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Cost of Capital Tutorial
About the Tutorial The goal of this tutorial is to give the reader a thorough understanding of one of the most important, and least understood, concepts in corporate finance - the cost of capital. While the cost of capital can be considered a fundamental building block of corporate finance, it is frequently ignored by many companies as they go about their day to day operations. However, by ignoring the cost of capital, companies run the risk of misallocating capital and therefore destroying rather than creating shareholder value. This tutorial will give the reader the tools necessary to determine what debt and equity capital costs so that a proper comparison can be made between a company’s cost of capital, and the return a company is actually earning on that invested capital. Learning Objectives The first part of the tutorial will be devoted to acquainting the reader with the cost of debt capital. The risk/return nature of debt capital will be discussed, as well as the tax benefits to be derived from the use of debt as a financing tool. In addition, financing instruments such as leases that really represent a form of debt will also be addressed. This cost of debt discussion will be followed by an introduction to the cost of equity capital. In this section, we will address the development of the Capital Asset Pricing Model and explain how this model is used to determine the appropriate cost of equity capital. As part of understanding the Capital Asset Pricing Model, the reader will be introduced to concepts such as the risk-free rate of return, the market risk premium, and beta coefficients (both levered and unlevered). This section will be followed by a discussion of the weighted average cost of capital. The reader will be shown how to properly weight a company’s cost of debt capital and its cost of equity capital so that a single, blended cost of capital rate can be created. In that regard, the reader will learn how to use two different, but equivalent, methodologies for calculating the weighted average cost of capital. Finally, common pitfalls in the use of cost of capital will be presented and discussed so that the reader will understand how those pitfalls can be avoided.
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Therefore. the higher will be the interest rate demanded by the lender to compensate him for that risk. COST Return % Exhibit 1-1 10.0 © Shareholder Value Consultants. there is a direct risk/return correlation associated with the cost of debt. or that it may not be received in a timely manner. Inc. In any case. 3 . That explicit cost of capital is the cost of debt capital. The cost of debt capital embodies a cost for both the time value of money. Cost of Debt Capital What exactly is the cost of capital? The answer to this question has two parts. there is an explicit cost of capital. That risk is that the lender may not receive the expected interest and/or principal in their entirety. the greater the risk. First. This cost is obvious to see as it appears as an expense on the income statement.COST OF CAPITAL The cost of capital is a concept that needs to be understood in detail as it is one of the most important financial principles to be found in the business world. and for the risk the lender takes on in lending money to the borrower.
50% to compensate the lender for the time value of money plus any possible risk of inflation.S. borrowers may have to pay double digit interest rates in order to obtain capital from this source.g. the market today demands a rate of 4.7% = 5. Debt does have a particular attribute that serves to reduce its actual cost to the borrower. On the far left hand side of the graph is a United States Treasury security (e. The following example illustrates this concept: Pre-Tax Interest Rate = 8% Company’s marginal tax rate = 30% After-Tax Interest Expense = Pre-Tax Int. 4 . 30 Year U.6% The fact that interest expense is tax deductible can make debt a cost effective means of obtaining capital in the marketplace. Treasury Bond).Marginal Tax Rate) = 8% x (1 . the government rebates a portion of that interest expense back to the company depending on the company’s marginal tax rate. Given that this security is riskless. a holder of this type of debt security can always be assured of getting 100 cents on the dollar of interest and principal in a timely manner. This junk debt can be so risky with regard to interest and principal payments that even within today’s relatively low interest environment. Leases A lease can be thought of as a borrowing source. That attribute is the fact that interest expense on borrowed funds is tax deductible.Exhibit 1-1 graphically shows how the cost of debt rises as the risk of the debt is increased. This security is considered to be riskless because the United States government will always pay its debt obligations in full and on time. Exp. the required interest rate to compensate for that additional risk also increases. As the risk of a debt security increases. Inc. In effect. On the far right hand side of Exhibit 1-1. and so we need to address this financing vehicle as a form of debt capital. the risk is so great that debt that falls within this section are sometimes call “junk”. Even if the government has to resort to inflating the money supply to do so.30%) = 8% x . whenever a company borrows money. x (1 . There are essentially two types of © Shareholder Value Consultants.
