Cost of capital: meaning and valuation

 Content: Introduction 3 1. Meaning of the Cost of Capital 4 1.1. Definitions 4 1.2. Impact on Company and Investment Decisions 6 2. Calculation of the Cost of Capital 10 2.1. Meaning of Weighted Average Cost of Capital 10 2.2. Calculation of WACC and Case Studies 12 3. Cost of Capital application in the World and Lithuania 23 Conclusions 26 Information Source 27 Introduction The Cost of Capital is one of the most disputed topics in finance. It is necessary for firms to properly estimate their cost of capital in order to make proper decisions regarding acceptance or rejection of capital projects. The aim of my course work is to analyze the Cost of Capital in different aspects. That is why I have decided to examine the following steps. Firs of all, I explained the variety of possible definitions of the main term “the Cost of Capital” and saw that all of them mean pretty much the same. As I realize that the Cost of Capital should have some meaning in company’s decision making, I presented the impact of my matter to investment appraisal and proved that with the case of particular hotel and the impact of its cost of capital. As the Cost of Capital is a certain rate, it definitely must have some form of estimating the value, so I provided the basic calculations of my matter. And as this matter is closely related with the Weighted Average Cost of Capital, I firstly defined what does the WACC mean and what it is used for. Further more you will find the main formulas and couple certain ways to calculate the WACC and those calculations were sustained by examples and couple case studies in real corporations. At the end of my course work I have included some articles to show how the Cost of Capital work in the World and Lithuania. 1. Meaning of The Cost of Capital 1.1. Definitions Cost of Capital is the required rate of return that a firm must achieve in order to cover the cost of generating funds in the marketplace. Based on their evaluations of the riskiness of each firm, investors will supply new funds to a firm only if it pays them the required rate of return to compensate them for taking the risk of investing in the firm’s bonds and stocks. If, indeed, the cost of capital is the required rate of return that the firm must pay to generate funds, it becomes a guideline for measuring the profitabilities of different investments. When there are differences in the degree of risk between the firm and its divisions, a risk-adjusted discount-rate approach should be used to determine their profitability. What impacts the cost of capital? The Cost of Capital becomes a guideline for measuring the profitabilities of different investments. Another way to think of the Cost of Capital is as the opportunity cost of funds, since this represents the opportunity cost for investing in assets with the same risk as the firm. When investors are shopping for places in which to invest their funds, they have an opportunity cost. The firm, given its riskiness, must strive to earn the investor’s opportunity cost. If the firm does not achieve the return investors expect (i.e. the investor’s opportunity cost), investors will not invest in the firm’s debt and equity. As a result, the firm’s value (both their debt and equity) will decline. Cost of Capital - The opportunity cost of an investment; that is, the rate of return that a company would otherwise be able to earn at the same risk level as the investment that has been selected. For example, when an investor purchases stock in a company, he/she expects to see a return on that investment. Since the individual expects to get back more than his/her initial investment, the cost of capital is equal to this return that the investor receives, or the money that the company misses out on by selling its stock. Cost of Capital - The required return necessary to make a capital budgeting project worthwhile, such as building a new factory. Cost of capital would include the cost of debt and the cost of equity. The cost of capital determines how a company can raise money (through a stock issue, borrowing, or a mix of the two). This is the rate of return that a firm would receive if they invested their money someplace else with similar risk. Cost of Capital - The amount a firm must pay the owners of capital for the privilege of using it. This includes interest payments on corporate debt, as well as the dividends generated for shareholders. In deciding whether to proceed with a project, , firms should calculate whether the project is likely to generate sufficient revenue to cover all the costs incurred, including the cost of capital. Cost of Capital for a firm is a weighted sum of the cost of equity and the cost of debt (see the financing decision). Firms finance their operations by three mechanisms: issuing stock (equity), issuing debt (borrowing from a bank is equivalent for this purpose) (those two is external financing), and reinvesting prior earnings (internal financing). Cost of Capital -This is the amount on which you first claim CCA. The capital cost of a depreciable property is usually the total of: • the purchase price, not including the cost of land (which is not depreciable); • the part of your legal, accounting, engineering, installation, and other fees that relates to the purchase or construction of the depreciable property (not including the part that applies to land); • the cost of any additions or improvements you made to the property after you acquired it, provided you have not claimed these costs as a current expense; and • soft costs (such as interest, legal and accounting fees, and property taxes) related to the period you are constructing, renovating, or altering the building, if you have not deducted these expenses as current expenses. Legal and accounting fees for the purchase of a rental property are allocated between the cost of the land and the capital cost of the building. If land is acquired for rental purposes or for construction of a rental property, the legal and accounting fees apply to the land. Cost of Capital can also be defined as “the opportunity cost of all capital invested in an enterprise.” Let's dissect this definition: 1. "Opportunity cost" is what you give up as a consequence of your decision to use a scarce resource in a particular way. 2. "All capital invested" is the total amount of cash invested into a business. 