'

A ne* 1eta or the pro?ect &'st $e o'nd $% 'sing the @a&ada E)'ation3
9eta of assets= 9eta of e"uity/ :$7($6t)(;/<)= Then a new return can be calculated using this new 9eta: >isk 3d8usted ;iscount >ate= risk free rate7 (beta of assets)(market risk premium)

Other practical proble!s in esti!ating the cost of capital

*." +ntroduction There may occur circumstances in which the approaches introduced and explained in the previous chapters to estimate the cost of capital cannot be used. This may be the case when the cost of capital of a non/listed firm has to be estimated3 in fact, when shares are not listed, there is no information available to estimate the company's beta. 8imilar types of problems may arise when a company has not issued debt securities, when a domestic financial mar%et is not mature enough to estimate the equity ris% premium reliably, or when the financial mar%et volatility raises concerns over the company specific parameters. This chapter presents some alternative approaches that can be used in the aforementioned circumstances in order to alleviate the uncertainty of '()) estimation in the absence of sufficiently reliable information from the financial mar%et. #n all of these cases some additional measures can be adopted in order to avoid errors in '()) estimation. Ene option is to use good comparator companies and another one is to use the high>low/method and sensitivity analysis. a) Comparator companies #n case some of the parameters of the '()) can not be estimated reliably as a consequence of data unavailability, a useful approach is to base the estimation of the parameters, or of the '()) itself, using comparator companies, as in the case of divisional '()) calculation. 'hen selecting companies, which have to serve as a comparison, the following aspects should be considered* The comparator company, or companies, should be comparable in si?e with the company being evaluated. The si?e can be measured for example in revenues or in total mar%et capitali?ation3 the latter is not applicable in case of unlisted firm. &urther, it is preferable that the comparator companies are selected from countries

which are similar to the country of the relevant company, for example in terms of income per capita, as the ris% of telecom business is li%ely to differ depending on the income level of the country in which companies operate. #n fact, in countries with a higher income level, the use of a phone is li%ely to be less sensitive to changes in income, whereas in lower income countries, telephone services are li%ely to have higher income elasticity. The penetration rate could also be a criterion for selecting the most appropriate comparator companies. &or example, a low penetration rate could be an indication that phone services are used predominantly by businesses, since the urban population is li%ely to be more sensitive to the economy. b) High/low scenario approach and sensitivity analysis The high>low scenario approach is useful when it is possible to produce various estimates, using different methods, but none of these estimates is clearly more reliable than the others. This is done in practice by identifying the highest and lowest level for each of the envisaged parameters and calculate a range of cost of capital outcomes. The main purpose of the high>low scenario approach is to average out errors made in individual parameter estimation. #n addition to the high>low scenario approach, sensitivity analysis could be used. This means that after ma%ing the best estimate of a parameter, one calculates the '()) using this best estimate. #n order to determine whether the '()) is vulnerable to errors in the estimation of this parameter, one can also use the highest and the lowest values of this parameter, produced in the analysis, and incorporate them in the '()) calculation as well and determine the effect on the '()). #f the effect is large, one should consider spending more time and effort to increase the reliability of the estimation of this one parameter.

. Therefore ta%ing only a recent period ris%s missing information and biasing the results, suggesting that betas should be calculated over as long a period as possible. There is therefore a trade/off between the relevance of the estimation period and the need for a sufficiently long time period to ensure the regression results are robust. <ost estimate services use period ranging from 5 to ; years for the regression. The relevant frequency should be defined in order to have a data set of a reasonable si?e, which can generate a statistically significant estimate of the value of beta. ( beta calculated through regression analysis of historical information provides an approximation. 4owever, estimation errors are li%ely because betas may vary significantly over time. Therefore, the estimation of the relevant beta from historical information may need to be complemented with other forward/loo%ing approach.