BITS Pilani

presentation
BITS Pilani Dr. Nivedita Sinha
Hyderabad Campus Department of Economics & Finance
Agenda

Cost of Capital

10/19/2020
BITS Pilani, Hyderabad Campus
Determine the hurdle rate

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Cost of capital or Hurdle rate or
Discount rate
The hurdle rate is the minimum acceptable rate of return on a capital
investment project given its risk and it is the opportunity cost of
forgoing other projects of similar risk.

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 Cost of Capital – opportunity cost of forgoing alternate
investments of similar risk

Firm with Shareholder

Pay cash dividend invests in
excess cash
financial asset
A firm with excess cash can either pay a dividend
or make a capital investment

Shareholder’s
Invest in Terminal
project Value
Because stockholders can reinvest the dividend in risky financial assets, the expected
return on a capital-budgeting project should be at least as great as the expected return
on a financial asset of comparable risk.
Discount rate of a project should be the expected return on a financial asset of
comparable risk. Accept the project only if it generates return greater than what
is required (i.e. greater than the hurdle rate). BITS Pilani, Hyderabad Campus
Weighted Average Cost of Capital
(WACC)
 WACC (Weighted Average cost of capital) is the weighted average of the
expected after-tax rates of return of the firm’s various sources of invested
capital

 Invested capital is capital raised by a firm through the issuance of

interest bearing debt and equity (both preferred and common)

 WACC can be viewed as the expected rate of return that investors forgo
from alternative investment opportunities with equivalent risk

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WACC Formula
WACC = Rb (1-T)wb + Rpwp + Rsws
where
• w’s or weights are the proportions in which funds are raised – proportions of
its’ market values

• Rs is the estimated required rates of return for the firm’s common equity (cost
of equity) and Rp is for preferred equity (cost of preferred equity)

•Rb is the estimated required rates of return for the firm’s interest bearing debt –
rate of return required by the firm’s creditors (cost of debt)
•It is adjusted by a factor 1-T (where T is corporate tax rate) to reflect the
fact that firm’s interest expense are tax- deductible
• Creditors receive a return equal to Rb but firm experiences a net cost of Rb
(1-T)

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 Financial Instruments – Equity and
Debt
 Common Stock/Equity – Ownership shares in a publicly held
corporation. Equity claims held by “residual owners” of the firm, who
are last to receive any distribution of earnings or assets

 Preferred Stock/Equity– A type of stock whose holders are given

certain priority over common stockholders in the distribution of
dividend. Usually the dividend rate is fixed at the time of issue. Preferred
stock holders normally do not receive voting rights.

 Debt instrument– Any interest bearing liability whether short term or

long term having 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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WACC Calculation steps

Step 1 : Estimate the opportunity cost of each of the sources of financing

and adjust it for the effects of taxes wherever applicable
Cost of equity capital
Cost of common equity (Rs)
Cost of preferred equity (Rp)
Cost of debt (Rb) – pretax and after tax Rb(1-T) where T is the
marginal corporate tax rate

Step 2 : Estimate the firm’s capital structure and determine the relative
importance of each component in the mix – calculating the weights
• (ws,wp,wb)

Step 3 : Calculate the firm’s WACC by computing a weighted average of

the estimated after-tax cost of capital sources used by the firm (Putting in
the WACC formula)
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 Rs – The Cost of Equity capital
• From the firm’s perspective, the expected return is the Cost of Equity
Capital:

R s  RF  β ( R M  RF )
• To estimate a firm’s cost of equity capital, we need to know three
things:

1. The risk-free rate, RF

2. The market risk premium, R MRM RFR F

Cov( Ri , RM ) σ i , M
3. The company beta, βi   2
Var ( RM ) σM
Rs – The Cost of Equity capital
If the project is all equity financed – weighted average cost of capital or
the hurdle rate is the required rate of equity return or cost of equity
capital.
Investment decision: Invest (or Accept the project) if the return on the
investment is greater than or equal to the hurdle rate
Example
Suppose the stock of Stansfield Enterprises, a publisher of PowerPoint
presentations, has a beta of 1.5. The firm is 100% equity financed.
Assume a risk-free rate of 3% and a market risk premium of 7%.
What is the appropriate discount rate for an expansion of this firm?

