# COST OF CAPITAL PDF

Estimating the marginal cost of each source of capital. A. company's cost of capital is the cost of its long-term sources of funds: debt, preferred equity, and. We introduced the cost of capital briefly in Chapter 10, because we needed some appreciation of the detail and learn how to calculate a firm's cost of capital. forecasts or costs of capital nor for proper actions or interpretation of the requirements for impairment We hope that this year's Cost of Capital Study also .

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Financial Management Decisions. Cost Of Capital. INTRODUCTION: It has been discussed in lesson -4 that for evaluating capital investment proposals. Sources of capital; Cost of each type of funding; Calculation of the weighted average cost of capital (WACC); Construction and use of the marginal cost of capital. CHAPTER 9 The Cost of Capital F ortune magazine conducts annual surveys of business leaders to identify the most-admired U.S. companies. Since the.

Goyal and Welch suggest that historical mean is a good tool for forecasting the equity premium. Siegel predicted that the ERP will decrease on account of low current dividend yields and high equity valuations. Campbell and Shilier forecasted low returns due to the perception that the market was overvalued.

Amott and Ryan suggested that the forwardlooking ERP is actually negative. Arnott and Bernstein argued that the forward-looking ERP is near zero or negative. Many studies suggest that long-term predictability is much better than short-term predictability. The implied forward looking estimates of ERP can be estimated on the basis of underlying expectations of growth in corporate earnings and dividends using the ex ante approach.

Fama and French estimate the equity premium using dividend and earnings growth rates to measure the expected rate of capital gain. The study observed that the increase in the price earnings ratio would have resulted in a realized ERP, which was higher than the ex ante expected premium.

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Robert suggests that the expected ERP can be estimated on the basis of a normal or unconditional ERP the long-term average and a conditional ERP based on the current level of the stock market and economy relative to the long-term average. Kozhan et al. Skew risk is tightly related to variance risk. Elroy et al. The study observes that larger equity returns were obtained in the second half of the twentieth century compared to the earlier period.

This pattern was basically due to growth of corporate cash flows, lower transaction and monitoring costs, lower inflation rates and lower required rates of returns as expected by investors on account of decreased investment risks. The study also observes that increases in overall price to dividend ratio are on account of the long-term decrease in the required risk premium.

Estimation of cost of capital 99 long-term government bond yield is 6 percentage points in terms of arithmetic mean and 4 percentage points in geometric mean terms. Survey-based studies generally support higher ERPs. Welch conducted a survey of academic financial economists to elicit their view on ERP and forecasted a geometric long horizon ERP of approximately 4 percentage points.

Graham and Harvey based on multiyear survey of chief financial officers of US companies suggest expected year geometric average ERP in the range of 3. Studies have also documented long-term average or unconditional estimate of ERP.

Shannon et al. This study documents realized risk premiums of 6. Academic studies indicate that ERP are lowest in periods of business expansion and highest in periods of recession.

Fabio finds that ERP is positively correlated with long-term bond yields and with default premium measured as the differential rates between Aaa- and Baa-rated bonds. Mayfield suggest that the required market risk premium for the period after is 5. Harris and Marston find an average market risk premium of 7. Fernando and Carlos estimate the ERP by combining information from 20 models and point that equity premium reached historical heights in July at The study also states that the ERP during the financial crisis in was There are estimates for historical risk premium, which are based on long time period from onward.

At the same time, risk estimates are also based on shorter time period of 10, 20, or 50 years. Hence, the risk estimates are of different values. The disadvantage of using longer period is that the risk perception of the investor changes over the period of time.

If shorter periods are used, greater standard errors in the estimation is found. The calculation of standard error of the estimate for 5 and 50 years comes to 8.

The choice of treasury bill or treasury bond as the riskfree asset is also a factor for variation in the estimated values for risk premium. If the risk-free asset is taken as treasury bills, then the difference between the average return on stocks minus the yield on treasury bill is calculated for the risk premium.