transfers most of the risk of ownership of the asset to the lessee. Because capital leases have characteristics similar to those of straight debt capital. a new lease is entered into with new future lease payment obligations. we need to add today’s value of that operating lease into our total capital figure. The best way to approximate what those implied interest expense amounts would be is to multiply the calculated present value of © Shareholder Value Consultants. and will therefore have an impact on a company’s investment capital and NOPAT. the cost of capital associated with this financing vehicle will be equivalent to a company’s cost of debt capital. The only caveat with this approach is that this calculation will tend to understate the true investment capital value of the operating lease unless an assumption is made that at the end of the current lease. called a capital lease. are typically recorded in the footnotes of a company’s financial statements. we must calculate the implied interest expense embodied within the operating lease payments. From an economic point of view. the interest expense associated with the lease payments should be added back when developing the net operating profit after taxes (NOPAT) statement for either Free Cash Flow or Economic Profit purposes. Inc. an operating lease is similar to a straight debt obligation or to a capital lease. In order to properly reflect the impact that the operating lease payments will have on NOPAT. This effectively treats the lease payment as a perpetuity (i. Operating leases are the second type of lease. One type of lease. As such. An operating lease is one in which the risk of ownership of the asset is primarily retained by the lessor. an operating lease allows a company to gain the use of an asset in exchange for future periodic payments to the owner of the asset. This is in keeping with the concept of eliminating the impact of any financing related flows (including lease financing) from the NOPAT calculation. which is probably a reasonable assumption). In that regard. the company will always have operating lease obligations. the dollar amounts of these kinds of leases are counted as invested debt capital for purposes of Free Cash Flow or Economic Profit calculations. The present value of the lease payments is recorded on the balance sheet as a fixed asset on the “left hand side”. A capital lease is accounted for as if the asset had been purchased through the use of straight debt. This can be done by dividing the current operating lease payment by the cost of debt capital. since these leases are a form of debt capital. Due to the debt equivalent nature of a capital lease. The future lease payment obligations however. Again.leases. operating leases do not appear on the financial statements of a company.e. 5 . Another approach to calculating the current investment capital value of the operating lease would be to discount all of the future operating lease payments (these figures are usually listed in the footnotes of a company’s financial statements). These new obligations would then be similarly discounted back to the present. and as debt capital on the “right hand side”. To capture the investment capital impact of an operating lease.
This is in keeping with the idea that operating leases. With a large enough portfolio of stocks. he has lost value. are really just different forms of borrowing. Even though net income. Inc. earned that particular return for the same level of risk elsewhere in his universe of investment possibilities. 6 . which is the cost of equity capital. and therefore truly represent debt obligations from an economic point of view. If an investor expects a company to earn “X”% on invested capital. if any one stock exhibited a significant decline. the important element in determining the risk of a stock was how its price moved within the overall portfolio. is fairly straightforward. the greater the return expected by the equity holders. the overall cost of debt capital can be used as the cost of capital associated with operating leases. an investor will have an expectation that he be fairly compensated for having made an equity investment within a company. because investors have a universe of opportunities at their disposal with respect to where they invest their money. the greater the expected variability in the equity flows. and yet it is the more important and more expensive of the two major capital costs. That is. that would probably be offset by another stock that had experienced a substantial increase. then. from the investor’s point of view. The cost of equity capital does not appear anywhere on the traditional financial statements. on average. there has been a decline in value because that increase was simply not enough! Historically. Since an investor had the capability of holding a large number of securities in his portfolio. As a result. when the academic community offered a different perspective on equity risk. This view held sway until the early 1970’s. risk was now considered in a portfolio sense. the risk of any one individual security was of no concern. It can also be thought of as an opportunity cost. As we did with capital leases. Rather than consider risk as something related to an individual security. Cost of Equity Capital While the explicit cost of capital. The methodology developed to determine this portfolio risk involved observing how the stock price of a given company moved over a long period of time in © Shareholder Value Consultants. The resulting figure (representing the approximated interest expense) should then be added into NOPAT in order to keep the NOPAT figure on a pure operating (ex financing costs) footing. and the company earns something less than that. Value has been lost because he could have. or even cash flow. Because of this opportunity cost element. may have increased within the company. there is also an implicit cost of capital. the cost of equity capital was viewed in a straightforward risk/return manner. along with capital leases. as embodied in the cost of debt capital.the operating lease (as mentioned above) by the cost of debt capital.
