What Is the Significance of

Cost of Capital?
 Cost of Capital and Value
The timeline
Forecasting Period Constant Growth Stage

0 1 2 3 … T T+1
Year ……
V0op CF1 CF2 CF3 … CFT CFT+1 ……

The equation
T
CFt Terminal ValueT
Value = ∑
t=1 ( 1 + r ) t
+
( 1+ r )T
 Cost of Capital and Valuation
Cost of capital to firm
Future economic benefit
Return to capital providers
Future CF
Discount rate

Return Risk
 Weighted Average Cost of Capital

rWACC = wdrd(1 - T) + wprp + were

• Does cost of capital change?

• What we know and don’t know

 Capital Structure

rWACC = wdrd(1 - T) + wprp + were

• Financing structure
exclude operating liabilities
• Target capital structure
vs. historical capital structure

• Market value vs. book value

 Capital Structure
Average capital structure ratios of companies by industry

Industry Industry description Short-term Long-term Total Preferred Common Firm-year

Code debt to debt to debt to stock to equity to Obs
market cap market cap market cap market cap market cap

10 Metal mining 1.5% 5.8% 7.3% 0.2% 92.5% 2,211

23 Apparel and other finished 7.5% 12.8% 20.4% 0.2% 79.5% 239
products made from
fabrics and similar
materials
13 Oil and gas extraction 3.8% 21.1% 24.9% 0.7% 74.4% 2,165
50 Wholesale trade-durable 8.8% 19.3% 28.0% 0.8% 71.1% 590
goods
59 Miscellaneous retail 5.3% 24.0% 29.3% 0.8% 69.9% 481
62 Security and commodity 13.5% 16.4% 29.9% 0.6% 69.4% 670
brokers, dealers,
exchanges, and services
48 Communications 1.8% 38.0% 39.8% 0.9% 59.3% 1,065
79 Amusement and recreation 2.5% 37.5% 40.0% 1.3% 58.6% END
281
services

Source: Corporate Valuation by Holthausen & Zmijewski, Cambridge Business Publishers

How to
Estimate Cost of Debt?
 General Process
WACC = wd rd (1 - T) + wp rp + we re

• Identify the debt structure.

What types of debt? How much? Percentage?

• Determine the appropriate method to estimate

the cost for each type of debt.

• Estimate the weighted average cost of debt.

 Estimate Cost of Debt
Types of debt Methodology
Private borrowing Interest rate / loan rate
Newly issued
Coupon rate
corporate bond

Outstanding public
Yield to maturity (YTM)
corporate bond
Private corporate Yield of comparable
bonds bonds
 If Bonds Do Not Trade
Cost of debt
= benchmark rate + default premium

• Benchmark
often government bonds or LIBOR

• How large is the default premium?

Use the default or credit spread to factor in the
level of default risk
 Credit Rating
MOODY’S S&P FITCH
Long-term Short-term Long-term Short-term Long-term Short-term

Aaa AAA AAA

Aa1 AA+ AA+

Aa2 AA A- 1 + AA F1 +
Aa3 AA- AA-

A1 Prime 1 A+ A+
A- 1 F1
A2 A A

A3 Prime 2 A- A-

Baa1 BBB+ A- 2 BBB+ F2

Baa2 BBB BBB
Prime 3 A- 3 F3
Baa3 BBB- BBB-

Ba1 BB+ BB+

Ba2 BB B BB

Ba3 BB- BB- B

B1 B+ B+

B2 Not prime B B

B3 B- B-
C
Caa CCC CCC

Ca CC CC C
C C C
D D
D D

Source: The Association of Corporate Treasures

 Default / Credit Spread
Yield spread over U.S. treasuries by bond rating, December 2013

A 104

A- 118

BBB+ 139

BBB 174

BBB- 224

BB+ 247

BB 269

Basis points

Source: Bloomberg bond portfolio with 10–year maturity

 If the Company
Does NOT Have Credit Rating
Estimate a rating / synthetic rating
• Use key financial ratios
• Use a scoring model
 Determining the Credit Rating
Use key financial ratios
Adjusted key industrial financial ratios, long-term debt
Three-Year (2005−2007) Medians

Financial ratio AAA AA A BBB BB B CCC

EBITDA/revenues (%) 22.2 26.5 19.8 17.0 17.2 16.2 10.5
Return on capital (%) 27.0 28.4 21.8 15.2 12.4 8.7 2.7
EBIT interest coverage (×) 26.2 16.4 11.2 5.8 3.4 1.4 0.4
EBITDA interest coverage (×) 32.0 19.5 13.5 7.8 4.8 2.3 1.1
Funds from operations/total debt (%) 155.5 79.2 54.5 35.5 25.7 11.5 2.5
Free operating cash flow/total debt (%) 129.9 40.6 31.2 16.1 7.1 2.2 −3.6
Debt to EBITDA 0.4 0.9 1.5 2.2 3.1 5.5 8.6
Debt/debt plus equity (%) 12.3 35.2 36.8 44.5 52.5 73.2 98.9

Source: Standard & Poor’s, CreditStats.