3. "In an enterprise" refers to the fact that we are measuring the opportunity cost of all sources of capital, which include debt and equity. 1.2. Impact on Company and Investment Decisions Every company in its normal course of business at some point of time requires funds for its operations, expansion, acquisition, modernization and replacement of long-term assets. The company obtains funds either by borrowing, issuing shares or through its retained earnings. The investment decision is crucial to the company because they are irreversible decisions; having a long-term implication and involve huge amount of funds. When making an investment decision, the company has to take into account the returns expected by the investors, as they provide the money to the corporate. Investors are generally risk-averse and demand a premium for bearing risk. The greater the risk of an investment opportunity, the greater would be the risk-premium required by the investors. The company’s objective is to maximize the shareholder’s wealth through its investment projects. The opportunity cost or the required rate of return from the investment should be more than the next best alternative investment opportunity and the risk borne by the investor. Firms must decide whether to invest in capital projects. The value of the firm will only increase when the after-tax return on capital projects exceeds the after-tax cost of providing returns to claimholders of the firm. If the after-tax return on a capital project is greater than the after-tax cost of providing returns to claimholders, the capital project should be accepted. If the after-tax return on a capital project is less than the after-tax cost of providing returns to claimholders, the capital project should be rejected. To make proper decisions regarding acceptance or rejection of capital projects, it is necessary for firms to properly estimate their cost of capital. If financing cost is reduced, NPV increases, more projects end up with NPV > 0, more wealth created to shareholders. Remember that: The goal of the corporation is to maximize the value of shareholders’ equity! Let us analyze the case of one certain unnamable hotel and see how it assesses the cost of capital and its impact. Kirby D. Payne, CHA - July, 1997 “Never having had enough capital to take advantage of all the various opportunities to grow that have presented themselves, I am very conscious of the cost of capital. The less you have, the costlier it is and the harder it is to get. Capital for hotel ventures typically consists of two components, debt and equity. Their costs are the interest on the debt, the investors' expected return on equity and the cost of obtaining the capital itself. Some of the cost of raising capital can initially be folded back into the debt or equity but in the end it is paid for with additional interest or less profit distribution. The cost of debt actually includes several different components. Among the possible components are mortgage origination fees, mortgage brokerage commissions, points, prepayment penalties (if one prepays later in order to obtain better terms from another source), legal fees (the borrower's and the lender's), appraisal fee, environmental study fee, and finally interest. The component with the most impact over time is interest. Interest rates charged for commercial mortgages are impacted by a number of factors. These might include, but are not limited to, the term of the loan, whether the interest rate is variable or fixed, the basis on which the variable interest moves and the amount it can fluctuate in any one period, interest rates at the time the loan commitment is made, the actual source of the funds the lender will be using to make the mortgage loan and a lot of issues that are purely subjective. These subjective items include the lender's perception of these items: the risk of the hotel project relative to the other loans that could be made; the ultimate value of the collateral; the financial stability of the borrowing entity and its principals; quality of management; and if the project "fits" in the lender's loan portfolio relative to the type of project it is. Where the lender stands relative to achieving their lending goals for the time period and the political strength of the particular person carrying the loan through the underwriting process are also major factors. Aside from looking at debt coverage ratios and loan to value ratios the lender is going to consider all these other factors at some level. They will all ultimately affect the amount of the loan and the terms. Every aspect of the terms has a relative cost to the borrower. For instance a lender may make the borrower escrow funds to complete certain required improvements in the hotel. Distribution of those funds will not be done until they receive all documentation that the improvements are completed, paid for and lien releases obtained. This means the borrower has to come up with the funds from other sources until the lender releases the funds. There is a cost to those additional funds, either additional interest or opportunity cost because they are not invested elsewhere. If the escrow agreement is written so that the bank will pay for the improvements from the escrow fund as they are completed the borrower may not have to come up with as much extra money. The lender, however, is now assuming some risk that the projects will, in fact, be completed. For this to work