If the treasury bond rate is considered as the risk-free rate, then the difference between average return on stocks minus the yield on treasury bond rate is used as the risk premium. The two standard statistics used for estimating historical average Valuation return on the stocks are the arithmetic and geometric mean. The results vary based on these two estimates. This results in a risk premium of 6.

During the same period, the geometric mean-based returns on stock and bond were 9. Hence, arithmetic return is the rate of return that investors expect over the next year for the random annual rate of return on the market. Geometric average is the compounded annual growth rate or time weighted rate of return.

The use of the arithmetic mean ignores the estimation error and serial correlation in returns. There is a paradox in the fact that if we consider a long-term period for historical risk premium estimation, then the risk assumptions would have undergone changes during the long period.

At the same time, if we use a short period, the challenge would be to deal with large standard error associated with the risk premium estimates on account of stock volatility. The study suggests considerable variation in risk premiums across countries. The study finds that the mean real returns were an annualized 5. The dataset was based on two North American markets, eight euro currency markets, five other European markets, three Asia pacific market, and one African market region Table 4.

The risk premium in other markets like emerging countries can be calculated by adding a country premium to the base premium of the developed market. ERP 5 Base premium for matured developed equity market 1 country risk premium.

These ratings that measure the default risk of a country is based on a number of factors like political stability, trade balances, and stability of national currency. These sovereign ratings can be used to estimate the default spreads over the riskless rate. This rating suggested a stable outlook, which reflected 4 Annual Returns on Stocks, T. Bonds and T. Estimation of cost of capital Table 4. Moody services gave a bond implied rating of Baa3 in October The yield on Brazilian government bond with year maturity was The average yield on US government bond with year maturity was 6.

In this case, it is found to be 8. Bonds Online Group, Thomson Reuter. Consider the following inputs. Beta for the company 5 1. Cost of equity for Brazil company in US dollars 5 [6.

The inflation rate in Brazil in September was 6. The spread values represent basis points bps over a US treasury security of the same maturity, or the closest matching maturity. Then the interest rate on the bond is calculated as the US treasury yield for the year bond plus the default spread. In this case, it equals 2. The default spread can vary for bonds with same rating but different maturity periods.

The default spread is found to increase during periods of low economic growth. The equity risk is measured by the standard deviation in stock prices.

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Relative standard Estimation of cost of capital deviation of stock prices in emerging country is found out in relation to standard deviation of stock prices in the US market. Then the ERP in the emerging market is obtained as the product of risk premium in the United States and the relative standard deviation of stock prices in the United States.

Another alternate approach is based on the implied equity premiums. The sample of bonds are required as single bonds may be mispriced or misrated. The two measures to estimate the interest rate on bond are the current yield on the bond and YTM. The YTM is the rate required in the market on the bond. YTM is the interest rate that makes the present value of the coupons and the face value of the bond equal to the market price. YTM is considered to be a superior measure of market rate of interest.

The risk and return models are discussed in detail in Chapter 2. All models have two important components—the risk-free rate and risk premium. Estimation of historical returns are based on a period of daily, weekly, or monthly returns. That is Ri 5 a 1 bRm The slope of regression b corresponds to the beta of the stock, which measures the systematic risk of the stock. In previ- ous chapters we have seen that investors require a return of rs.

However, a company must earn more than rs on new external equity to provide this rate of return to in- vestors, because there are flotation costs when a firm issues new equity. Few firms with moderate or slow growth issue new shares of common stock through public offerings. There are three reasons for this. As we noted earlier, flotation costs can be quite high.

Sup- pose a company has an extremely profitable new project but will have to finance it with external capital. Therefore, it is logical to think that managers will want to finance really good new projects with debt, temporarily increasing the debt ratio but planning to sell stock when profits rise and pull up the stock price. On the other hand, if things look bad, management might want to finance with stock to let new shareholders share in the pain.

