Ch7 Cost of Capital Flashcards
(18 cards)
What is the Cost of Capital?
The cost of capital is the minimum return a firm must generate on its investments to create value. It reflects the opportunity cost of using capital. In practice, it’s the WACC (Weighted Average Cost of Capital), combining cost of equity and cost of debt, weighted by their market values.
Components of Cost of Capital
Cost of Equity: Return required by shareholders. Cost of Debt: Effective interest rate on borrowings (after tax). Weights: Based on market values of equity and debt. Used as a hurdle rate in capital budgeting and valuation.
Risk-Free Rate – Concept
A risk-free asset must have no default risk, no price risk, and no liquidity risk. Usually proxied by zero-coupon government bonds in the same currency and duration as the cash flows being valued.
Risk-Free Rate – Practical Choice
Use term-matching zero-coupon government bonds. In practice, analysts often use a single long-term rate, e.g., 10-year Bund or Treasury. Not matching maturities introduces minor inaccuracies.
Market Risk Premium (MRP)
MRP = Expected return on the market − Risk-free rate. Represents the additional return required for taking equity risk. Influenced by investor risk aversion, market volatility, and economic conditions.
Historical Premium Approach
Default method for estimating MRP: 1. Choose a historical period. 2. Calculate average return on stocks. 3. Subtract average return on a risk-free asset. Use geometric mean for long-term averages.
Standard Error in Historical Premium
Estimation error = σ / √n. σ = standard deviation of market returns. n = number of years. Example: σ = 24%, n = 25 → SE = 4.8%. Longer periods reduce error but may include outdated data.
Beta – Concept and Estimation
Beta measures systematic risk: how sensitive a stock is to market movements. Estimated via regression: Ri = αi + βi (RM - Rf) + εi. Interpretation: β > 1: aggressive, β < 1: defensive, β = 1: same as market.
R-Squared and Firm-Specific Risk
R²: % of stock’s return variation explained by market. 1 - R²: idiosyncratic (diversifiable) risk. Important for assessing reliability of beta. Diversified investors care only about market risk.
Fundamental Drivers of Beta
- Product Type – Cyclical goods → higher beta. 2. Operating Leverage – More fixed costs → higher beta. 3. Financial Leverage – More debt → higher beta. All increase earnings volatility.
Levered vs Unlevered Beta
Unlevered Beta (βU): Pure business risk. Levered Beta (βL): Includes financial risk. Formula: βL = βU[1 + (1 - τ)D/E], where τ = tax rate.
Bottom-Up Beta
Used when no reliable regression beta is available. Steps: 1. Identify business segments. 2. Find unlevered betas of peers. 3. Take weighted average. 4. Re-lever with the firm’s D/E and tax rate.
Total vs Market Beta (Private Firms)
Market beta assumes diversified investor. Total beta adjusts for undiversified owners: Total Beta = Market Beta / √R². Leads to higher cost of equity for private firms.
Cost of Equity (CAPM)
Formula: kE = Rf + β × MRP. Reflects required return on equity. Used when project returns accrue to shareholders only. Example: Rf = 2%, β = 1.13, MRP = 4% → kE = 6.52%.
Cost of Debt
If bonds are traded: use YTM. If not: use recent loan interest or synthetic rating via interest coverage. After-tax cost of debt = kD × (1 - τ).
Interest Coverage and Synthetic Ratings
Interest Coverage = EBIT / Interest Expense. Example: 2000 / 315 = 6.35 → Rating ≈ A → Default spread ≈ 1.00%. Add spread to risk-free rate to get cost of debt.
WACC (Weighted Average Cost of Capital)
Formula: WACC = kE × (E / D+E) + kD × (1 - τ) × (D / D+E). Used for evaluating returns to the firm (all capital providers). Reflects blended cost of equity and debt.
Choosing the Hurdle Rate
Use cost of equity if project cash flows go to equity holders (e.g., dividends). Use WACC if project cash flows go to the firm (e.g., unlevered FCF). Correct match is critical.
