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Attribution Non-Commercial (BY-NC)

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College of Business

University of Illinois at Urbana-Champaign

Prof. George Pinteris

Finance 422

company’s cost of capital. To begin with, recall that the capital budgeting decision states

that each company is faced with a number of investment opportunities and must pursue

those with positive NPV. An investment has a positive NPV only if its returns exceed

what is offered by the financial markets in investments of equivalent risk. At the same

time, a company’s creditors and shareholders expect to be compensated for the

opportunity cost of investing their funds in the particular company instead of another

investment opportunity of equivalent risk. Thus, for any company to decide whether to

pursue an investment opportunity, it is important to estimate the correct discount rate that

will be used to discount expected cash flows from that investment. This discount rate is

called the company’s cost of capital.

A company can raise funds from creditors and equity investors to finance its

investments. Creditors require an expected return on their loaned funds that also includes

a premium for default risk, which is called the cost of debt. Equity investors also require

an expected return that includes a premium for the risk of holding the particular

company’s stock. This is called the cost of equity. Thus, we can think of the overall cost

of financing that the company is faced with as the weighted-average of the cost of debt

and the cost of equity. This is the company’s cost of capital and it is estimated by the

weighted-average cost of capital (WACC). The company’s WACC will be the discount

rate that will be used to discount the expected future free cash flows from the company’s

investments.

The company’s cost of capital is also known as the company’s hurdle rate. It is

known as such because it is the rate that managers should use to evaluate potential

investment opportunities and to reevaluate, at regular intervals, the company’s existing

investments. The cost of capital gives the hurdle rate that a company needs to exceed

collectively in all of its investments. Also, by knowing its cost of capital a company can

explore ways of financing a project. Altering, for example, the mix of debt and equity

may have an impact, if any, on the company’s overall cost of capital.

The estimation of a company’s WACC must be consistent with the overall valuation

approach and the definition of cash flows to be discounted. Note that this process

involves discounting future cash flows and, thus, the estimation of the WACC must have

a forward-looking focus. The estimation of WACC must be characterized by the

following elements:

• The company’s cost of capital must be a weighted-average of all sources of

capital since free cash flows are available to all providers of capital.

• It must be calculated on an after-tax basis since the free cash flows are after taxes.

• It must be adjusted for the systematic risk that each provider of capital bears given

that they expect to be compensated for taking that risk.

• Use market, not book, values for the weights of each financing source given that

these represent the true claims of providers of capital.

• Be subject to adjustments across the cash flow forecast period due to changes in

inflation, systematic risk or the company’s capital structure.

where kd is the cost of debt, ke is the cost of equity, T is the marginal tax rate, D is

the market value of debt, E is the market value of equity, and V is the market value of the

company (V = D + E). In the above formula, we have included the two general sources of

a company’s capital, debt and equity. These could be further decomposed into more

sources (for example, preferred and common stock), but this, in general, complicates the

calculation of WACC. Thus, to estimate WACC we need three pieces of information.

First, we need to estimate the cost of the company’s debt. Second, we need to estimate

the cost of the company’s equity. Third, we need to develop market value weights for the

company’s capital structure.

The company’s cost of debt shows the cost of borrowing funds from creditors. It

differs from the required rate of return that creditors expect to receive because a company

can subtract its interest costs when calculating its taxable income. Therefore, the required

rate of return of a company’s creditors will be higher than the company’s actual cost of

debt.

To estimate the company’s cost of debt we need information about the current level

of interest rates, the default risk of the particular company and the marginal tax rate.

Estimating a company’s cost of debt one should not use book values, but instead rely on

market information as much as possible. The following guidelines can be helpful:

• If a company has traded long-term bonds, then we should use the current yield on

these bonds as our estimate of the cost of debt. This may be easily done for larger

companies with outstanding bonds that are liquid and trade regularly rather than

for smaller companies.

• If a company has outstanding bonds that do not trade regularly, then we could use

the company’s credit rating and default spread.

• For even smaller companies or private companies with no credit ratings, we could

evaluate the company’s recent borrowing history or estimate a synthetic rating.

The latter is a rating based on the company’s financial ratios. We could do this by

comparing the particular company’s financial ratios to those of others that do

receive credit ratings.