The net result is that if a mature company announces plans to issue additional shares, investors typically take this as a signal of bad news; as a result, the stock declines. In the remainder of this section, we assume that the company does not plan to issue new shares. Does new equity capital raised by reinvesting earnings have a cost? Many companies sell stock to their employees, and companies occasionally issue stock to finance huge projects or mergers.

Also, some utilities regularly issue common stock. The Cost of Capital opportunity cost—the earnings could have been paid out as dividends or used to redownload stock, and in either case stockholders would have received funds that they could reinvest in other securities.

Thus, the firm should earn on its reinvested earn- ings at least as much as its stockholders themselves could earn on alternative investments of equivalent risk. What rate of return could stockholders expect to earn on equivalent-risk invest- ments? The answer is rs, because they could presumably earn that return by simply downloading the stock of the firm in question or that of a similar firm.

Therefore, rs is the cost of common equity raised internally as reinvested earnings. Whereas debt and preferred stock are contractual obligations that have easily de- termined costs, it is more difficult to estimate rs. However, we can employ the prin- ciples described in Chapters 6 and 7 to produce reasonably good estimates for the cost of equity.

Three methods are typically used: These methods are not mutually exclusive: Self-Test What are the two primary sources of equity capital? Why do most established firms not issue additional shares of common equity? Estimate the risk-free rate, rRF. Estimate the current market risk premium, RPM, which is the required market return minus the risk-free rate. The following sections explain how to implement this four-step process.

There is no such thing as a truly riskless asset in the U. Projects and Their Valuation real rate rises, and a portfolio of short-term T-bills will provide a volatile earnings stream because the rate earned on T-bills varies over time.

## Cost of Capital

A survey of highly regarded companies shows that T-bond, go to http: Select their choice, and here are our reasons. Selected relatively long-term basis. Therefore, it is reasonable to think that stock returns Interest Rates.

Short-term Treasury bill rates are more volatile than are long-term Treasury bond rates and, most experts agree, are more volatile than rs. In theory, the CAPM is supposed to measure the required return over a particu- lar holding period. When it is used to estimate the cost of equity for a project, the theoretically correct holding period is the life of the project. Although most analysts use the yield on a year T-bond as a proxy for the risk-free rate, yields on or year T-bonds are also reasonable proxies.

Estimating the Market Risk Premium Recall from Chapter 6 that the market risk premium, RPM, is the required return on the stock market minus the risk-free rate, where the risk-free rate usually is defined as the yield on a year Treasury bond. This is also called the equity risk pre- mium, or just the equity premium. Since most investors are risk averse, they require a higher anticipated return a risk premium to induce them to invest in risky equities versus a Treasury bond.

Unfortunately, the required return on the market, and hence the equity premium, is not directly observable. Three approaches may be used to es- timate the market risk premium: We proceed with an explanation of each approach. Historical Risk Premium. Historical risk premium data for U. Ibbotson defines the annual equity risk premium as the difference between 10 See Robert E.

Bruner, Kenneth M. Eades, Robert S. Harris, and Robert C. For exam- ple, see the analysis of the — federal—debt limit disagreement between the White House and Congress provided in Srinivas Nippani, Pu Liu, and Craig T. Morningstar, Inc.

The Cost of Capital the historical realized returns on stocks and the historical returns on long-term T-bonds. There are several problems with using historical averages to estimate the current risk premium.

First, stock returns are quite volatile, which leads to low confidence in estimated averages. For example, the estimated historical average premium is 6. In other words, there is a very good chance that the true risk premium is much different from the calculated 6. Second, the historical average is extremely sensitive to the period over which it is cal- culated. Just 9 years ago the historical average premium was 8. In fact, over the past 12 years the average T-bond return has been higher than the average stock return, resulting in a negative his- torical premium.

This causes problems in interpreting historical returns because a change in the required risk premium causes an opposite change in the observed premium. For ex- ample, an increase in the required premium means that investors have become more risk averse and require a higher return on stocks.