efficiently for the lender, borrower and contractors, the escrow agreements and contracts for construction all have to be coordinated to all parties' satisfaction. The cost of coordinating these items will show up as time, legal fees and probably higher prices from the contractor. The point here is that a hotel developer with sufficient capital does not have to do these things or bear these costs. These savings increase the return on the investment as compared to a developer with less capital. If the lender perceives one borrower and his or her project to be less risky than another's they may grant more favorable terms in the loan in the form of slightly lower interest. On the surface the impact of this may not be significant but the reality is quite different. For instance on a $10,000,000 project with a $7,500,000 mortgage for 20 years the difference between an interest rate of 8.5% and 8.25% is $14,184 in principal and interest payments. If one disregards the tax implications of this and only evaluates the cash on cash return on equity the difference is just over a half a percentage point. If the investors were going to receive an average cash on cash return on equity from operations of 19.65% with the 8.5% percent interest rate they will now receive one of 20.217%. Which developer will have the easier time raising equity capital? Among other things easier means less costly. And less costly also translates into even higher returns on equity. While one doesn't usually think of equity as having a cost it does. In the simplest terms an individual investor has choices as to where s/he might invest. These alternatives all have different levels of expected return and risk. The higher the perceived risk the higher the expected return. If this investor could have invested in a government backed security and had a return of 6.0% without risk then their perceived cost is at least that amount. If they are going to take the risk of investing in something they know nothing about, have no control over and which has no liquidity they are going to have a much higher expectation for their investment return. The developer is probably going to have to forego some return until the investors' expectations are met. This is a cost of capital to the developer. Another example might be when the developer is larger and decides to go to the public for the equity. Whether the approach is through a registered private placement memorandum or a small stock offering there will be significant legal, accounting and other fees associated with the fund raising project. Depending on the planned source of funds, the size of the fund raising has to be greater than a certain amount to justify these methods. On the other hand a major publicly traded REIT (Real Estate Investment Trust) or C corporation has already gone to this expense. So much money, hundreds of millions or more, has been raised that the cost of the funds is relatively low relative to interest rates. Such a company will simply buy a hotel for cash from their cash reserves or credit lines in a very short process and if appropriate get a mortgage at their leisure on very favorable terms. Because they were able to act quickly and pay all cash to the seller this buyer probably obtained much more favorable terms on the purchase. As a further point, because their cost of capital was so much lower their earnings expectations do not need to be as high as the smaller entity with the higher cost of capital. It is this relationship to the cost of capital that makes these companies appear to overpay for existing hotels as viewed from the smaller entities' perspective. By driving up the price of existing hotels, these companies lower the achievable returns of the smaller companies when both are seeking the same types of hotels. This is one reason smaller companies seek out hotels to buy that the larger companies may not pursue for one reason or another. The smaller company needs to deal with sellers who are patient and wait while the capital for the purchase is raised. The seller will wait because they have been unable to sell it to another buyer or because the price is higher. In either case the return will be lower or the risk is higher for the buyer. After all, why wouldn't anyone else buy the hotel? In the end, the company with less capital cannot afford to make mistakes and has to maximize cash flow by being a very good hotel marketer and operator. The company with more capital and higher returns can, of course, afford to pay premium wages to its key executives and other staff. The cost and availability of capital affects every aspect of competition in the hotel industry in very fundamental ways.” From this case we can conclude, that the cost of capital makes substantial impact on various lenders (or investors) and borrowers (or owners of businesses) decisions concerned with the investment. 2. Calculation of The Cost of Capital As calculation of the Cost of Capital is done through the calculation of Weighted Average Cost of Capital, let us briefly define the latter concept (the Weighted Average Cost of Capital). 2.1. Meaning of the Weighted Average Cost of Capital (WACC) Weighted Average Cost of Capital -A calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation. Broadly speaking, a company’s assets are financed by either debt or equity. Weighted Average Cost of Capital is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances. A firm's Weighted Average Cost of Capital is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm. Weighted Average Cost of Capital - An average representing the expected return on all of a company's securities. Each source of capital, such as stocks, bonds, and other debt, is weighted in the calculation according to its prominence in the company's capital structure. Weighted Average Cost of Capital - An average that takes into account the proportional relevance of each component, rather than treating each component equally. What is the Weighted Average Cost of Capital used for? The Weighted Average Cost of Capital for any particular business or project is the rate of return required by the providers of capital (both debt and equity) having regard to the risk characteristics inherent in the project. Businesses or projects, which are able to earn returns greater than the cost of capital, add value for investors. Conversely, businesses or projects, which, while they may still be profitable, produce returns less than the cost of capital, destroy investor value. Equity investors have two components for their cost of capital: • an explicit opportunity cost such as dividend payments; and • an implicit opportunity cost in the form of an expected cash equivalent gain in share price. 