7 .7%. Finally. . a trend line was created. the stock would move up or down by . would move up or down by that same 1%. This stock would therefore be considered less risky than the market portfolio because of its smaller relative movement as compared to the market portfolio.relation to a market portfolio of stocks as embodied in a broad index of stocks such as the S&P 500.7%. and the slope of that trend line was called “beta”. © Shareholder Value Consultants. If a stock has a beta of 1. since its beta was equal to that of the market portfolio.4%. then for every 1% movement in the market portfolio (up or down).0 as well. for instance. A beta of 1. Inc. then that stock was considered to be as risky as the market portfolio. By graphing the relationship that existed for the returns on a given stock vis-à-vis the returns on the market portfolio. Beta as a measure of stock risk is easily interpreted. the stock would move up or down by 1. if another stock had a beta of.0.4%.0 would also signify that the stock was of “medium” or “moderate” risk. The beta of the market portfolio was arbitrarily given a designation of “1. then for every 1% movement in the market portfolio (up or down). then that indicates that for every 1% movement in the market portfolio (up or down). for instance. on average. If a given stock had a beta coefficient of 1. This particular stock would therefore be considered of equal risk to the market portfolio. This particular stock would be considered riskier than the market portfolio because of its greater relative movement as compared to the market portfolio. 1. the stock.0”. If another stock had a beta of.
U. As we mentioned earlier. Because this security is riskless. Inc. risk (along the “x” axis) is defined in terms of beta.S.COST OF Return % Exhibit 1-2 Exhibit 1-2 graphically shows how beta relates to the cost of equity. As we take on more “beta risk” by moving towards the right along the “x” axis. Mark Retur © Shareholder Value Consultants. As can be seen from the graph. At a beta equal to 1. it has a beta of “0”. Its return is set based on its stated interest rate.S. at this risk level. 30 Yr. This intuitively makes sense since a Treasury security does not move in relation to the stock market. while rate of return is represented by the “y” axis. the required return necessary to compensate an investor is higher than what was required for the riskless security. we are at the risk level associated with the market portfolio. the return that is required increases. such as the 30 Year Treasury Bond. Treasury obligation. and the principal amount will be returned at the stated time.0. a riskless security is defined as a U. As can be seen from the graph. T-Bo 8 .
This 6% number can be interpreted as the percentage premium that the market portfolio offered an investor for having taken on additional risk.COST O Return % Exhibit 1-3 The difference between the required return on the riskless Treasury security and the required return on the market portfolio is defined as the market risk premium (Exhibit 1-3). the academics created what was called the Capital Asset Pricing Model (CAPM). In studying this differential historically over a long period of time. Armed with this theory that the cost of equity capital for a company is related to the risk-free rate. if the riskless security offered a return of 4%. the beta of a company. and the market risk premium. For instance. Treasury security. If. the market portfolio return tended to equal 13% (again 6 percentage points higher). on average. As a matter of fact. Inc.S. in any given year. the academics discovered that this number remained remarkably stable over the years. compared to the return an investor could receive on a long term U. then the market portfolio in that same year tended to offer a return of 10% (6 percentage points higher). the riskless security’s return was 7%. T-B . in another year. This CAPM formula quantified the cost of equity capital for a company as follows: © Shareholder Value Consultants.S. this number tended to gravitate to 6%. 9 Mar Retu 30 Y U.