Thus, an increase in the required premium causes a simultaneous decrease in the observed premium. Forward-Looking Risk Premiums. An alternative to the historical risk premium is the forward-looking, or ex ante, risk premium.

As explained previously, we can use the yield to maturity on a year T-bond as an estimate of the risk-free rate, which was 2. The challenge is to estimate the required return on the market, rM. The most common approach is to assume that the market is in equilibrium, in which case the required return is equal to the expected return: If we assume that the market dividend will grow at a constant rate and that the firms that make up the market pay out as dividends all the funds available for distribution i.

It is a little more difficult, but not impossible, to find an estimate of the expected dividend yield. There is no definitive answer to that question, but neither are we totally in the dark.

Sales revenue growth is determined by growth in prices and units sold. In the long WWW run, price growth will follow inflation. We can get a forward estimate of inflation by subtracting the real interest Go to the Federal Reserve Web site at http: The yield of an inflation-protected Treasury.

In the long run, quantity growth will be driven by population growth. What is a reasonable estimate of sustainable population growth? Combining long-term population growth with expected inflation suggests that the long-term constant growth rate in sales is around 2.

Will innovation create net increases in the quantity sold as new products hit the market, or will new products simply replace old products, resulting in no net increase in quantity sold?

Real productiv- ity measured as per capita GDP in the United States has grown at an average annual rate of about 1. Will this continue, or will the law of diminishing returns cause productivity eventually to level off? When stocks are redownloadd each year, the number of outstanding shares declines each year, so the long-term growth rate in dividends per share DPS no longer is equal to the growth rate in sales.

Let g be the long-term growth rate in total payouts which should be the same as the long-term growth rate in sales and earnings and let gDPS be the long-term growth in DPS. We can also incorporate noncon- stant payouts. Allowing for nonconstant growth and stock redownloads, we estimate that the required market return is about 8.

First, analysts and profes- sors! Second, the accuracy and truthfulness of ana- lysts who work for investment banking firms has been questioned in recent years. This suggests it might be better to use the forecasts of independent analysts, such as those who work for publications like Value Line, rather than those who work for the large investment banking firms who sell stocks for a living. Third, different analysts 16 For example, see the analysis by Douglas J.

We discuss payout strategies in more detail in Chapter Surveys of Experts. What do the experts think about the market risk premium?

Their answers over the past 8 years have implied an average ex- pected risk premium of 3. According to recent surveys of professors, the expected market risk premium is around 5. Professors Eugene Fama and Kenneth French ex- amined earnings and dividend growth rates during the period from to and estimated the forward-looking market risk premium to be 2.

After reading the previous sections, you might well be confused about the best way to estimate the market risk premium. Some factors suggest that the premium has declined. The introduction of pension plans, Social Security, health insurance, and disability insurance over the last 50 years means that people today can take more chances with their investments, which should make them less risk averse.

Moreover, many households have dual in- comes, which also allows investors to take more chances.

## Cost of capital

Finally, the historical aver- age return on the market as Ibbotson measures it is probably too high for two reasons. The first is survivorship bias: The second reason is that increases in required returns cause decreases in observed returns, and vice versa.

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On the other hand, we have recently seen a huge plunge in stock and home prices, most of us know people who have recently lost their jobs, and the pundits speak of investors exiting the stock market as a result of recent losses and fears of more losses. For updates on the survey, see http: Fama and Kenneth R. The Cost of Capital some recent data. But just how low is it? When stock prices are rela- tively high, investors feel less risk averse, so we would use a risk premium at the low end of our range.

Conversely, when prices are depressed, we would use a premium at the high end of the range. To find an estimate of beta, The result is called the historical beta because it is based on historical data.

Although go to http: Or go to Thomson returns. The returns for a company can be calculated using daily, weekly, or monthly ONE—Business School periods, and the resulting betas will differ. Beta is also sensitive to the number of years Edition. Beta is shown in of data that are used. With too few years, there will be few observations and the regres- the Key Fundamentals section. In practice, it is common to use either 3 to 5 years of monthly returns, or perhaps 1 to 2 years of weekly returns.