2.2. Calculation of WACC and Case Studies In order to illustrate the calculation specifically I decided to include some explanations of certain new definitions or situations while evaluating the WACC. The main formula for calculating the WACC is: WACC = wd (cost of debt) + ws (cost of stock/RE) + wp (cost of preferred stock) Where, wd = weight of debt (i.e. fraction of debt in the firm’s capital structure) ws = weight of stock wp = weight of preferred stock The further step is to calculate the rest elements of the above written formula. Cost of Debt (Kd) We must use the after tax cost of debt because interest payments are tax deductible for the firm. Kd after taxes = Kd (1 – tax rate) Example If the cost of debt for Cowboy Energy Services is 10% (effective rate) and its tax rate is 40% then: Kd after taxes = Kd (1 – tax rate) = 10 (1 – 0.4) = 6.0 % We use the effective annual rate of debt based on current market conditions (i.e. yield to maturity on debt). We do not use historical rates (i.e. interest rate when issued; the stated rate). Cost of Preferred Stock (Kp) Preferred Stock has a higher return than bonds, but is less costly than common stock. Why? In case of default, preferred stockholders get paid before common stock holders. However, in the case of bankruptcy, the holders of preferred stock get paid only after short and long-term debt holder claims are satisfied. Preferred stock holders receive a fixed dividend and usually can not vote on the firm’s affairs. Kp = preferred stock dividend / market price of preferred stock or ,if issuing new preferred stock, Kp = preferred stock dividend / (market price of preferred stock (1 – flotation cost)) Unlike the situation with bonds, no adjustment is made for taxes, because preferred stock dividends are paid after a corporation pays income taxes. Consequently, a firm assumes the full market cost of financing by issuing preferred stock. In other words, the firm cannot deduct dividends paid as an expense, like they can for interest expenses. Example If Cowboy Energy Services is issuing preferred stock at $100 per share, with a stated dividend of $12, and a flotation cost of 3%, then: Kp = preferred stock dividend / (market price of preferred stock (1 – flotation cost)) = $12 / ($100 (1-0.03)) = 12.4 % Cost of Equity (i.e. Common Stock & Retained Earnings) The cost of equity is the rate of return that investors require to make an equity investment in a firm. Common stock does not generate a tax benefit as debt does because dividends are paid after taxes. The cost of common stock is the highest. Why? Retained earnings are considered to have the same cost of capital as new common stock. Their cost is calculated in the same way, except that no adjustment is made for flotation costs. Calculating the cost of common stock (K)s using CAPM (capital asset pricing model) The CAPM is one of the most commonly used ways to determine the cost of common stock. This “cost” is the discount rate for valuing common stocks, and provides an estimate of the cost of issuing common stocks. Ks = Krf +  (Km - Krf) Where, Krf is the risk free rate • is the firm’s beta Km is the return on the market Example Cowboy Energy Services has a B = 1.6. The risk free rate on T-bills is currently 4% and the market return has averaged 15%. Ks = Krf +  (Km - Krf) = 4 + 1.6 (15 – 4) = 21.6 % Now we have the elements we need, so let us put everything together: Recall: WACC = wd (cost of debt after tax) + ws (cost of stock/RE) + wp(cost of PS) Example Cowboy Energy Services maintains a mix of 40% debt, 10% preferred stock, and 50% common stock in its capital structure. The WACC is: WACC = 0.4(6%) + 0.1 (12.4) + 0.5(21.6) = 2.4 + 1.24 + 10.8 = 14.4 % Determining the Weights to be used: The example above gives you the weights to use in calculating the WACC. How do you calculate the weights yourself? The firm’s balance sheet shows the book values of the common stock, preferred stock, and long-term bonds. You can use the balance sheet figures to calculate book value weights, though it is more practicable to work with market weights. Basically, market value weights represent current conditions and take into account the effects of changing market conditions and the current prices of each security. Book value weights, however, are based on accounting procedures that employ the par values of the securities to calculate balance sheet values and represent past conditions. The table on the next page illustrates the difference between book value and market value weights and demonstrates how they are calculated. Value Dollar Amount Weights or % of total value assumed cost of capital (%) Book Value Debt 2,000 bonds at par, or $1000 2,000,000 40.4 10 Preferred stock 4,500 shares at $100 par value 450,000 9.1 12 Common equity 500,000 shares outstanding at $5.00 par value 2,500,000 50.5 13.5 Total book value of capital 4,950,000 100 11.24 is the WACC Market Value Debt 2,000 bonds at $900 current market price 1,800,000 30.2 10 Preferred stock 4,500 shares at $90 current market price 405,000 6.8 12 Common equity 500,000 shares outstanding at $75 current market price 