5 x 6% = 6.1 x 6. one can see that the cost of capital for a company is equal to the risk-free rate of the long term Treasury security plus an additional premium.4% + 1.Cost of Equity = Risk Free Rate + Beta x (Market Risk Premium) Looking at this formula.4% Market risk premium = 6. EXAMPLE: Risk-free rate = 6.4% Market risk premium = 6% Company Beta = 1. That premium is related to the company’s beta. signifying more portfolio risk. multiplied by the market risk premium.0% = 6.5 Cost of Equity = 6. which is assumed to be constant at 6%. as follows: Risk-free rate = 6.4% + 6.0% = 15.4% + 1. Inc.4% + 9. then the cost of equity capital would have been higher. 10 .0% Company Beta = 1.6% Cost of Equity = 13.0% If the company’s beta had been higher.1 Cost of Equity = 6.4% © Shareholder Value Consultants.
6 x 6% = 6. 11 . If a company is not publicly traded.4% + .0% Calculating the cost of equity capital for a company using this methodology is relatively easy to do. how can one proceed with using the CAPM? If a particular company is privately held. Inc. In that case.S. Treasury securities is easily obtained from any one of a number of sources including The Wall Street Journal. A simplistic way to do that is to look at publicly traded peer companies or competitors for the particular company in question. One can then take an average of the betas for those companies and use that average as a proxy for the particular company’s beta. The risk-free rate on long term U.4% + 3.A lower beta for the company would have resulted in a lower cost of equity capital. this approach will provide a reasonable approximation for beta that will allow one to use the CAPM. The business risk component (or unlevered beta) will be a function of the kind of industry the company is in. The market risk premium is assumed to be a constant at 6%.6% = 10. and Morgan Stanley. It captures the risk of a company’s operations without regard to financing risk. The more a © Shareholder Value Consultants. Levered and Unlevered Betas A more sophisticated way to determine a private company’s beta is to recognize that company betas are really made up of two components. For companies that are publicly traded. Those components reflect a company’s business risk and its financial (debt) risk. and the kinds of products or services a company sells. company betas can be obtained from various sources including the Value Line publication (usually available at most public libraries). Goldman Sachs. a proxy for beta will need to be developed. or for a fee from Wall Street investment houses such as Merrill Lynch. as follows: Risk-free rate = 6.4% Market risk premium = 6% Company Beta = . or not publicly traded. a direct beta for that company will not exist. While not a perfect solution.6 Cost of Equity = 6.
This can be seen from the following: Beta L = Beta U x (1 + Debt x (1 . considers the amount of debt a company has in its capital structure. “Debt” represents the market value of debt. adds to the overall business risk that a company’s equity holders must bear. a company that is privately held will need to rely on proxy measures for its beta. the greater the company’s unlevered beta will be. causes its stock to move vis-à-vis the market. The greater the proportion of debt a company has in its overall capital structure. while the business risk (unlevered beta) for all companies within a specific industry may be reasonably similar. and “t” represents the marginal tax rate. As we said earlier. The way we can address this issue is to calculate unlevered betas by use of the following equation: Beta L = Beta U x (1 + Debt x (1 . or products and services. In a circumstance where there is no debt whatsoever in a company’s capital structure. “Beta U“ represents the unlevered beta. Peer/competitor companies can be used to approximate what a specific company’s beta might be. A cursory look at the above equation gives us an indication as to how unlevered and levered betas can differ depending on the level of debt versus equity in a company’s capital structure. 12 . and the levered and unlevered betas will be the same. This financial risk. However. the financial risk that each of those companies has taken on may cause their levered betas to vary markedly from one another. “Equity” represents the market value of equity. or levered beta. “Beta L“ represents the levered beta. the term within the parentheses will reduce to “1”. The second component. therefore. as we now see. This levered beta is ultimately the beta that is of paramount importance since it reflects both kinds of risks (business and financial) that a company faces. The sum of a company’s business risk (unlevered beta) and financial risk yields a company’s total equity risk. for financial risk. and vice versa. Inc. the greater the risk to the equity holders that the company’s debt obligations will not be covered by business operations.company’s industry.t)) Equity © Shareholder Value Consultants.t)) Equity In the above equation.