Note also that, in practice, one should try to estimate market opportunity costs for

the various components of a company’s debt. This may not be a very precise exercise and

it involves making simplifying assumptions along the way. For example, one would not

distinguish between callable and noncallable debt given that the difference is cost

between the two is small.

Estimating a company’s cost of equity is the most difficult. Contrary to debt, the

cost of equity cannot be observed in the market. The standard approach is to use the

CAPM. We will mention some alternatives later.

The CAPM states that the opportunity cost of equity is equal to the risk-free rate

plus the multiple of the market risk premium and the company’s systematic risk as given

by the company’s beta. This is written as follows:

an estimate of the risk-free rate, an estimate of the company’s beta, and an estimate of the

market risk premium. There seems to be a general consensus as to how to obtain the first

two pieces of information, but not equal consensus on how to obtain the third.

that has no default risk and is not correlated with returns on anything else. In other words,

it is a return that we know with certainty for the time horizon that we are examining. In

practice, we have some alternatives to choose from: the rates for short-term Treasury bills

(such as the 90-day T-bill) or the rates for long-term Treasury bonds (such as the 10-year

or 20-year bond). The point to note is that we should try to match our investment horizon

with the maturity of the government security whose yield we will use in our calculation.

For example, McKinsey and Co. (2000) recommends using the yield on a 10-year T-

bond for the following reasons:

• This rate matches better the duration of cash flows for most investment projects.

• This rate approximates the duration of the stock market index portfolio.

• It is less susceptible to unexpected changes in inflation and the liquidity premium,

which may affect more yields on longer-term bonds.

As far as obtaining an estimate for a company’s beta, this can be done more easily

by using publicly available information. Several companies, such as Value Line, Barra,

Bloomberg, etc. provide estimates of beta for large numbers of companies. In using an

estimate in the CAPM, one needs to be careful in using historical averages of betas.

Remembering that the cost of capital is a forward-looking concept, we must estimate a

company’s expected beta. Thus, a historical average may not reveal recent trends in the

value of beta. Overall, the choice of beta is a judgment call and the emphasis must be on

trying to see which number better estimates the stock’s expected beta. Additionally, using

information on betas from more than one source and comparing the beta that you selected

with the industry average is also important. McKinsey & Co. (2000) recommends that if

the betas from various sources vary by more than .2 or the beta for a company is more

than .3 from the industry average, one should consider using the industry average instead.

Finally, the choice of the market risk premium is more controversial. In this

calculation, we must consider the historical period that we use to estimate the risk

premium, whether to use an arithmetic or geometric average. See the discussion in Case

12 for a more in-depth analysis of this issue.

Other models, such as the APM or the Dividend Discount Model (DDM) could be

used to estimate a company’s cost of equity. However, they are not as widely used as the

CAPM. In particular, the DDM is more suitable for mature, stable-growth companies

with constant and predictable growth rates of dividends. Thus, it is not suitable either for

companies with no dividends or for companies with unstable revenue and earnings

growth rates.

In the cost of capital estimation, we must use market values for debt and equity in

the calculation of weights. The reason is that we are interested in estimating a company’s

cost of capital today and book values are backward looking and do not represent the

value that investors place on a company’s equity today. Moreover, recall that the cost of

capital is a forward-looking concept and market, not book, values provide a more

accurate calculation of debt and equity weights. Nevertheless, for debt, book values are

usually close to market values. But, this cannot be said for equity, as well.

To determine the weights for debt and equity we need to know the capital structure

of the company (the proportions of debt and equity financing). Ideally, we would like to

know the capital structure in each year that we will be discounting cash flows from

investment projects. In practice, this becomes too complicated and we tend to think in

terms of a target capital structure for the entire period. But, as we mentioned above, this

assumption must be reevaluated periodically due to changes in a company’s capital

structure that may affect its cost of capital. For example, by issuing more debt a company

may be able to reduce its overall cost of capital.

Note that the choice of a target capital structure is also dictated by the presence of a

circularity problem in our calculations. In order to estimate the WACC we need to know

the market weights of debt and equity. In order to do so, we need to know, in particular,

the market value of equity. But, this depends on the discount rate used to discount future

free cash flows, which is given by the WACC. Estimating the target capital structure, we

could use the current market-based capital structure of the company and review the

capital structure of similar companies, as well as examine the management’s policy

towards financing.

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