Cost of capital
Encyclopedia
The cost of capital
is a term used in the field of financial investment to refer to the cost of a company's funds (both debt
and equity
), or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities". It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.
The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In practice, the interest-rate paid by the company can be modelled as the risk-free rate plus a risk component (risk premium
), which itself incorporates a probable rate of default (and amount of recovery given default). For companies with similar risk or credit ratings
, the interest rate is largely exogenous
(not linked to the company's activities).
The cost of equity is more challenging to calculate as equity does not pay a set return to its investors. Similar to the cost of debt, the cost of equity is broadly defined as the risk-weighted projected return required by investors, where the return is largely unknown. The cost of equity is therefore inferred by comparing the investment to other investments (comparable) with similar risk profiles to determine the "market" cost of equity. It is commonly equated using the CAPM formula (below), although articles such as Stulz 1995 question the validity of using a local CAPM versus an international CAPM- also considering whether markets are fully integrated or segmented (if fully integrated, there would be no need for a local CAPM).
Once cost of debt and cost of equity have been determined, their blend, the weighted-average cost of capital (WACC), can be calculated. This WACC can then be used as a discount rate
for a project's projected cash flows.
. This default premium will rise as the amount of debt increases (since, all other things being equal, the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of equity (earnings are after-tax
as well). Thus, for profitable firms, debt is discounted by the tax rate. The formula can be written as (Rf + credit risk rate)(1-T), where T is the corporate tax rate and Rf is the risk free rate.
The yield to maturity
can be used as an approximation of the cost of capital.
Cost of equity = Risk free rate of return + Beta x (market rate of return- risk free rate of return)
Where Beta= sensitivity to movements in the relevant market:
Where:
The risk free rate is taken from the lowest yielding bonds in the particular market, such as government bonds.
model", which is
times the market risk premium.
The risk premium varies over time and place, but in some developed countries during the twentieth century it has averaged around 5%. The equity market real capital gain
return has been about the same as annual real GDP growth. The capital gains on the Dow Jones Industrial Average
have been 1.6% per year over the period 1910-2005. http://home.earthlink.net/~intelligentbear/com-dj-infl.htm The dividends have increased the total "real" return on average equity to the double, about 3.2%.
The sensitivity to market risk (β) is unique for each firm and depends on everything from management to its business and capital structure
. This value cannot be known "ex ante" (beforehand), but can be estimated from ex post (past) returns and past experience with similar firms.
are a component of equity, and therefore the cost of retained earnings (internal equity) is equal to the cost of equity as explained above. Dividends (earnings that are paid to investors and not retained) are a component of the return on capital to equity holders, and influence the cost of capital through that mechanism.
The total capital for a firm is the value of its equity (for a firm without outstanding warrant
s and options
, this is the same as the company's market capitalization
) plus the cost of its debt (the cost of debt should be continually updated as the cost of debt changes as a result of interest rate changes). Notice that the "equity" in the debt to equity ratio
is the market value of all equity, not the shareholders' equity on the balance sheet.To calculate the firm’s weighted cost of capital, we must first calculate the costs of the individual financing sources:
Cost of Debt, Cost of Preference Capital and Cost of Equity Cap..
Calculation of WACC is an iterative procedure which requires estimation of the fair market value of equity capital.
that the company must pay in order to borrow money. By utilizing too much debt in its capital structure, this increased default risk can also drive up the costs for other sources (such as retained earnings and preferred stock) as well. Management must identify the "optimal mix" of financing – the capital structure
where the cost of capital is minimized so that the firm's value can be maximized.
The Thomson Financial league tables show that global debt issuance exceeds equity issuance with a 90 to 10 margin.weighted average cost of capital
showed that, under certain assumptions, the value of a leveraged firm and the value of an unleveraged firm should be the same.
Capital (economics)
In economics, capital, capital goods, or real capital refers to already-produced durable goods used in production of goods or services. The capital goods are not significantly consumed, though they may depreciate in the production process...
is a term used in the field of financial investment to refer to the cost of a company's funds (both debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
and equity
Equity (finance)
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
), or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities". It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.
