Cost of Capital Real-world example

FIN 5080 Dr. Palkar

Cost of Equity

Equity valuation models such as the CAPM, APM, or other multi-factor models require a risk-free rate and a market risk premium (in the CAPM) or premiums (in the APM and multi-factor models) We will begin by discussing these common inputs
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Risk-free Rate

Requirements for a asset to be risk-free

We define a risk-free as one for which the investor knows the expected returns with certainty. Therefore, for a asset to be risk-free (i.e actual returns = expected returns), it must satisfy three conditions:

Risk-free Rate - Requirements

1.

There has to be no default risk

This generally implies that the security has to be issued by the government This implies that there are no intermediate cash flows. To illustrate, say, you want to estimate the expected returns over a 5year period. In that case, a 6-month T-Bill rate, though default-free, will not be risk-free because there is a reinvestment risk of not knowing what the interest rate will be in 6 months. Even a 5-year T-Bond is not risk-free, because the coupon on the bond will be reinvested at rates that cannot be predicted today. The appropriate risk-free rate for the 5-year period will be the expected return on the default-free (government) 5-year zero-coupon 3 bond.

2.

There can be no uncertainty about reinvestment rates

Risk-free Rate - Requirements

3.

The risk-free rate should be measured consistently with how the cash flows are measured

If cash flows are estimated using real growth rates (no price inflation), we should use a real risk-free rate The risk-free rate should be in the same currency in which the cash flows are estimated.

Market Risk Premium

Requirements for estimating risk premiums

The risk premium in CAPM measures the extra return that would be demanded by investors for shifting their money from a riskless investment to a market portfolio of risky investments, on average. Therefore, it must satisfy two conditions:

Market Risk Premium - Requirements

1.

Risk aversion of investors

As the investors become more risk-averse, they will demand a higher premium for shifting from a riskless asset Greater the risk aversion of investors, greater is the risk premium Riskier the investment, greater is the risk premium This depends on factors such as how involved the firms are in managing risk, their economic fundamentals, current stock prices, etc

2.

Riskiness of the investment

Market Risk Premium - Requirements

One approach for estimating the risk premium in the CAPM is to base it on historical premiums earned in the past period. This approach is composed of the following three steps:
1. 2.

3.

Define the estimation period Calculate the average returns on the stock index and the average returns on the risk-free asset over the period Risk premium = Average returns on the stock index Average returns on the risk-free asset

Estimating Risk Premiums

Note that, in doing so, we are assuming that,

The risk aversion of investors has not changed in a systematic way across time The riskiness of the stock index portfolio has not changed in a systematic way over time

Source: http://pages.stern.nyu.edu/~adamodar/
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Estimating Risk Premiums Some issues

Estimation issues:

Users of asset pricing models generally agree that historical premium is in fact the best estimate of the risk premium looking forward, but still there are large differences in the actual premiums used in practice For example, risk premiums estimated in the U.S. markets by different investment banks, consultants, and corporations range from 2% - 12% even though they are almost all using the same database obtained from Ibbotson database. There are three reasons for the deviation in risk 9 premiums:

Estimating Risk Premiums Some issues

1.

Time period used

Some analysts use entire data (which goes back to 1928) whereas some analysts use data over shorter time periods (last 50, 20, or even 10 years) Advantage of using shorter periods is a more updated estimate but it comes at a cost of greater estimation error in the risk premium estimate.
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Estimating Risk Premiums Some issues

2.

Choice of risk-free security

The Ibbotson database reports returns on both TBills and bonds. Estimation of risk premium will change based on how the risk premium for stocks are calculated using short-term rates or longterm rates Generally in corporate finance and valuation, risk-free rate is the long term government bond rate and not the short-term rate (i.e. risk premiums using the T-bonds are mostly used)

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Estimating Risk Premiums Some issues

3.