Unfortunately, betas calculated in different ways can be different, and it is impossible to know for certain which is correct. Even though these indexes are correlated with one another, using different indexes in the regression will result in a different beta, and we would surely obtain a different beta if we broadened the index to include real estate and other assets. One modification, called an adjusted beta, attempts to correct a possible statistical bias by adjusting the historical beta to make it closer to the known average beta of 1.

Fourth, the estimate of beta for any individual company is statistically imprecise. The average company has an estimated beta of 1.

## SOLVED PROBLEMS COST OF CAPITAL

For most companies, if your regression produces an estimated beta of 1. Harris and Felicia C. Projects and Their Valuation The preceding discussion refers to conditions in the United States and other countries with well-developed financial markets where relatively good data are avail- able. Moreover, further compli- cations arise when we are dealing with multinational companies, especially those that raise equity capital in different parts of the world.

We might, for example, be rela- tively confident in the beta calculated for the parent company in its home country but less confident of the betas for subsidiaries located in other countries. Still, our dis- cussion should help improve your judgment regarding the choice of beta for use in cost-of-capital studies, and it should also keep you from being too dogmatic about the accuracy of your beta and therefore your estimated cost of capital.

Hundreds, perhaps thousands of studies have been conducted to test the valid- ity of the CAPM, but there have been no definitive answers. The principal problem is that the CAPM itself deals only with expectations, yet the tests of the theory such as the Fama-French work described in Chapter 6 have necessarily relied on historical data. Still, we do know that security analysts and portfolio managers rely on the CAPM for much of their work, and betas are widely publicized.

Therefore, it is reasonable to use the CAPM when you estimate the cost of equity, as most academics recommend and most corporate practitioners do. Just recognize that there may be other factors at work and so—even if you could estimate rRF, bi, and RPM exactly—your estimate of rs might still not be exact. Therefore, NCC is riskier than an average company, and its cost of equity is about Indeed, despite the difficulties we have pointed out, surveys indicate that the CAPM is the dominant choice for the vast majority of companies in the United States and around the world.

The Cost of Capital Self-Test What is generally considered to be the more appropriate estimate of the risk-free rate: Explain both the historical and the forward-looking approach to estimating the market risk premium. Describe some problems one encounters when estimating beta.

What is rs? Assuming the stock is in equilibrium, we can solve for rs to obtain the required rate of return on common equity, which for the marginal investor is also equal to the expected rate of return: In equilibrium this expected return is also equal to the required return, rs. This method of estimating the cost of equity is called the discounted cash flow, or DCF, method.

The stock price and the dividend are easy to obtain, but the expected growth rate is difficult to estimate, as we will see in the following sections. Historical Growth Rates. If earnings and dividend growth rates have been rela- tively stable in the past, and if investors expect these trends to continue, then the past realized growth rate may be used as an estimate of the expected future growth rate. This is a reasonable proposition, but such situations occur only at a handful of very mature, slow-growing companies.

Unfortunately, this limits the usefulness of historical growth rates as predictors of future growth rates for most companies. Retention Growth Model. Most firms pay out some of their net income as divi- dends and reinvest, or retain, the rest.

The more they retain, and the higher the earned rate of return on those retained earnings, the larger their growth rate.

This is the idea behind the retention growth model. Projects and Their Valuation The payout ratio is the percent of net income that the firm pays out in dividends, and the retention ratio is the complement of the payout ratio: We know that, other things held constant, the earnings growth rate depends on the amount of income the firm retains and the rate of return it earns on those retained earnings, and the retention growth equation can be expressed as follows: Under these assumptions, the earnings growth rate will be constant, and it will also be the dividend growth rate.