Now suppose Stansfield Enterprises is evaluating the following independent

projects. Each costs Rs.100 and lasts one year. Which project(s) should he
accept?

Project’s Estimated
Project Beta of project
Cash Flows Next Year
A 1.5 R s Rs.125
RF  β ( R M  RF )
B 1.5 Rs.113.5
C 1.5  3 %  1 .5  7 %
R s Rs.105
Example
R s  RF  β ( R M  RF )

R s  3%  1.5  7%
R s  13.5%
Beta of Project’s Estimated
Project IRR NPV at 13.5%
project Cash Flows Next Year
A 1.5 Rs.125 25% Rs.10.13
B 1.5 Rs.113.5 13.5% Rs. 0
C 1.5 Rs.105 5% -Rs.7.49
Using the SML
IRR
Project

Good A
project

30% B

C Bad project
3
%
Firm’s risk (beta)
1.5
An all-equity firm should accept projects whose IRRs exceed the cost of
equity capital and reject projects whose IRRs fall short of the cost of
capital.
Revision last session

Factors on which beta depends on

• Type of Business
• Operating leverage
• Financial leverage

Why we perform un-levering and re-levering of beta?

Formulas for beta equity and beta unlevered (also called

beta assets)

10/19/2020
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Beta – Exploring fundamentals
Determinant 1: Cyclicality of revenues
 Industry Effects: The beta value for a firm depends upon the
sensitivity of the demand for its products and services and of its costs
to macroeconomic factors that affect the overall market.
 Cyclical companies have higher betas than non-cyclical firms
 Firms which sell more discretionary products will have higher betas
than firms that sell less discretionary products
Beta – Exploring fundamentals
Determinant 2: Operating leverage
 Operating leverage refers to the proportion of the total costs of the firm
that are fixed.
 Other things remaining equal, higher operating leverage results in
greater earnings variability which in turn results in higher betas.
Beta – Exploring fundamentals
Determinant 3: Financial leverage
 As firms borrow, they create fixed costs (interest payments) that make
their earnings to equity investors more volatile.
 This increased earnings volatility which increases the equity beta
Cost of Capital for Divisions and
Projects
Project IRR

The SML can tell us why:

Incorrectly accepted
negative NPV
projects
Hurdle RF  β FIRM ( R M  RF )
rate
Incorrectly rejected
rf positive NPV projects
Firm’s risk (beta)
bFIRM
A firm that uses one discount rate for all projects may make incorrect capital
budgeting decisions. If projects are of different risks, choosing the same
discount rate is incorrect.
 Estimating Beta

In a world with corporate taxes, and riskless debt (beta of debt is 0), it can be shown that the relationship between the beta of the unlevered firm and the beta of levered equity is:

 Debt 
β Equity  1   (1  TC ) β Unleveredfirm
 Equity 
However, if debt is not riskless, the beta of debt is non-zero. Then the relationship between the beta of unlevered firm and beta of levered equity is:
B
β Equity  β Unleveredfirm  (1  TC )(β Unleveredfirm  β Debt ) 
S
Using Regression approach : Top down beta L

Refer to excel template

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Estimating Beta contd.

Using Unlevering and Relevering of beta : Bottom up

Advantage over Top down approach:-

The standard error of the beta estimate will be much lower

The betas can reflect the current (and even expected future) mix of
businesses that the firm is in rather than the historical mix

Note: beta of debt taken as negligible

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Cost of Preferred Stock

• Preferred stock is a perpetuity, so its price is equal to the dividend paid

divided by the current required return.

• Rearranging, the cost of preferred stock is:

RP = C / PV
Where C is the cash received each year (dividends on preferred stock)
PV is Market Price of preferred stock
Estimating the Cost of Debt
 If the firm has bonds outstanding, and the bonds are traded, the yield to
maturity on a long-term, straight (no special features) bond can be used
as the interest rate.