3,750,000 63.0 13.5 Total market value of capital 5,955,000 100 What is the WACC? Note that the book values that appear on the balance sheet are usually different from the market values. Also, the price of common stock is normally substantially higher than its book value. This increases the weight of this capital component over other capital structure components (such as preferred stock and long-term debt). The desirable practice is to employ market weights to compute the firm’s cost of capital. This rationale rests on the fact that the cost of capital measures the cost of issuing securities – stocks as well as bonds – to finance projects, and that these securities are issued at market value, not at book value. Target weights can also be used. These weights indicate the distribution of external financing that the firm believes will produce optimal results. Some corporate managers establish these weights subjectively; others will use the best companies in their industry as guidelines; and still others will look at the financing mix of companies with characteristics comparable to those of their own firms. Generally speaking, target weights will approximate market weights. If they don’t, the firm will attempt to finance in such a way as to make the market weights move closer to target weights. Hurdle rates: Hurdle rates are the required rate of return used in capital budgeting. Simply put, hurdle rates are based on the firm’s WACC. To understand the concept of hurdle rates, I like to think of it this way. A runner in track jumps over a hurdle. Projects the firm is considering must “jump the hurdle” – or in other words – exceed the firm’s borrowing costs (i.e. WACC). If the project does not clear the hurdle, the firm will lose money on the project if they invest in it – and decrease the value of the firm. The hurdle rate is used by firms in capital budgeting analysis. Large companies, with divisions that have different levels of risk, may choose to have divisional hurdle rates. Divisional hurdle rates are sometimes used because firms are not internally homogeneous in terms of risk. Finance theory and practice tells us that investors require higher returns as risk increases. For example, do the following investment projects have the same level of risks? Engineering projects such as highway construction, market-expansion projects into foreign markets, new-product introductions, E-commerce startups, etc. Breakpoints (BP) in the WACC: Breakpoints are defined as the total financing that can be done before the firm is forced to sell new debt or equity capital. Once the firm reaches this breakpoint, if they choose to raise additional capital their WACC increases. For example, the formula for the retained earnings breakpoint below demonstrates how to calculate the point at which the firm’s cost of equity financing will increase because they must sell new common stock. (Note: The formula for the BP for debt or preferred stock is basically the same, by replacing retained earnings for debt and using the weight of debt.) BPRE = Retained earnings / Weight of equity Example: Cowboy Energy Services expects to have total earnings of $840,000 for the year, and it has a policy of paying out half of its earnings as dividends. Thus, the addition to retained earnings will be $420,000 during the year. We now want to know how much total new capital – debt, preferred and retained earnings – can be raised before the $420,000 of retained earnings is exhausted and the company is forced to sell new common stock. We are seeking the amount of capital which represents the total financing that can be done before Cowboy Energy Services is forced to sell new common stock to maintain their target weights in their WACC. Let’s assume that Cowboy Energy Services maintains a capital structure of 60% equity, 40% debt. Using the formula above: BPRE = Retained earnings / Weight of equity = $420,000/0.60 = $700,000 Thus, Cowboy Energy Services can raise a total of $700,000 in new financing, consisting of 0.6($700,000) = $420,000 of retained earnings and 0.40($700,000) = $280,000 of debt, without altering its capital structure. The BPRE = $700,000 is defined as the retained earnings break point, or the amount of total capital at which a break, or jump, occurs in the marginal cost of capital. Can there be other breaks? Yes, there can – depending on if there is some point at which the firm must raise additional capital at a higher cost. Additionally, let us examine more or less similar way of calculating the WACC with the case study in Gateway Inc. We calculate a company's weighted average cost of capital using a 3-step process: I. Cost of capital components. First, we calculate or infer the cost of each kind of capital that the enterprise uses, namely debt and equity. A. Debt capital. The cost of debt capital is equivalent to actual or imputed interest rate on the company's debt, adjusted for the tax-deductibility of interest expenses. Specifically: The after-tax cost of debt-capital = The Yield-to-Maturity on long-term debt x (1 - the marginal tax rate in %) B. Equity capital. Equity shareholders, unlike debt holders, do not demand an explicit return on their capital. However, equity shareholders do face an implicit opportunity cost for investing in a specific company, because they could invest in an alternative company with a similar risk profile. Thus, we infer the opportunity cost of equity capital. We can do this by using the "Capital Asset Pricing Model" (CAPM). This model says that equity shareholders demand a minimum rate of return equal to the return from a risk-free investment plus a return for bearing extra risk. This extra risk is often called the "equity risk premium", and is equivalent to the risk premium of the market as a whole times a multiplier--called "beta"--that measures how risky a specific security is relative to the total market. Cost of equity capital = Risk-Free