Choice of arithmetic versus geometric averages

The arithmetic average is the mean of the series of annual returns whereas the geometric average is the compounded return Conventional wisdom argues for the use of arithmetic average.

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Risk Parameters - Beta

In CAPM, the beta of the asset is estimated relative to the market portfolio There are three approaches available for estimating beta:

Using historical data on market prices for individual assets

Regress excess stock returns on excess market returns

Type of business (cyclical), degree of operating leverage (high fixed costs), degree of financial leverage (higher debt)
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Estimating beta from fundamentals

Estimating beta from accounting data

Regress change in firms earnings on changes in market earnings

The CAPM Approach

Cost of equity

Risk-free rate, Rf Market risk premium, E(RM) Rf Systematic risk of asset,

RS

Rf

[ E ( RM ) R f ]
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Cost of Debt ( rd )

What is debt?

General Rule: Debt generally has the following characteristics:

Commitment to make fixed payments in the future The fixed payments are tax-deductible Failure to make the payments can lead to either default or loss of control of the firm to the party to whom payments are due.
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Cost of Debt

The cost of debt measures the current cost to the firm of borrowing funds to finance projects Cost of debt is determined by the following terms:
1.
2. 3.

Current level of interest rates Default risk of the company Tax advantage associated with debt
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Cost of Debt
1.

Current level of interest rates

As interest rates rise, the cost of debt for firms will also increase As the default risk of a firm increases, the cost of borrowing money will also increase Because interest is tax-deductible, the tax benefits that accrue from paying interest makes the after-tax cost of debt lower than the pre-tax cost After-tax cost of debt = Pretax cost of debt (1- tax rate)

2.

Default risk of the company

3.

Tax advantage associated with debt

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Cost of Debt

The simplest scenario for estimating the cost of debt occurs when a firm has long-term bonds outstanding that are widely traded and have no special features, such as convertibility or first claim on assets, etc. In that case, the market price of the bond, along with the coupon rate and maturity, are used to compute the yield to maturity of the bond which we use as the before-tax cost of debt. However, many firms have bonds that do not trade on a regular basis.
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Cost of Debt

So, another approach is, if the firm is rated, use the bond rating and a typical default (or yield) spread on bonds with that rating to estimate the cost of debt. If the firm is not rated, and it has recently borrowed long term, use the interest rate on the borrowing

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Cost of Debt using Default Spreads

Pre-tax cost of debt for Corporate Bonds = Yield of T-Bond of similar maturity + Default Spread Yield on corporate bond should be higher than on Treasury bond with the same maturity because corporate bonds carry default risk

the risk that the corporation may not make all scheduled payments. Difference between the Bond Yield and the yield on the Treasury Bond of similar maturity
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Yield (or default) spread

Bond Ratings and Spreads at Different Maturities at a Given Point in Time

Rating
Aaa/AAA Aa1/AA+ Aa2/AA Aa3/AAA1/A+ A2/A A3/ABaa1/BBB+ Baa2/BBB Baa3/BBBBa1/BB+ Ba2/BB Ba3/BBB1/B+ B2/B B3/BCaa/CCC+ US Treasury Yield

1 yr
14 22 24 25 43 46 50 62 65 72 185 195 205 265 275 285 450 4.74

2 yr
16 30 37 39 48 51 54 72 80 85 195 205 215 275 285 295 460 4.71

3 yr
27 31 39 40 52 54 57 80 88 90 205 215 225 285 295 305 470 4.68

5 yr
40 48 54 58 65 67 72 92 97 102 215 225 235 315 325 335 495 4.63

7 yr
56 64 67 71 79 81 84 121 128 134 235 245 255 355 365 375 505 4.6

10 yr
68 77 80 81 93 95 98 141 151 159 255 265 275 395 405 415 515 4.59

30 yr
90 99 103 109 117 121 124 170 177 183 275 285 295 445 455 465 545 4.56

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Estimating the cost of debt

We can approximate the pre-tax cost of debt for the firm by obtaining the yield on the Treasury Bond of similar maturity and adding the default spread. Then, post-tax cost of debt = pre-tax cost of debt * (1- tax rate)

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Problems in application in real world

1.

