How to determine cost of capital for any listed company?
The cost of capital is an important ingredient in both investment decision-making by the company’s management as well as the valuation of the company by investors. The company is said to have created value if it produces a return in excess of the cost of capital and is said to have destroyed value if it earns a return less than the cost of capital. The riskier the investment’s cash flows, the greater is its cost of capital. Cost of capital for an entire company can be defined as the required rate of return that investors demand the average-risk investment of a company.
The most popular way to estimate this required rate of return is to calculate the marginal cost of each of the different sources of capital and then calculate a weighted average of these costs. This weighted average is referred to as the weighted average cost of capital (WACC), alternatively known as the marginal cost of capital (MCC) as it is the cost incurred by the company for additional capital. Taking into account the main sources of capital to be common stock, preferred stock & debt and assuming that in some jurisdictions, interest expense may be tax deductible, the expression for WACC is
WACC = wd*rd(1 – t) + wp*rp + we*re
wd = the proportion of debt that the company uses when it raises new funds
rd = the before- tax marginal cost of debt
t = the company’s marginal tax rate
wp = the proportion of preferred stock the company uses when it raises new funds
rp = the marginal cost of preferred stock
we = the proportion of equity that the company uses when it raises new funds
re = the marginal cost of equity
Let us see how to calculate the costs of different sources of capital -
Cost of debt:
The cost of debt can be defined as the cost of debt financing to a company when it issues a bond or takes out a bank loan. There are two methods used to calculate the before-tax cost of debt namely the yield-to-maturity approach and the debt-rating approach.
Yield-to-maturity approach- The yield-to-maturity (YTM) is the annual return that an investor earns on a bond if the investor purchases the bond today and holds it until maturity. To simplify it more, it is the yield that equates the present value of the bond’s promised payments to its market price.
Debt-rating approach - It may happen that the current market price for a company’s debt is unavailable. In such cases, the debt-rating approach can be used to estimate the before-tax cost of debt. The debt-rating of the company is considered, and the before-tax cost of debt is estimated by using the yield on comparably rated bonds for maturities that are almost close to that of the company’s existing debt.
Cost of preferred stock:
The cost of preferred stock is the cost that a company has promised to pay preferred stockholders as a preferred dividend while issuing preferred stock. For a non-convertible, non-callable preferred stock that has a fixed dividend rate and no maturity date (fixed rate perpetual preferred stock), the following formula can be used for the value of preferred stock:
Pp = Dp/Rp
Pp = the current preferred stock price per share
Dp = the preferred stock dividend per share
rP = the cost of preferred stock
Cost of common equity
The cost of common equity, usually known simply as the cost of equity, is the rate of return required by a company’s common shareholders. Common equity can be raised by a company through reinvestment of retained earnings or through the issuance of new shares of stock. Widely used approaches for estimating the cost of equity include the capital asset pricing model, the dividend discount model, and the bond yield plus risk premium method.
Capital asset pricing model- In the capital asset pricing model (CAPM) approach, we consider a basic relationship that the expected return on a stock, E(Ri), is the sum of the risk- free rate of interest, RF, and a premium for bearing the stock’s market risk, βi (RM − RF):
E(Ri) = Rf + βi [E(RM) - RF)
βi = the return sensitivity of stock i to changes in the market return
E(RM) = the expected return on the market
E(RM) − RF = the expected market risk premium
Dividend discount model approach - The dividend discount model establishes that the intrinsic value of a share of stock is the present value of the share’s expected future dividends.
Bond yield plus risk premium approach: The bond yield plus risk premium approach is based on the financial theory that the cost of capital of riskier cash flows is higher than that of less risky cash flows. The estimate is, therefore,
re = rd + risk premium
Hence, we can conclude that cost of capital estimation is a challenging and keen task. It is not observable but must be estimated. Arriving at cost of capital need bunch of assumptions and estimates.