Rate + (Beta x Market Risk Premium). II. Capital structure. Next, we calculate the proportion that debt and equity capital contributes to the entire enterprise, using the market values of total debt and equity to reflect the investments on which those investors expect to earn a minimum return. III. Weighting the components. Finally, we weight the cost of each kind of capital by the proportion that each contributes to the entire capital structure. This gives us the Weighted Average Cost of Capital (WACC), the average cost of each dollar of cash employed in the business. Case Study: Gateway, Inc., as of April 21, 2000 To demonstrate how to calculate a company's cost of capital, we will use the Gateway case study. I. Cost of capital components. Gateway draws upon two major sources of capital from the capital markets: debt and equity. A. Cost of Gateway's debt capital. As of the end of 1999, Gateway only had debt of $8.5 million. Because this amount is so small, it will not significantly affect our Weighted Average Cost of Capital calculation. Our first step in calculating any company's cost of capital is to consult the relevant annual 10-K regulatory filings with the Security and Exchange Commission (SEC).This document tells us that Gateway has two components to its total debt of $8.488 million: 1. Regular debt. Gateway has $8.415 million of "Notes payable through 2002 with interest rates ranging from 3.9% to 5.5%." We can calculate that the middle of this range equals 4.7%. We can also calculate that Gateway's Notes Payable of $8.415 million comprises 99.14% of the company's total debt of $8.488 million. 2. Capital leases. Gateway also has $73, 000 in "capital leases." A capital lease is a debt-like agreement in which a firm agrees to pay fixed amounts to someone who leases them land or equipment. Gateway's SEC filing tells us that this debt-equivalent capital lease has a "fixed rate of 6.5%" We can calculate that Gateway's $73,000 of capital leases comprises 0.86% of the company's total debt of $8.488 million. Because there are two kinds of debt with different interest rates, we have to weight the different interest rates associated with each kind of debt by the relevant proportion of debt that each comprises. In this case, the pre-tax cost of debt would be equivalent to (4.7% x 99.14%) + (6.5% x 0.86%), or 4.72%. However, we are not done yet. We noted above that we have to adjust for the tax-deductibility of interest expenses, which lowers the cost of debt according to the following formula: After-Tax Cost of Debt Capital = The Yield-to-Maturity on long-term debt x (1 - - the marginal tax rate) Given Gateway's marginal tax rate of 35%, the company's after-tax cost of debt equates to 4.72% x (100% - 35%), or 3.1%. Notably, Gateway has both near-zero debt levels and a near-zero after-tax cost of debt, which means it will have virtually no effect on the company's weighted average cost of capital. Thus, the purpose of this cost-of-debt calculation is purely instructional. Also, please note that in this example, we have used a company's actual cost of debt as a proxy for its marginal cost of long-term debt. A company's marginal cost of long-term debt may be better estimated by summing the risk-free rate and the "credit spread" that lenders would charge a company with a specific credit rating. B. Cost of Gateway's equity capital. We noted above that: Cost of Equity Capital = Risk-Free Rate + (Beta x Market Risk Premium). To calculate any company's cost of equity capital, we need to find a reliable source for each of these inputs: 1. Risk-free Rate. We suggest using the rate of return on long-term (ten-year) government treasury bonds as a proxy for the risk-free rate. Sources for this include: • CBS Marketwatch. Even unregistered users can use CBS MarketWatch's free bond quotes. • New York Times. Any user can see the "10yr. Tres. Yield" on the front page of the New York Time's web site. • Wall Street Journal. Paid subscribers to the WSJ's online service can find quotes for key interest rate measures (including the ten-year T-Bond). 2. Beta coefficient. There are a variety of sources available for obtaining the beta coefficient for a particular company. • Value Line Investment Survey. Paid subscribers to this service can obtain Value Line's estimates of a company's beta coefficient. Value Line can be accessed either online or offline through a paid subscription, as well as at most public libraries. • Yahoo. Yahoo offers free beta estimates through its Company Profile service. • Bloomberg. Free beta estimates from Bloomberg can be accessed online. • Barra. Barra publishes the Barra Beta Book monthly to suscribers. You may be able to find this resource in a good business library. 3. Equity Risk Premium. Forward looking approaches, as well as more recent historical data, suggest an equity risk premium in the 3 to 5 percent range. We use an Equity Risk Premium estimate of 3.2%. To continue with our Gateway case study, we used the following estimates for these three factors as of April 21, 2000: • Risk-free rate of 5.85%. • Beta coefficient of 1.3. • Equity risk premium of 3.2%. Using these estimates, Gateway's cost of equity capital = Risk-Free Rate + (Beta x x Market Risk Premium).