and assuming a marginal tax rate of 30%.t)) Beta L = Beta U x (1 + (1 . then our equation changes as follows: Beta L = Beta U x (1 + Debt x (1 .70.t)) Beta L = Beta U x (1) Beta L = Beta U If we instead assume that the debt to equity ratio is equal to 100%.Beta L = Beta U x (1 + 0% x (1 .30%)) Beta L = Beta U x (1 + (70%)) Beta L = Beta U x (1.t)) Equity Beta L = Beta U x (1 + 100% x (1 . our relationship between the levered and unlevered beta will be: Beta L = Beta U x (1 + (1 .t)) Beta L = Beta U x (1 + 100% x (1 .t)) Using a debt to equity ratio of 100%.70) The unlevered beta in this example can therefore be determined by starting with the levered beta and dividing by 1. Inc. 13 . © Shareholder Value Consultants.70) Beta L = Beta U (1.
The above formula for converting levered betas into unlevered betas is particularly useful for the private company that is seeking to develop a cost of equity capital. and the marginal tax rate is 30%.30)) 1.05) 1. which it intends to maintain.59 = Beta U The unlevered beta for companies in this industry. For example.05 .20. which would strictly reflect the operating risk for companies in a particular industry without regard to financing risk.20 = Beta U x 2. Let’s further assume that this particular company operates today with a debt to equity ratio of 50%.05 1.t)) Equity 1. 14 . let’s assume that a particular company finds that its peers/competitors have an average beta of 1. as follows: Beta L = Beta U x (1 + Debt x (1 .20 = Beta U x (1 + 1. we are in a position to relever the beta using the debt to equity ratio of the company in question.59. © Shareholder Value Consultants.20 = Beta U x (1 + 1. including our particular company.70) 1.50 x . Now that we have the unlevered beta. Inc.20 = Beta U x (1 + 1.. the average ratio of debt to equity ratio for those companies is 150%.20 = Beta U 2. is . How would we calculate an appropriate levered beta for this company? The first step would be to use our formula to calculate an unlevered beta.50 x (1 .
80 Based on our calculation.50 x (1 . Weighted Average Cost of Capital In order to properly reflect the cost of capital for a company that has both debt and equity in its capital structure. If that is the case. the market value of debt may not be readily available. the weightings for debt and equity use the market values for both debt and equity in developing the percentages. we need to calculate a weighted average cost of capital (WACC). This is accomplished by determining what percent of a company’s overall capital structure consists of debt and what percent consists of equity.To relever. we would simply use our original formula.59 x 1. and the debt and equity components would also be quantified using market values for each. one can use the book value of debt. Inc..t)) Equity Beta L = . assuming a debt to equity ratio of 50%. then as a proxy for market value. even for publicly traded companies. 15 . However.59 x (1 + . While clearly not as accurate for calculating a © Shareholder Value Consultants.35 Beta L = . the company would have a levered beta equal to . as follows: Weighting (Debt) = Market Value of Debt__________ Market Value of Debt + Market Value of Equity Weighting (Equity) = Market Value of Equity_________ Market Value of Debt + Market Value of Equity As can be seen from the above equations. as follows: Beta L = Beta U x (1 + Debt x (1 .80.30)) Beta L = . The overall capital structure would be quantified using market value.