It is usually easy to estimate the pre-tax cost of debt for firms that have bond ratings available for them. However, there are few potential problems that may arise in real world applications Disagreement between rating agencies
There are few firms over which rating agencies disagree, with one agency assigning a much higher or lower rating to the firm than others.
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Problems in application in real world

2.

Multiple bond ratings for same firm

The same firm can have many bond issues with different ratings based on how the bond is structured and secured

3.

Lags and errors in the rating process

Rating agencies make mistakes and there is evidence that rating changes occur after the bond market has already recognized the change in the default risk
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Alternative plan: Synthetic ratings

An alternative option is to plan the role of a rating agency and assign a rating based on its financial ratios The next slide presents a simple version of synthetic rating where we list the range of Times Interest Earned Ratios (TIE) for manufacturing firms and report the report the typical default spreads for bonds in each ratings class.

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TIE

TIE and Ratings >12.50 AAA

9.50-12.50 7.50-9.50 AA A+

Rating

Typical Default Spread 0.35% 0.50% 0.70%

6.00-7.50
4.50-6.00 4.00-4.50 3.50-4.00 3.00-3.50 2.50-3.00

A
ABBB BB+ BB B+

0.85%
1.00% 1.50% 2.00% 2.50% 3.25%

2.00-2.50
1.50-2.00 1.25-1.50 0.80-1.25 0.50-0.80 <0.65

B
BCCC CC C D

4.00%
6.00% 8.00% 10.00% 12.00% 20.00%
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TIE and Synthetic Ratings

Assuming that a company has a TIE Ratio of 3.35. Based on this ratio, we would assess a synthetic rating of BB for the firm and attach a default spread of 2.5% to the risk-free rate to arrive at the pre-tax cost of debt.

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TIE and Synthetic Ratings-Comments

By using synthetic ratings on TIE ratio alone, we run the risk of missing information that is available in other financial ratios used by credit agencies. The synthetic rating approach can be extended to include other ratios such as the Altmans Z score which is a proxy for default risk and then apply the ratings based on the Z-score
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Altmans Z-score, 1983 Model

6.56 * (working capital / total assets) + 3.26 * (retained earnings / total assets) + 6.72 * (EBIT / total assets) + 1.05 * (book value of equity / book value of debt) = Altmans Z-score

Altmans Z-score

Indicator of overall financial health Cutoffs: less than 1.1 bankrupt 1.1 2.6 gray area greater than 2.6 healthy A Z-score of 1.1 or less does not mean the company is bankrupt, but does suggest that financial problems may exist

TIE and Synthetic Ratings-Comments

Note, however, that these extensions come at a cost. Using the Altmans Z-score may yield better estimates of synthetic ratings than those based on TIE ratios, but the changes in ratings arising from these scores are much more difficult to explain than those based on TIE ratios. At the end, we may prefer the flawed but simple and more transparent ratings offered by TIE ratios.
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Short-term and Long-term Debt

Most publicly traded firms have multiple borrowings short-term and long-term bonds and bank debt with different terms and interest rates. Although there are some analysts who create separate categories for each type of debt and attach a different cost to each category, this approach is tedious and sometimes all information is not available.

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Short-term and Long-term Debt

There are two ways to approach this problem:

Combine all debt short-term (excluding payables and accruals) and long-term, bank debt, and bonds and attach the long-term cost of debt to it. In other words, add the default spread to the long-term T-Bond rate and use that rate as the pre-tax cost of debt 2. Use Prime Rate + Adjustment for risk of the company for short-term debt, and use long-term T-Bond rate + default spread for long-term debt. Prime Rate Data Source: http://research.stlouisfed.org/fred2/series/MPRIME?cid=117 /
1.
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