For example, Value Line provides such forecasts on about 1, companies, and all of the larger brokerage houses provide similar forecasts. These growth rate summaries, such as those compiled For example, see http: These earnings www. For ex- ample, one widely followed analyst forecasted that NCC would have a Such nonconstant growth forecasts can be converted to an approximate constant growth rate.

Computer simulations indicate that dividends be- yond Year 50 contribute very little to the value of any stock—the present value of all dividends beyond Year 50 is virtually zero, so for practical purposes we can ignore anything beyond 50 years.

If we consider only a year horizon, then we can de- velop a weighted average growth rate and use it as a constant growth rate for cost- of-capital purposes.

In the NCC case, we assume a growth rate of This produces an average growth rate of 0. NCC is not expected to redownload any stock. Based on these assumptions, its estimated DCF cost of common equity is The dividend yield can be estimated without much error, but there is uncertainty in the growth estimate.

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We would like to know the expected average growth rate as forecasted by the marginal investor, but that rate simply cannot be observed. However, we have considered three methods that can be used to estimate ex- pected future growth: Of these three methods, the third is the most logical. What are three ways to estimate the expected dividend growth rate, and which of these methods is likely to provide the best estimate?

It is logical to think that firms with risky, low- rated, and hence high—interest rate debt will also have risky, high-cost equity, and the procedure for basing the cost of equity on a readily observable debt cost utilizes this logic. If the appropriate over-own-bond-yield risk premium is 3.

The overall average of these three methods is These results are unusually close, so it would make little difference which one we used. However, if the methods produced widely varied estimates, then a financial analyst would have to use his or her own best judgment regarding the relative merits of each estimate and then choose one that seemed reasonable under the circumstances. Recent surveys indicate that the CAPM is by far the most widely used method.

The bond-yield-plus-judgmental- risk-premium is relied upon primarily by companies that are not publicly traded. People experienced in estimating the cost of equity recognize that both careful analysis and sound judgment are required. Discussions with financial executives indicate that most are comfortable with this range.

The Cost of Capital equity capital. Unfortunately, this is not possible—finance is in large part a matter of judgment, and we simply must face that fact. However, for those that do, the cost of new common equity, re, or external equity, is higher than the cost of equity raised internally by reinvesting earnings, rs, because of the flotation costs involved in issuing new common stock.

What rate of return must be earned on new investments to make issuing stock worthwhile? Put another way, what is the cost of new common stock? The answer, for a constant growth firm, is found by applying this formula: However, because of flotation costs the company must earn more than Specifically, if the firm earns If it earns less than If it earns more than As we noted previously, most analysts use the CAPM to estimate the cost of equity.

How would the analyst incorporate flotation costs into a CAPM cost estimate? He went on to say that in his opinion a great deal of judgment is required; in his company, lower-level staffers derived relatively precise results and then experienced, senior managers applied judgment when making decisions based on those results. He thought this procedure worked out well for his company. Reprinted with permission. To incorporate flotation costs into the CAPM estimate, we would simply add 0.

As an alternative, you could find the average of the CAPM, DCF, and over-own-bond-yield-plus-judgmental- risk-premium costs of equity ignoring flotation costs and then add to it the 0.

Table shows the average flotation costs for debt and equity issued by U. The common stock flotation costs are for non-IPO issues. For IPOs, flotation costs are higher: The data in Table include both util- ity and nonutility companies; if utilities had been excluded, the reported flotation costs would have been higher.

Table shows that flotation costs are significantly higher for equity than for debt. Notice that all flotation costs, as a percentage of capi- tal raised, fall as the amount of capital raised increases. The lower cost for issuing debt results from two factors. First, debt is a contractual obligation; hence returns are more predictable, which makes selling debt easier.

Second, corporate debt is sold mainly in large blocks to institutional investors, whereas common stock is sold in smaller amounts to many different investors; this imposes higher costs on the investment banks, who pass these costs on to the issuing company. Self-Test What are flotation costs? Why are flotation costs higher for stock than for debt?