Summary
For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk. If a project is of similar risk to a company's average business activities it is reasonable to use the company's average cost of capital as a basis for the evaluation. A company's securities typically include both debt and equity, one must therefore calculate both the cost of debt and the cost of equity to determine a company's cost of capital. However, a rate of return larger than the cost of capital is usually required.The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In practice, the interest-rate paid by the company can be modelled as the risk-free rate plus a risk component (risk premium
Risk premium
A risk premium is the minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset, in order to induce an individual to hold the risky asset rather than the risk-free asset...
), which itself incorporates a probable rate of default (and amount of recovery given default). For companies with similar risk or credit ratings
Bond credit rating
In investment, the bond credit rating assesses the credit worthiness of a corporation's or government debt issues. It is analogous to credit ratings for individuals.-Table:...
, the interest rate is largely exogenous
Exogenous
Exogenous refers to an action or object coming from outside a system. It is the opposite of endogenous, something generated from within the system....
(not linked to the company's activities).
The cost of equity is more challenging to calculate as equity does not pay a set return to its investors. Similar to the cost of debt, the cost of equity is broadly defined as the risk-weighted projected return required by investors, where the return is largely unknown. The cost of equity is therefore inferred by comparing the investment to other investments (comparable) with similar risk profiles to determine the "market" cost of equity. It is commonly equated using the CAPM formula (below), although articles such as Stulz 1995 question the validity of using a local CAPM versus an international CAPM- also considering whether markets are fully integrated or segmented (if fully integrated, there would be no need for a local CAPM).
Once cost of debt and cost of equity have been determined, their blend, the weighted-average cost of capital (WACC), can be calculated. This WACC can then be used as a discount rate
Discount rate
The discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....
for a project's projected cash flows.
Cost of debt
The cost of debt is computed by taking the rate on a risk free bond whose duration matches the term structure of the corporate debt, then adding a default premiumPremium
Premium may refer to:* Premium , a promotional item that can be received for a small fee when redeeming proofs of purchase that come with or on retail products....
. This default premium will rise as the amount of debt increases (since, all other things being equal, the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of equity (earnings are after-tax
After Taxes
After Taxes is the second studio album by rapper Sheek Louch. It was released via the independent label Koch Records instead of on a major label like Walk witt Me, Sheek's first album. His sophomore release spawned a minor hit with "Kiss Your Ass Goodbye"...
as well). Thus, for profitable firms, debt is discounted by the tax rate. The formula can be written as (Rf + credit risk rate)(1-T), where T is the corporate tax rate and Rf is the risk free rate.
The yield to maturity
Yield to maturity
The Yield to maturity or redemption yield of a bond or other fixed-interest security, such as gilts, is the internal rate of return earned by an investor who buys the bond today at the market price, assuming that the bond will be held until maturity, and that all coupon and principal payments...
can be used as an approximation of the cost of capital.
Cost of equity
Cost of equity = Risk free rate of return + Premium expected for riskCost of equity = Risk free rate of return + Beta x (market rate of return- risk free rate of return)
Where Beta= sensitivity to movements in the relevant market:
Where:
- Es
- The expected return for a security
- Rf
- The expected risk-free return in that market (government bond yield)
- βs
- The sensitivity to market riskMarket riskMarket risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices...
for the security
- RM
- The historical return of the stock market/ equity market
- (RM-Rf)
- The risk premiumRisk premiumA risk premium is the minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset, in order to induce an individual to hold the risky asset rather than the risk-free asset...
of market assets over risk free assets.
The risk free rate is taken from the lowest yielding bonds in the particular market, such as government bonds.
Expected return
The expected return (or required rate of return for investors) can be calculated with the "dividend capitalizationDividend Discount Model
The dividend discount model is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments. In other words, it is used to evaluate stocks based on the net present value of the future dividends. Dividend discount model is a tool...
model", which is
Comments
The models state that investors will expect a return that is the risk-free return plus the security's sensitivity to market riskMarket risk
Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices...
times the market risk premium.