= 5.85% + (1.3 x 3.2%), or 10%. III. Weighting the components. Finally, we weight the cost of each kind of capital by the proportion that each kind of capital contributes to the entire enterprise. This gives us the Weighted Average Cost of Capital (WACC), the average cost of each dollar of cash employed in the business. To review, Gateway's after-tax cost of debt is 4.72% and its cost of equity is 10%. As of April 21, 200, the market value of Gateway's debt is equal to $8.5 million and the market value of Gateway's equity approaches $17 billion. Thus, debt contributes virtually 0% of Gateway's capital while equity contributes virtually 100%. Gateway's weighted average cost of capital is thus 4.72% x 0% + 10% x 100%, or 10%. Now, let us analyze one more case in a real world related to the Cost of Capital. IBM's Cost of Capital A Case Study Let us estimate the cost of capital for IBM. To help with this task we have been provided with a balance sheet (see below) and the following information: • The beta of the stock is 1.09, based upon a regression of IBM stock returns against the S&P 500 Index.. • The share price is $130, and there are 943 million shares outstanding. • The firm has $61.7 billion in debt on its balance sheet. Since the debt is mostly short-term or recently issued, one may assume that the book value of the debt provides a good approximation of its market value. IBM incurs a marginal corporate tax rate of 36%. • The firm is rated A by the rating agencies, and the default spread over for A-rated 10-year bonds is currently 96 basis points over the corresponding US treasury yield. • 10- year Treasuries currently yield about 4.40%, and the expected long-term return on the broad stock market is about 12% Let us estimate: a. The cost of equity for IBM. b. The cost of capital for IBM. IBM Balance Sheet 12-96 12-97 12-96 as % of assets 12-97 as % of assets Assets ($ mln.) Cash 8137 7553 10,03 9,27 Inventories 5870 5139 7,24 6,31 Other 26688 27726 3289 3402 Current assets 40695 40418 50,16 49,59 Non-current assets 40437 41081 49,84 50,41 Total assets 81132 81499 100 100 Liab.&Shar-s' Equity ($mln.) Current liabilities 34000 33507 41,91 41,11 Long-term debt 25504 28176 31,44 34,57 Other liabilities 15632 14480 19,27 17,77 Total liabilities 75136 76163 92,61 93,45 Shareholders' equity 21628 19816 26,66 24,31 Total liab.& equity 96764 95979 119,27 117,77 Balance Sheet Ratios Current ratio 1,2 1,2 Debt/Equity ratio 1,2 1,4 Suggested Solution a. The cost of equity from the CAPM is: 4.40%+1.09(12%-4.40%) = 12.68% b. The after-tax cost of debt is: Rate (1-Taxrate) = 5.36%(1-. 36) = 3.43% The market value of equity is price x shares = 130*0.943 billion = $122.59 billion. The debt, short- as well as long-term, is worth $61.7 billion. The sum of these is $184.29 billion. The weighted-average cost of capital is 12.68%(122.59/184.29)+3.43%(61.7/184.29) = =9.59% 3. Cost of Capital application in the World and Lithuania Let us now examine couple articles to see how the cost of capital is used in the real world and what problems it may cause. Cost of Equity Capital Knowing the rate of return that investors expect from the company’s stock is one of the most important facts that can be obtained to understand whether or not company is meeting investors’ expectations. With this knowledge, you can make better decisions in such areas as funding projects, investing in research and development, pursuing acquisitions, buying back your stock and/or paying dividends. Despite the importance of this information, companies rarely give their cost of equity capital calculation the rigorous scrutiny it deserves. As recent surveys show, most companies use Capital Asset Pricing Model (CAPM) as the preferred practice to estimate cost of equity capital, but practitioners point to the many weaknesses and inadequacies of using this model. Some of the major problems identified with use of CAPM are: (1) wide divergences in estimated equity costs depending on assumptions deployed, (2) lack of company specific factors in the computation, and (3) complete dependence on historical data. Survey Sampling/Study Description Findings/Recommendations Best Practices in Estimating the Cost of Capital: Survey and Synthesis Cost-of-capital survey administered to 27 corporations and 10 leading financial advisers. Seven best selling textbooks and trade books were also analyzed. Best practice is largely consistent with finance theory. Despite broad agreements at the theoretical level, however, several problems in application remain that can lead to wide divergence in estimated capital costs. The Capital Asset Pricing Model (CAPM) is the dominant model for estimating cost of equity capital. Betas are drawn substantially from published sources, preferring those betas using a long period of equity returns. Some firms use multi-factor models (e.g., Arbitrage Pricing Theory), but these formed a small minority. Further applied research on two principal topics is needed. First, practitioners need additional tools for sharpening their assessment of relative risk. The variation in company-specific beta estimates from different published sources can create large differences in capital-cost estimates. Appropriate use of averages across industry or other risk categories is an avenue worth exploration. Second, practitioners could benefit from further research on estimating equity market risk premium. Current practice displays large variations and focuses primarily on averaging past data. Use of expectation data appears to be a fruitful approach. The Theory and Practice of Corporate Finance: Evidence from the Field Survey was sent to 4440 corporate Chief Financial Officers, of which 398 (or 9%) responded. The survey's primary objectives were to examine current practices in: (1) capital budgeting; (2) methodology in calculating cost of capital and (3) overall capital structure. The Capital Asset Pricing Model (CAPM) is the most popular method of determining cost of equity capital. Over 70% of firms responding use this methodology. The second most popular method is defined as "average of historical rates of return" on a firm's common stock. The term, historical rate, was not defined however. These discoveries led the researchers to conclude, "although CAPM is popular, we show that it is not clear that the model is applied properly in practice. Of course, even if it is applied properly, it is not clear that the CAPM is a very good model." Cost of Capital - Survey of Issues and Trends in India Survey was conducted in December 1999. Thirty-four respondents from across leading