 Determining the Credit Rating
Example: Rowing Inc. If interest coverage ratio is
Greater than Less than/equal to Rating is Avg YTM is
is a private company that 12.5 100000 Aaa/AAA 0.75%
manufactures the rowing 9.5 12.499999 Aa2/AA 1.00%
fitness machine. 7.5 9.499999 A1/A+ 1.10%
The average interest 6 7.499999 A2/A 1.25%
coverage ratio over last three 4.5 5.999999 A3/A- 1.75%
years is seven. 4 4.499999 Baa2/BBB 2.25%
3.5 3.9999999 Ba1/BB+ 3.25%
The table provides the data 3 3.499999 Ba2/BB 4.25%
on the average yield of U.S. 2.5 2.999999 B1/B+ 5.50%
corporate bonds by rating. 2 2.499999 B2/B 6.50%

The marginal tax rate is 21%. 1.5 1.999999 B3/B- 7.50%

1.25 1.499999 Caa/CCC 9.00%

Estimate a synthetic rating 0.8 1.249999 Ca2/CC 12.00%

and after-tax cost of debt. 0.5 0.799999 C2/C 16.00%

-100000 0.499999 D2/D 20.00%
 Determining the Credit Rating
Use Z-score model
Z= 1.2(X1) + 1.4(X2) + 3.3(X3) + 0.6(X4) + 1.0(X5)

Average Z-score by S&P bond rating

X1= working capital/total assets
X2= retained earnings/total assets AAA 6.20

X3= earning before interest and taxes AA 4.73

to total assets ratio A 3.74

X4= market value of equity BBB 2.81

BB
to book value of total liabilities ratio 2.38

B 1.80
X5= sales/total assets
CCC 0.33 END
How to
Estimate Cost of Equity?
 General Process
WACC = wd rd (1 - T) + wp rp + we re

• Determine the appropriate model.

• Make appropriate assumption(s).

• Gather data and determine the model inputs.

• Implement and estimate the cost of equity.

 Capital Asset Pricing Model (CAPM)

Return Risk

𝒓𝒓𝒆𝒆 = 𝒓𝒓𝒇𝒇 + 𝜷𝜷 × 𝒓𝒓𝒎𝒎 − 𝒓𝒓𝒇𝒇

Cost of equity Risk-free Beta Expected
or rate systematic market risk
return to risk premium
equity holders (MRP)
 Power of “DIVERSIFICATION”

σp
35% Idiosyncratic risk

Stand-alone risk (σp)

20%

Market risk

0
10 20 30 40 2,000 stocks
 Market Risk
• Market / Systematic risk
vs. idiosyncratic / company specific risk
• How is beta interpreted?
Questions Corporations Financial advisors Textbooks/trade books

What do you 53% Explicitly reference 73% Fundamental beta 100% Mentioned
Bloomberg betas from Barra published sources
use as your
beta factor? 26% Use published source 44% Beta from
(other than Bloomberg) or Bloomberg
a third party advisors;
three of theses mention
Barra
37% Mention self-calculated 18% Self-calculated
betas but some may use historical beta or
Bloomberg for this other published
source
26% Mention comparisons
across sources

Source: Brotherson, Eades, Harris, and Higgins (2013), Journal of Applied Finance, Spring/Summer, Issue 1
 Risk Free Rate
Which rf ?
Questions Corporations Financial advisors Textbooks/trade books
What do you use 52% 10-year treasuries 73% 10-year 50% Long-term
for the risk-free treasuries treasuries
rate (both
21% 20-year treasuries 18% 20-year 33%
maturity and
treasuries Long-term
measurement)?
treasuries less
historical “term
premium”
21% 30-year treasuries 9% 30-year 17% Match tenor of
treasuries treasury to that
of investment
5% N/A
21% use something other 36% use some historical
than the spot yield to average rather than the
maturity (e.g., some from of spot yield to maturity
historical averaging)

Source: Brotherson, Eades, Harris, and Higgins (2013), Journal of Applied Finance, Spring/Summer, Issue 1
 Market Risk Premium
How to understand MRP( rm – rf )?
U.S.- S&P 500 market risk premium %

16%
9/11 and tech bubble
14% and Enron/Worldcom
LTCM
12%
Market risk
10% premium 6.0%