Again. The point to bear in mind is that we are not trying to attain exactitude with these proxy approaches for either debt value or equity value.weighting factor as market value would be. then as a proxy. Thus there is a built-in mechanism that tends to move the market value of debt back to book value. then as “old” debt. Inc. Rather. the company can presume that its equity market value approximates 11 times its current Free Cash Flow. after-tax = 4. and therefore does not have a published value. with a current market value that is either greater than or less than book value.6% © Shareholder Value Consultants. the average market multiple for those companies is 11 times their current Free Cash Flow. In this case.6% Cost of Equity = 13. The market value of equity can also be problematic if a company is not publicly traded. a proxy needs to be used. it is constantly being replaced with debt whose book value and market value are one and the same at issuance.6%) + (60% x 13. If. as with debt. book value is nonetheless a reasonable proxy for market value. This is so because if a company is maintaining a particular debt to equity capital structure.0%) = 1.8% + 7. matures.8% = 9. The WACC is calculated by applying the weighting on debt to the cost of debt and the weighting on equity to the cost of equity: WACC = Weighting (Debt) x Cost of Debt + Weighting (Equity) x Cost of Equity EXAMPLE: Weighting (Debt) = 40% Weighting (Equity) = 60% Cost of Debt. One approach would be to look at the multiples to current Free Cash Flow at which those public companies are currently trading. for instance. we are trying to develop reasonable weightings that will ultimately permit us to calculate the weighted average cost of capital (WACC). 16 .0% WACC = (40% x 4. one can look at peer companies or competitors who are publicly traded for guidance. making the use of book value reasonable for weighting purposes.
It is also the rate that would be used to discount future expected flows from future investment opportunities. as follows: Beta L = Beta U x (1 + Debt x (1 .1 = Beta U 1.In this example.t)) Equity 1.67 x (1 .47 1.1 = Beta U x (1 + . This we can do using our earlier formula. we assumed the cost of equity capital was 13%..1 (this is the beta we used in our earlier example calculation for the cost of equity capital).30)) 1. and the risk-free rate of return is equal to 6. 9. Inc.t x Debt ) Capital where C* = the weight average cost of capital C = the unlevered cost of equity capital t = the marginal tax rate In the prior calculation of the weighted average cost of capital. In order to calculate the unlevered cost of equity capital.75 = Beta U © Shareholder Value Consultants.1 = Beta U x 1. we will need to calculate an unlevered beta.47 .4%. An alternative approach to calculating the weighted average cost of capital is through the use of the following formula: C* = C x (1 . 17 . Let’s assume that the beta associated with that cost of capital is equal to 1.6% would be the weighted average cost of capital that would be compared to a company’s return on investment to determine whether value has been created or not.
. Inc. This may seem surprising. as follows: Cost of Equity = Risk Free Rate + Beta x (Market Risk Premium) Cost of Equity = 6.40) C* = 10. In the absence of tax deductibility.9% This calculation represents the unlevered cost of equity capital.88 C* = 9.4% + 4. The reason for this result is that the actual benefit to a company of using debt capital within its capital structure is the tax deductibility of debt. shown below: C* = C x (1 . and then weighting those costs based upon the relative debt to total capital (40%) within the capital structure. a company would receive no © Shareholder Value Consultants.0% Cost of Equity = 6.5% Cost of Equity = 10.6% we achieved earlier by using the specific cost of debt capital and the specific cost of equity capital.75 and the Capital Asset Pricing Model formula. We now have the necessary components to utilize the alternative formula for the calculation of the weighted average cost of capital.9% x (1 . we can calculate an unlevered cost of equity capital..t x Debt ) Capital C* = 10.75 was the unlevered beta.9% x (1 .9% x . 18 .4% + .6% This is the same 9.30 x .Using the unlevered beta of . given that we have not explicitly used the cost of debt capital in this latest formula.75 x 6. since our beta of .12) C* = 10.
