💹Business Valuation Unit 6 – Cost of Capital & Risk Assessment

What's This All About?

• Cost of capital represents the minimum return a company must earn on its investments to satisfy its investors (includes debt and equity holders)
• Assessing risk is crucial in determining the appropriate cost of capital for a company
  • Higher risk generally leads to higher required returns from investors
• The weighted average cost of capital (WACC) is a commonly used metric that accounts for the costs of both debt and equity financing
• Understanding cost of capital helps managers make informed decisions about capital budgeting and project selection
  • Projects with returns exceeding the cost of capital create value for the company
• Investors use cost of capital to evaluate the attractiveness of investment opportunities and assess whether they are being adequately compensated for the risk they are taking
• Accurately estimating cost of capital is essential for business valuation as it directly impacts the present value of future cash flows
• Cost of capital can vary across industries and even within the same industry depending on company-specific factors (risk profile, capital structure)

Key Concepts to Remember

• Cost of equity represents the required rate of return for equity investors
  • Often estimated using the Capital Asset Pricing Model (CAPM): $r_e = r_f + \beta(r_m - r_f)$
    • $r_e$: cost of equity
    • $r_f$: risk-free rate
    • $\beta$: beta coefficient (measure of systematic risk)
    • $r_m$: expected market return
• Cost of debt is the effective interest rate a company pays on its debt financing
  • Calculated as: $r_d = r_d^* (1 - t)$
    • $r_d$: after-tax cost of debt
    • $r_d^*$: pre-tax cost of debt (yield to maturity)
    • $t$: marginal tax rate
• WACC formula: $WACC = \frac{E}{V} r_e + \frac{D}{V} r_d (1 - t)$
  • $\frac{E}{V}$: proportion of equity financing
  • $\frac{D}{V}$: proportion of debt financing
• Risk premium is the additional return required by investors for taking on higher risk
  • Equity risk premium: $ERP = r_m - r_f$
• Systematic risk (non-diversifiable risk) is captured by beta in the CAPM
  • Beta measures the sensitivity of a stock's returns to market movements
• Unsystematic risk (company-specific risk) can be diversified away by investors and is not compensated for in the CAPM

The Nitty-Gritty Details

• Estimating beta for a company involves regressing its stock returns against market returns
  • Adjusted beta: $\beta_{adjusted} = \frac{2}{3} \beta_{raw} + \frac{1}{3}$
    • Assumes beta tends towards the market average (1.0) over time
• Risk-free rate is typically based on government bond yields (U.S. Treasury bonds)
  • Should match the duration of the cash flows being discounted
• Market risk premium is the difference between the expected market return and the risk-free rate
  • Can be estimated using historical data or implied from current market prices
• Marginal tax rate should be used in calculating the after-tax cost of debt
  • Represents the tax rate applied to the last dollar of taxable income
• Capital structure weights ($\frac{E}{V}$ and $\frac{D}{V}$) should be based on market values, not book values
  • Market value of equity: current stock price × number of shares outstanding
  • Market value of debt: estimated using bond pricing models or approximated using book value if the debt is not actively traded
• When estimating the cost of equity for a private company, additional adjustments may be necessary (size premium, company-specific risk premium)

Real-World Examples

• A manufacturing company with a beta of 1.2, a risk-free rate of 3%, and a market risk premium of 5% would have a cost of equity of: $r_e = 3\% + 1.2(5\%) = 9\%$
• If the same company has a pre-tax cost of debt of 6%, a marginal tax rate of 25%, and a capital structure of 60% equity and 40% debt, its WACC would be:
  • $WACC = 0.6(9\%) + 0.4(6\%)(1 - 0.25) = 7.2\%$
• A utility company with stable cash flows and lower risk might have a beta of 0.8, resulting in a lower cost of equity and WACC compared to the manufacturing company
• Startups and high-growth companies often have higher costs of capital due to their higher risk profiles and reliance on equity financing
  • Venture capital investors typically require returns of 20% or more to compensate for the high risk

Common Pitfalls and How to Avoid Them

• Using book values instead of market values for capital structure weights
  • Always use market values to reflect the true economic value of debt and equity
• Failing to match the risk-free rate to the duration of the cash flows being discounted
  • Use a risk-free rate with a similar maturity to the cash flows (e.g., 10-year Treasury yield for 10-year cash flow projections)
• Not adjusting for the marginal tax rate when calculating the after-tax cost of debt
  • The tax deductibility of interest expenses reduces the effective cost of debt
• Relying on a single method to estimate the cost of equity (e.g., CAPM) without considering other approaches (dividend discount model, bond yield plus risk premium)
  • Triangulate results from multiple methods to improve the accuracy of the estimate
• Ignoring company-specific factors that may affect the cost of capital (e.g., size, liquidity, corporate governance)
  • Consider adding premiums or discounts to the cost of equity based on these factors

Practical Applications

• Capital budgeting decisions: Companies use the cost of capital as a hurdle rate for evaluating investment projects
  • Projects with internal rates of return (IRR) exceeding the cost of capital are generally accepted
• Business valuation: The cost of capital is used as the discount rate in discounted cash flow (DCF) valuation models
  • Higher cost of capital results in lower present values and lower valuation multiples (P/E, EV/EBITDA)
• Performance evaluation: Managers are often assessed based on their ability to generate returns above the cost of capital
  • Economic Value Added (EVA) = Net Operating Profit After Tax (NOPAT) - (Invested Capital × WACC)
• Optimal capital structure: Companies strive to find the mix of debt and equity financing that minimizes their WACC
  • Trade-off between the tax benefits of debt and the increased financial risk and potential costs of financial distress
• Investor decision-making: Investors compare the expected returns of investments to their required rates of return (cost of capital) to determine whether an investment is attractive

Putting It All Together

• The cost of capital is a fundamental concept in finance that impacts various aspects of corporate decision-making and valuation
• Estimating the cost of capital involves assessing the required returns for both debt and equity investors
  • CAPM is widely used for estimating the cost of equity
  • After-tax yield to maturity is used for estimating the cost of debt
• The WACC represents the overall cost of capital for a company, considering its capital structure and the respective costs of debt and equity
• Accurately assessing risk is crucial in determining the appropriate cost of capital
  • Systematic risk (beta) and unsystematic risk (company-specific factors) should be considered
• Managers and investors use the cost of capital to make informed decisions about investments, valuation, and performance evaluation
• Minimizing the cost of capital by optimizing the capital structure can enhance shareholder value

Extra Resources to Check Out

• Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset (3rd ed.). Wiley.
  • Comprehensive guide to valuation, including detailed discussions on estimating the cost of capital
• Pratt, S. P., & Grabowski, R. J. (2014). Cost of Capital: Applications and Examples (5th ed.). Wiley.
  • In-depth analysis of cost of capital estimation, with practical examples and case studies
• McKinsey & Company. (2020). Valuation: Measuring and Managing the Value of Companies (7th ed.). Wiley.
  • Widely recognized as the "valuation bible" for practitioners, with a chapter dedicated to estimating the cost of capital
• Damodaran Online: http://pages.stern.nyu.edu/~adamodar/
  • Website maintained by Professor Aswath Damodaran, with extensive resources on valuation, including datasets for risk-free rates, equity risk premiums, and industry betas
• CFA Institute. (2019). 2019 Cost of Capital Survey. https://www.cfainstitute.org/en/research/survey-reports/cost-of-capital-survey-2019
  • Annual survey of global investment professionals, providing insights into current practices and trends in cost of capital estimation