7.Cost of Capital

 

Cost of capital is the expected rate of return that the market requires in order to attract funds to a particular investment. In economic terms, the cost of capital for a particular investment is an opportunity cost, the cost of forgoing the next best alternative investment. In this sense, it relates to the economic principle of substitution— that is, an investor will not invest in a particular asset if there is a more attractive substitute.

The cost of capital usually is expressed in percentage terms, that is, the annual amount of dollars that the investor requires or expects to realize, expressed as a percentage of the dollar amount invested.

7.1          Pointers regarding Cost of Capital are as follows:

 

 

1.      COST OF CAPITAL IS FORWARD LOOKING

 

The cost of capital represents investors’ expectations. There are three elements to these expectations:

 

·         The “real” rate of return—the amount investors expect to obtain in exchange for letting someone else use their money on a riskless basis

·         Expected inflation—the expected depreciation in purchasing power while the money is tied up

·         Risk—the uncertainty as to when and how much cash flow or other economic income will be received.

 

2.      COST OF CAPITAL IS BASED ON MARKET VALUE, NOT BOOK VALUE

 

The cost of capital is the expected rate of return on some base value. That base value is measured as the market value of an asset, not its book value. For example, the yield to maturity shown in the bond quotations in the financial press is based on the closing market price of a bond, not on its face value.

 

3.      COST OF CAPITAL EQUALS DISCOUNT RATE

 

The essence of the cost of capital is that it is the percentage return that equates expected economic income with present value. The expected rate of return in this context is called a discount rate. A discount rate reflects both time value of money and risk and therefore represents the cost of capital.

4.      DISCOUNT RATE IS NOT THE SAME AS CAPITALIZATION RATE

 

Discount rate and capitalization rate are two distinctly different concepts. Discount rate equates to cost of capital. It is a rate applied to all expected incremental returns to convert the expected return stream to a present value.

 

7.2          Cost Components of a Company’s Capital Structure

 

The capital structure of many companies includes two or more components, each of which has its own cost of capital. Such companies may be said to have a complex capital structure. The major components commonly found are:

 

·         Debt

·         Preferred stock

·         Common stock or partnership interests

 

Similarly, a project being considered in a capital budgeting decision may be financed by multiple components of capital.

In a complex capital structure, each of these general components may have subcomponents, and each subcomponent may have a different cost of capital. In addition, there may be hybrid or special securities, such as convertible debt or preferred stock, warrants, options, or leases.

Now, each of these components will be discussed in detail:

 

7.2.1 Debt

 

Usually the cost of debt is equivalent to the company’s interest expense (after tax effect) and is easily ascertainable from the footnotes to the company’s financial statements (if the company has either audited or reviewed statements or compiled statements with footnote information). If the rate the company is paying is not a current market rate

(e.g., long-term debt issued at a time when market rates were significantly different), then the analyst should estimate what a current market rate would be for that component of the company’s capital structure.

Some companies have more than one class of debt, each with its own cost of debt capital.

The relevant market “yield” is either the yield to maturity or the yield-to-call date.

 

Tax Effect Lowers Cost of Debt

 

Because interest expense on debt is a tax-deductible expense to a company, the net cost of debt to the company is the interest paid less the tax savings resulting from the deductible interest payment. This cost of debt can be expressed by the formula:

 

K_d(1 – t)

 

Where:

K_d = Rate of interest on debt

t   = Tax rate (expressed as a percentage of pre-tax income)

 

7.2.2  Preferred Equity

 

If the capital structure includes preferred equity, the yield rate can be used as the cost of that component. If the dividend is at or close to the current market rate for preferred stocks with comparable features and risk, then the stated rate can be a proxy for market yield. If the rate is not close to a current market yield rate, then the analyst should estimate what a current market yield rate would be for that component of the company’s capital structure.

 

Cost of preferred equity:

K_p=D_p/P

 

Where,

K_P is the preferred dividend

P is the market price of the stock

 

7.2.3  Common Stock or Partnership Interests

 

Unlike yields to maturity on debt or yields on preferred stock, the cost of common equity for specific companies or risk categories cannot be directly observed in the market. The cost of equity capital is the expected rate of return needed to induce investors to place funds in a particular equity investment. As with the returns on bonds or preferred stock, the returns on common equity have two components:

 

·         Dividends or distributions

·         Changes in market value (capital gains or losses)

 

Because the cost of capital is a forward-looking concept, and because these expectations regarding amounts of return cannot be directly observed, they must be estimated from current and past market evidence. Primarily two methods are used for estimating the cost of equity capital from market data:

 

1.      Single-factor or multifactor approaches:

a.      Build-up models

b.      Capital Asset Pricing Model (CAPM)

 

2.      Discounted cash flow (DCF) approach

a.      Single-stage DCF model

b.      Multistage DCF models

 

 

 

Short-term notes                     Not technically part of the capital structure, but may be                                                      included in many cases, especially if being used as if long term.

 

Long-term debt                       YES

 

Capital leases                          Normally YES

 

Preferred stock                       YES

 

Common stock

 

Additional paid-in capital       YES—all part of common equity

 

Retained earnings

 

Off-balance sheet options

 

7.3          Weighted average cost of capital

 

The WACC is defined as the cost of financing the firm’s assets; it can be viewed as opportunity cost. The WACC is given by:

 

WACC = (k_e × W_e) + (k_p × W_p) + (k_d[1 – t] × W_d)

 

Where:

WACC = Weighted average cost of capital

K_e = Cost of common equity capital

W_e = Percentage of common equity in the capital structure, at market value

K_p = Cost of preferred equity

W_p = Percentage of preferred equity in the capital structure, at market value

K_d  = Cost of debt (pretax)

t = Tax rate

W_d = Percentage of debt in the capital structure, at market value

 

One important point to note here is that the relative weightings of debt and equity or other capital components are based on the market values of each component, not on the book values.