If the company were to evaluate both investments based upon the specific financing used at the time. one must be careful not to fall into the trap of thinking that if a specific financing is going to be used for a planned purchase of an asset (e. irrespective of the actual explicit financing that is used at that particular time. For example. Another way of conceptualizing this idea of ignoring the specific financing of the moment when evaluating an investment is to consider that once an investment is made and it is placed on the balance sheet. The company would be using different hurdle rates for both investments.6% related to the specific borrowing for that investment.4%. The only thing one can say in looking at a balance sheet is that the entire right hand side of the balance sheet (the debt and equity) supports the entire left hand side of the balance sheet (the assets). is in © Shareholder Value Consultants. then the cost of capital for that purchase is NOT just the 4.3% amount we calculated in our earlier example. since the use of cheaper debt would be exactly offset by the increase in the cost of equity due to the increase in financial risk (resulting from the greater use of debt). when an asset is purchased and appears on the balance sheet. even though the two pieces of equipment might be exactly the same. 19 . Therefore. then this is the discount rate that would be applied to both investment opportunities. if a company is looking at a possible purchase of fixed assets for $1000. The fallacy of looking only at the particular financing that used at a point in time to judge an investment can be seen in a scenario whereby a company purchases a piece of equipment for $1000 with borrowed funds with an after tax cost of debt of 4. One must always remember that whenever an investment is made within a company. It then purchases another piece of equipment for $1000 with internally generated (equity) funds with a cost of 12. then it would evaluate the first investment using a 4.6%. then the cost of capital for that investment opportunity is just the cost of that specific financing vehicle. If. The proper way to evaluate both investments would be to use the weighted average cost of capital. the owners of the company (the shareholders) always have a stake in that investment.g.particular benefit to using debt capital within its capital structure. Inc. ignoring the actual financing that was engaged in for each investment.4% hurdle rate. it is impossible to look at the debt and equity on the right hand side of that balance sheet and specifically assign particular pieces of debt and equity to particular assets. one should say that the financing of the asset. a piece of machinery). Cost of Capital Pitfalls When using the cost of capital for evaluation purposes. and plans to borrow the entire amount at an after tax interest rate of 4. for instance.6%.6% hurdle rate and the second investment using a 12. in general. with exactly the same risk and exactly the same expected future cash flows! This is clearly illogical. the WACC were equal to the 9.
Inc. 20 . © Shareholder Value Consultants.proportion to the overall market value weighting of debt and equity that exists on that balance sheet.
Inc.Richard Malekian Biography Richard Malekian is the President of Shareholder Value Consultants. His educational background includes an MBA in Finance from New York University. information technology. Mr. 72 Woods End Basking Ridge. and the creation of management incentive compensation programs that are linked to those metrics. and was also Vice President at Stern Stewart & Company. Those programs include the installation of financial management frameworks within client companies based on Economic Profit and Free Cash Flow. airlines. Shareholder Value Consultants. a management consulting firm that assists client companies in the creation of value for shareholders through the implementation of Economic Profit and Free Cash Flow programs. Malekian was a Director in the Shareholder Value Management group at PricewaterhouseCoopers.net © Shareholder Value Consultants. consumer products. His client experience covers several industries. chemicals. Earlier in his career. Additional areas of specialization include the executive education/training of client personnel in Economic Profit and Free Cash Flow techniques. retailing. 21 . NJ 07920 908-759-0890 r. and a Bachelor of Science degree in Finance from the Wharton School of Business at the University of Pennsylvania. he served as Vice President within the Corporate Finance Group at American Express. Prior to founding Shareholder Value Consultants. Inc.. and the quantification of customer loyalty initiatives using those measurement tools. and includes manufacturing services. Inc.malekian@att. and utilities.