Indian companies, lenders, and equity analysts furnished input on cost of equity, cost of debt, financial leverage and methods of reducing cost of capital. Ninety percent of the respondents used CAPM for computation of cost of equity capital, mainly due to its application simplicity and popularity. Of those respondents who used CAPM, three-quarters reported that the beta calculation does not adequately capture all relevant company specific factors in the computation of cost of equity. Accordingly, two-thirds of the CAPM users deploy premium or discounts to adjust CAPM results. The most popular adjustments used were factors representing business leadership, earnings sustainability, and quality of management. Corporate Finance In Europe - Confronting Theory With Practice International survey conducted among 313 CFOs on capital budgeting, cost of capital, capital structure, and corporate governance. U.S. results obtained by Campbell and Harvey (2002) were compared with that obtained from the U.K., the Netherlands, Germany and France. In concert with U.S. colleagues, European CFOs determine their cost of capital using CAPM, rather than applying arithmetic average historic returns or the dividend discount model. In the U.K., Netherlands, Germany and France, 47.1%, 55.6%, 34%, and 45.2% of CFOs, respectively rely on CAPM for estimating the cost of equity capital. The second and third popular methods for the European countries are: (1) the use of average historical returns and (2) the use of some version of a multi-beta CAPM. The fragment from the article “Sources of Finance of long-term investment and Methodical Aspects of its Cost Estimation” written by Vilija Aleknevičienė can help us to create a brief idea of how the Cost of Capital is used in Lithuania: “The methods, which are used to estimate cost of capital in Western countries, are hardly suitable for Lithuania. The estimation of cost of depreciation and revenue from sale of old assets is poorly researched. The first problem is that the most of researchers do not differentiate two concepts: capital and sources of finance. Capital means the sources of total assets and sources of finance mean the sources of cash. Financing of investment is possible, when we have enough cash. In most cases these two concepts are identical (bank loan, share capital), but in certain cases they differ (depreciation, revenue from sale of old assets). The second problem is that all researchers identified cost of debt capital and interest rate. Cost of debt capital in most cases is greater, than interest rate, because of such expenses as bank commissions, registration expenses of bank guarantee, loan contract and mortgage contract, insurance premium and so on. These expenses must be included into cost of debt capital, when they increase interest rate for the most part. The third problem is that the methods, which are used to estimate cost of capital in Western countries, are hardly suitable for Lithuania. Use of CAPM is problematical for two reasons: capital market is weak and rate of return on Government bonds is not risk-free (lately fluctuates from 15,8 to 7 %). DCF method for estimation of equity capital can be used only by few firms, where flow of expected dividends grows at a constant annual rate through time. The estimation cost of equity on interest rate of bond is simple, but least precise. Some companies issued bonds in 1999, so the use of this method is limited too. The most suitable method of estimating the cost of capital for all companies is the method of net profitability.” Conclusions • Cost of Capital is the required return necessary to make a capital budgeting project worthwhile. • The investment decision is crucial to the company because they are irreversible decisions. When making an investment decision, the company has to take into account the returns expected by the investors. The company’s objective is to maximize the shareholder’s wealth through its investment projects. • As calculation of the Cost of Capital is done through the calculation of Weighted Average Cost of Capital. The Weighted Average Cost of Capital is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. Businesses or projects, which are able to earn returns greater than the cost of capital, add value for investors • Think of the firm’s capital structure as a pie, that you can slice into different shaped pieces. The firm strives to pick the weights of debt and equity (i.e. slice the pie) to minimize the cost of capital. • Most companies use Capital Asset Pricing Model (CAPM) as the preferred practice to estimate cost of equity capital. Some of the major problems identified with use of CAPM are: (1) wide divergences in estimated equity costs depending on assumptions deployed, (2) lack of company specific factors in the computation, and (3) complete dependence on historical data. • Methods, which are used to estimate cost of capital in Western countries, are hardly suitable for Lithuania. Use of CAPM is problematical for two reasons: capital market is weak and rate of return on Government bonds is not risk-free. DCF method for estimation of equity capital can be used only by few firms, where flow of expected dividends grows at a constant annual rate through time. The estimation cost of equity on interest rate of bond is simple, but least precise. Some companies issued bonds in 1999, so the use of this method is limited too. The most suitable method for companies is the method of net profitability. Information source: 1. T. Ogier, J. Rygman, L.Spicer “The Real Cost of Capital: a business field guide to better financial decisions”, 2004 2. www.investopedia.com 3. www.teachmefinance.com 4. www.investowords.com 5. www.expectationsinvesting.com 6. www.wikipedia.org 7. www.quicktaxweb.ca 8. www.ssc.uwo.ca 9. www.morevalue.com 10. www.economist.com 11. www.ktu.lt 12. www.demarche.com

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