The risk premium varies over time and place, but in some developed countries during the twentieth century it has averaged around 5%. The equity market real capital gain
Capital gain
A capital gain is a profit that results from investments into a capital asset, such as stocks, bonds or real estate, which exceeds the purchase price. It is the difference between a higher selling price and a lower purchase price, resulting in a financial gain for the investor...
return has been about the same as annual real GDP growth. The capital gains on the Dow Jones Industrial Average
Dow Jones Industrial Average
The Dow Jones Industrial Average , also called the Industrial Average, the Dow Jones, the Dow 30, or simply the Dow, is a stock market index, and one of several indices created by Wall Street Journal editor and Dow Jones & Company co-founder Charles Dow...
have been 1.6% per year over the period 1910-2005. http://home.earthlink.net/~intelligentbear/com-dj-infl.htm The dividends have increased the total "real" return on average equity to the double, about 3.2%.
The sensitivity to market risk (β) is unique for each firm and depends on everything from management to its business and capital structure
Capital structure
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
. This value cannot be known "ex ante" (beforehand), but can be estimated from ex post (past) returns and past experience with similar firms.
Cost of retained earnings/cost of internal equity
Note that retained earningsRetained earnings
In accounting, retained earnings refers to the portion of net income which is retained by the corporation rather than distributed to its owners as dividends. Similarly, if the corporation takes a loss, then that loss is retained and called variously retained losses, accumulated losses or...
are a component of equity, and therefore the cost of retained earnings (internal equity) is equal to the cost of equity as explained above. Dividends (earnings that are paid to investors and not retained) are a component of the return on capital to equity holders, and influence the cost of capital through that mechanism.
Weighted average cost of capital
The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm's cost of capital.The total capital for a firm is the value of its equity (for a firm without outstanding warrant
Warrant (finance)
In finance, a warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiry date....
s and options
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
, this is the same as the company's market capitalization
Market capitalization
Market capitalization is a measurement of the value of the ownership interest that shareholders hold in a business enterprise. It is equal to the share price times the number of shares outstanding of a publicly traded company...
) plus the cost of its debt (the cost of debt should be continually updated as the cost of debt changes as a result of interest rate changes). Notice that the "equity" in the debt to equity ratio
Debt to equity ratio
The debt-to-equity ratio is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets. Closely related to leveraging, the ratio is also known as Risk, Gearing or Leverage...
is the market value of all equity, not the shareholders' equity on the balance sheet.To calculate the firm’s weighted cost of capital, we must first calculate the costs of the individual financing sources:
Cost of Debt, Cost of Preference Capital and Cost of Equity Cap..
Calculation of WACC is an iterative procedure which requires estimation of the fair market value of equity capital.
Capital structure
Because of tax advantages on debt issuance, it will be cheaper to issue debt rather than new equity (this is only true for profitable firms, tax breaks are available only to profitable firms). At some point, however, the cost of issuing new debt will be greater than the cost of issuing new equity. This is because adding debt increases the default risk - and thus the interest rateInterest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
that the company must pay in order to borrow money. By utilizing too much debt in its capital structure, this increased default risk can also drive up the costs for other sources (such as retained earnings and preferred stock) as well. Management must identify the "optimal mix" of financing – the capital structure
Capital structure
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
where the cost of capital is minimized so that the firm's value can be maximized.
The Thomson Financial league tables show that global debt issuance exceeds equity issuance with a 90 to 10 margin.weighted average cost of capital
Modigliani-Miller theorem
If there were no tax advantages for issuing debt, and equity could be freely issued, Miller and ModiglianiModigliani-Miller theorem
The Modigliani–Miller theorem forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process , in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is...
showed that, under certain assumptions, the value of a leveraged firm and the value of an unleveraged firm should be the same.