Cost of Capital Tutorial Questions The following questions for should be answered by circling “True” or “False”. True False 3. Inc. True False 4. If a company is not publicly traded. 1. The cost of equity capital is commonly arrived at today by using the Capital Asset Pricing Model. A company’s cost of capital is simply the interest expense incurred on any funds the company may have borrowed. a beta for that company can be estimated by looking at the betas of peers/competitors of that company. The weighted average cost of capital can be calculated by taking the individual costs of debt and equity and weighting them by the market values (where available) of a company’s total debt and equity. 22 . True False © Shareholder Value Consultants. True False 2.
The cost of capital for a particular project will be related to the specific financing used for that project. 23 .5. Inc. True False © Shareholder Value Consultants.
1. The cost of equity capital is commonly arrived at today by using the Capital Asset Pricing Model. 24 . (True . that cost must be quantified and blended with the cost of debt to arrive at a total cost of capital. Inc. one must always assume that there is an additional cost of using an equity holder’s capital within a business.Cost of Capital Tutorial Questions and Answers The following questions should be answered by circling “True” or “False”.this answer is correct) The Capital Asset Pricing Model is a methodology that quantifies the cost of equity capital by taking into account the risk-free rate of return. (True . While the cost of equity capital is not captured anywhere on the financial statements (unlike debt).this is correct) A company’s cost of capital includes the explicit cost of any debt capital that may have been used. and the market risk premium. (False . As a result.this is incorrect) A company’s cost of capital will incorporate both debt capital (borrowed funds) and equity capital (owners’ funds). a company’s “beta” coefficient. plus the implicit cost of equity capital. © Shareholder Value Consultants. 2. A company’s cost of capital is simply the interest expense incurred on any funds the company may have borrowed.
one can be developed by looking at peer or competitor companies that are publicly traded within that given company’s industry.this is correct) When a beta for a given company is not readily available because the company is not publicly traded. (True .(False . a cost of equity capital can be determined and ultimately a weighted average cost of capital. an appropriate weighting can be developed that will properly blend the debt and equity within a company’s capital structure. The weighted average cost of capital can be calculated by taking the individual costs of debt and equity and weighting them by the market values (where available) of a company’s total debt and equity. a proxy can be developed for that given company.this is incorrect) All companies can be considered to have an “informal” beta coefficient. 4. 25 . By using a proxy for beta. (False . and prices that risk accordingly.this answer is incorrect) While older theories for the cost of equity capital relied on a company’s individual risk/return profile to quantify and price risk.this is correct) By using the market weights of a company’s debt and equity. that approach has largely been abandoned in favor of the Capital Asset Pricing Model approach which looks at a company’s risk in a “portfolio” context. 3. By taking an average of the publicly traded company betas. a beta for that company can be estimated by looking at the betas of peers/competitors of that company. Inc. © Shareholder Value Consultants. (True . even those that are not publicly traded. If a company is not publicly traded. yielding a “blended” cost of capital called the weighted average cost of capital.
one should always presume that the existing capital structure is maintained.this is incorrect) The individual costs of debt and equity must be weighted using market value weights in order to accurately calculate a weighted average cost of capital.this is incorrect) Irrespective of the specific financing that a company engages in for a particular project. the relative amounts of debt and equity within a company’s capital structure is taken into account in calculating the weighted average cost of capital. The cost of capital for a particular project will be related to the specific financing used for that project. By weighting the individual costs of debt and equity. This could lead to a misallocation of resources within the company. © Shareholder Value Consultants. Inc.this is true) Both the debt holders and the equity holders have a stake in all projects undertaken by a company. 5. 26 . That stake is determined by the existing weighting of debt and equity in the capital structure of the company. To only use a debt cost of capital on some projects and an equity cost of capital on others because that was the specific financing used on those particular projects would seriously understate or overstate the cost of capital hurdle rate. (True .(False . (False . and is therefore something to be avoided. and that therefore there is an implicit blending of debt and equity capital used for all projects.
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