If the firm must issue new stock, what is its cost of external equity, re? The Cost of Capital raise new capital in a manner that will keep the actual capital structure on target over time. In this chapter, we assume that the firm has identified its optimal capital structure, that it uses this optimum as the target, and that it finances so as to remain constantly on target. How the target is established is examined in Chapter The target proportions of debt, preferred stock, and common equity, along with the com- ponent costs of capital, are used to calculate the WACC, as shown previously in Equation First, the WACC is the cost the company would incur to raise each new, or marginal, dollar of capital—it is not the average cost of dollars raised in the past.

Third, the target weights should be based on market values and not on book values. We discuss these points in what follows. This is the same required rate of return that a new equity holder would have, whether the new investor bought stock in the secondary market or through a new equity offering. In other words, whether the shareholders are already equity holders or are brand-new equity holders, they all have the same required rate of return, which is the current required rate of return on equity.

First, suppose the firm exhausts its capacity to issue low-cost debt this year to take on projects with after-tax returns as low as 5. Then next year, when the firm must finance with common equity, it will have to turn down projects with returns as high as Second, both existing and new investors have claims on all future cash flows.

In fact, new debtholders receive a claim on the cash flows being generated by existing as well as new projects, while old debtholders and equity holders have claims on both new and existing projects. Weights for Component Costs: Book Values versus Market Values versus Targets Our primary reason for calculating the WACC is to use it in capital budgeting or corporate valuation, since we need to compare the expected returns on projects and companies with the cost of the funds used to finance them.

As Figure showed, accountants report financial statements in book value terms, but financial analysts can convert those numbers into market values.

At one time academics—and, to a lesser extent, financial executives—debated whether we should use book value versus market value weights when estimating the cost of capital. The main arguments in favor of book weights were 1 these are the numbers shown on financial statements, 2 the bond rating agencies seem to focus on book weights, and 3 book values are more stable than market values, so book value weights produce more stable inputs for use in capital budgeting.

The main ar- guments in favor of market value weights were 1 firms raise funds by selling securi- ties at their market values, not at book values, and 2 market values are more consistent with the idea of value maximization. Market value supporters won the argument, as they should have, but in a dynamic world it is simply not feasible to blindly and mechanically focus on current market value weights i. What they did, as we discuss in Chapter 15, was focus on a less mechanical, more judgmental capital structure—the Target Capital Structure.

At the target structure, the firm uses enough debt to gain the benefits of interest tax shields and also le- verages up earnings per share. However, the amount of debt is not so great that it subjects the firm to a high probability of financial distress during a period of eco- nomic recession. In the past, clining. Today, most large corporations raise capital many experts argued that U.

In particular, Japanese firms enjoyed a very low one global capital market instead of distinct capital mar- cost of capital, which lowered their total costs and thus kets in each country. Government policies and market made it hard for U. Recent conditions can affect the cost of capital within a given events, however, have considerably narrowed cost- country, but this primarily affects smaller firms that do of-capital differences between U.

What matters most is the risk of the individual ier and cheaper for U. Firms compare their data with those of benchmark firms in their industry; this allows firms to see how they are doing relative to other firms in their industry.

If a company uses too little debt then its earnings will be lower than they could have been without subject- ing the firm to undue risk, and individual stockholders, private equity firms, or hedge firms will probably challenge management and force it toward the optimal structure. Thus, forces exist to compel firms to set their target capital structures at levels that will maximize their intrinsic values and thus their stock prices.

Finally, note that an optimal capital structure in one economic environment may not be optimal under different market conditions. In a dynamic economy it is impor- tant to constantly monitor the situation and make adjustments to the target capital structure as circumstances change. Self-Test How is the weighted average cost of capital calculated?

Write out the equation. Should the weights used to calculate the WACC be based on book values, market values, or something else? A firm has the following data: Assume the firm will not issue new stock.