8%
Average= 6.4%
6%

4%

2%
0%
Apr-98 Apr-99 Apr-00 Apr-01 Apr-02 Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08

Source: Bloomberg, Federal Reserve Data

 Market Risk Premium
How to estimate MRP( rm – rf )?
Questions Corporations Financial advisors Textbooks/ Trade books

What do you 43% Cite historical data only 73% Cite historical data— 100% Mention historical
• 32% cite Ibbotson Ibbotson excess returns
use as your • 11% mention another
market risk source

premium? 16% Judgment using various 18% Forward-looking 50% Recommended

cited sources DDM antiemetic average;
17% geometric in
some instances,
33% are silent

16% Bloomberg 9% Use “range”: no

specific methodology
reported
16% Forward-looking calculation 87% Mention various
(Other than Bloomberg) other approaches
5% Ask bank
5% No specific methodology
reported
Of nine who reported a specific Of 10 who reported a
number, range was 4.87–9.02%, and specific number,
mean 6.49% range was 4.0–8.5%,
and mean was 6.6%
Source: Brotherson, Eades, Harris, and Higgins (2013), Journal of Applied Finance, Spring/Summer, Issue 1
 CAPM in Action
𝒓𝒓𝒆𝒆 = 𝒓𝒓𝒇𝒇 + 𝜷𝜷 × 𝒓𝒓𝒎𝒎 − 𝒓𝒓𝒇𝒇

Yield of • Financial • Financial

government databases databases
bond • Regression / • Survey
Modeling evidence
• Unlever beta • Financial
Relever beta modeling
 Other Models
D1
1. Dividend growth model rs
=
P0
+g

2. Premium over bond rs = rd + premium over bond

3. Build-up model

4. Fama-French factor models

rs = rf + β1 (rm -rf ) + β 2 (rs -rb ) + β 3 (rh -rl )
END
How to Estimate Beta?
Part I: General Approaches
 Estimating Beta
1. Determine the
model. Peer group
2. Make the approach
appropriate
assumptions.
3. Choose the
appropriate inputs. Beta
4. Gather data and
4. Relever using the
inputs.
subject company’s
5. Run regressions. target capital
structure.
Beta 3. Unlever the peer
group’s beta.
2. Estimate the beta of
comparables.
Regression
1. Study the business
approach and select the
comparables.
 Estimating Beta
Market model: Ri = a + βRm + ε
Home Depot: stock returns, 2009–2012
%
25

20

15

10
UPS monthly stock returns

0
-20 -15 -10 -5 0 5 10 15 20
-5

-10
Regression beta = 0.98
-15

-20

-25

-30
Morgan Stanley Capital Index (MSCI) global monthly returns
 Estimating Beta
Table III. Compromises underlying beta estimates
and their effect on estimated betas of sample companies

Bloomberg* Value line* Barra

Number of 102 260 Statically models
observations using company
Time interval Weekly over two Weekly over five characteristics
years years
Market index S&P 500 NYSE composite
proxy
Sample mean 0.96 0.93 0.91
beta
Sample median 0.98 0.90 0.96
beta
END

Source: Brotherson, Eades, Harris and Higgins (2013), Journal of Applied Finance, Spring/Summer, Issue 1
How Does Capital Structure
Affect Cost of Capital and Beta?
Capital Structure and Cost of Capital

Cost of equity (re)

WACC
Cost of capital

Cost of debt (rd X (1 - t))

Optimal capital structure

Debt / Total capitalization

 Risk and Cost of Capital

Risk Beta

ru
unlevered cost
of capital

re
cost of equity

rWACC
 Debt, Risk, and Beta
Example:
Underlying Debt Beta / Asset beta /
business ratio levered beta unlevered beta

Company A 80% 2 1.2

Company B 0 1.2 1.2

END
How to Estimate Beta?
Part II: Unlever and Relever Beta
 Unlevering Beta

Comparable
company
 Unlevering Beta
Unlevered beta estimates by industry
Industry Beta range
Electric utilities 0.5–0.7
Health care providers 0.7–0.8
Integrated oil and gas 0.7–0.8
Airlines 0.7–0.9
Consumer packaged goods 0.8–0.9
Pharmaceutical 0.8–1.0
Retail 0.8–1.0
Telecom 0.8–1.0
Mining 0.9–1.0
Automotive and assemblers 0.9–1.1
Chemicals 0.9–1.1
IT services, hardware 0.9–1.1
Software 0.9–1.1
Banking 1.0–1.1
Insurance 1.0–1.1
Semiconductors 1.0–1.3
 Relevering Beta

Peer group

Subject
company

Subject company’s
target capital structure
Unlevering and Relevering Beta

Unlever

Subject
Relever company

END