The stock and bond markets, and the market for short-term debt, are normally in equilibrium and thus fairly stable. However, at times the markets are disrupted, making it virtually impossible for a firm to raise capital at reasonable rates. This happened in and , before the U. Treasury and the Federal Reserve intervened to open up the capital markets. During such times, firms tend to cut back on growth plans; if they must raise capital, its cost can be extraordi- narily high.

## 7 Methods for Measuring Cost of Capital

Note also that if interest rates in the economy rise, the costs of both debt and equity will increase. The firm will have to pay bondholders a higher interest rate to obtain debt capital; and, as indicated in our discussion of the CAPM, higher interest rates also in- crease the cost of equity. Interest rates are heavily influenced by inflation. When infla- tion hit historic highs in the early s, interest rates followed, but they trended down until the financial crisis in led to an upward spike.

However, strong actions by the federal government in the spring of brought rates back down. These actions should encourage investment, and there is little doubt that they will eventually lead the econ- omy out of its recession.

Tax Rates. Tax rates, which are influenced by the president and set by Congress, have an important effect on the cost of capital. They are used when we calculate the after-tax cost of debt for use in the WACC. In addition, the lower tax rate on divi- dends and capital gains than on interest income favors financing with stock rather than bonds, as we discuss in detail in Chapter Three Factors the Firm Can Control A firm can affect its cost of capital through 1 its capital structure policy, 2 its divi- dend policy, and 3 its investment capital budgeting policy.

Capital Structure Policy.

In the current chapter we assume that the firm has a given target capital structure, and we use weights based on that target to calculate its WACC. However, a firm can change its capital structure, and such a change can affect its cost of capital. For example, the after-tax cost of debt is lower than the cost of equity, so if the firm decides to use more debt and less common equity, then this increase in debt will tend to lower the WACC. However, an increased use of debt will increase the risk of debt and the equity, offsetting to some extent the effect due to a greater weighting of debt.

In Chapter 15 we discuss this in more depth, and we demonstrate that the optimal capital structure is the one that minimizes the WACC and simultaneously maximizes the intrinsic value of the stock. Dividend Policy. Also, if the payout ratio is so high that the firm must issue new stock to fund its capital budget, then the resulting flotation costs will also affect the WACC.

So one cost of the stimulus program may be higher inflation. The Cost of Capital Investment Policy. Therefore, we are implicitly assuming that new capital will be invested in assets with the same degree of risk as existing as- sets. This assumption is generally correct, because most firms do invest in assets sim- ilar to those they currently use. However, the equal risk assumption is incorrect if a firm dramatically changes its investment policy.

For example, if a company invests in an entirely new line of business, then its marginal cost of capital should reflect the risk of that new business. Explain how a change in interest rates in the economy would be expected to affect each component of the weighted average cost of capital. No adjustments are needed when using the WACC as the discount rate when estimating the value of a company by discounting its cash flows. However, adjustments for risk are often needed when eval- uating a division or project.

For example, what if a firm has divisions in several busi- ness lines that differ in risk? Or what if a company is considering a project that is much riskier than its typical project? The following sections explain how to adjust the cost of capital for divisions and for specific projects. Divisional Costs of Capital Consider Starlight Sandwich Shops, a company with two divisions—a bakery opera- tion and a chain of cafes.

Should these projects be accepted or rejected? Many firms use the CAPM to estimate the cost of capital for specific divisions. Projects and Their Valuation only one division and uses only equity capital, so its cost of equity is also its corporate cost of capital, or WACC.Fabio finds that ERP is positively correlated with long-term bond yields and with default premium measured as the differential rates between Aaa- and Baa-rated bonds.

Preference Shares of Rs. Advise the company as to the better option based on the effective cost of capital in each case. Firms with high operating leverage tend to have higher beta values. Problem 11 ABC Ltd. Risk factor remains constant in an organization.

Many studies suggest that long-term predictability is much better than short-term predictability. However, if the cost of equity share capital i9 computed on the basis of dividend growth model i.