 If the firm is rated, use the rating and a typical default 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 from a bank, use the interest
rate on the borrowing or
 estimate a synthetic rating for the company, and use the synthetic
rating to arrive at a default spread and a cost of debt
Cost of debt – Synthetic rating
 The rating for a firm can be estimated using the
financial characteristics of the firm. In its simplest
form, the rating can be estimated from the interest
coverage ratio
Interest Coverage Ratio = EBIT / Interest Expenses
And then look up the Table

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s/syntrating.htm

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Cost of debt – Synthetic rating
Interest Coverage Ratio Rating Typical default spread
> 12.5 AAA 0.35%
9.50 - 12.50 AA 0.50%
7.50 – 9.50 A+ 0.70%
6.00 – 7.50 A 0.85%
4.50 – 6.00 A- 1.00%
4.00 – 4.50 BBB 1.50%
3.50 - 4.00 BB+ 2.00%
3.00 – 3.50 BB 2.50%
2.50 – 3.00 B+ 3.25%
2.00 - 2.50 B 4.00%
1.50 – 2.00 B- 6.00%
1.25 – 1.50 CCC 8.00%
0.80 – 1.25 CC 10.00%
0.50 – 0.80 C 12.00%
< 0.65 D 20.00%
Cost of debt = Risk free rate + Default risk premium (for the bond)
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g.htm BITS Pilani, Hyderabad Campus
The Weights for Cost of Capital
Calculation
 The weights used in the cost of capital computation should be market
values.
 Market Value of Equity should include the following
 Market Value of Shares outstanding

 Market Value of Debt is more difficult to estimate because few firms

have only publicly traded debt. There are two solutions:
 Assume book value of debt is equal to market value
 Estimate the market value of debt from the book value
 For Disney, with book value of 13,100 million, interest expenses of
$666 million, a current cost of borrowing of 5.25% and an weighted
average maturity of 11.53 years.
 1 
(1
 11.53 
Estimated MV of Disney Debt = 666 (1.0525)  13,10011.53  $12,915 million
 .0525  (1.0525)
 

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WACC Formula
WACC = Rb (1-T)wb + Rpwp + Rsws
where
• w’s or weights are the proportions in which funds are raised – proportions of
its’ market values

• Rs is the estimated required rates of return for the firm’s common equity (cost
of equity) and Rp is for preferred equity (cost of preferred equity)

•Rb is the estimated required rates of return for the firm’s interest bearing debt –
rate of return required by the firm’s creditors (cost of debt)
•It is adjusted by a factor 1-T (where T is corporate tax rate) to reflect the
fact that firm’s interest expense are tax- deductible
• Creditors receive a return equal to Rb but firm experiences a net cost of Rb
(1-T)

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The Weighted Average Cost of Capital

• The Weighted Average Cost of Capital is given

by:
Equity Debt
RWACC = × REquity + × RDebt ×(1 –
Equity + Debt Equity + Debt TC)

S B
RWACC = × RS + × RB ×(1 – TC)
S+B S+B

• Because interest expense is tax-deductible,

we multiply the last term by (1 – TC).
Firm Valuation
• The value of the firm is the present value of expected future
(distributable) cash flow discounted at the WACC

• To find equity value, subtract the value of the debt from the firm value
Problem 1 on WACC
Titan mining corp. Has 9.3 million shares of common stock
outstanding and 260,000 6.8% semi-annual bonds outstanding, par
value of $1000 each. The common stock currently sells for $34 per
share and has a beta of 1.2, bonds of 20 years to maturity and sell for
104% of par value. The market risk premium is 7%, T-bills are yielding
3.5% and Titan Mining’s tax rate is 35%.
a. What is the firm’s market value capital structure
b. If Titan mining is evaluating a new investment project that has the
same risk as firm’s typical project, what rate should the firm use to
discount the project’s CFs.

Market Value of equity = No of shares outstanding * Market price

Market Value of debt = Bond price * Bonds outstanding

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Problem 2 on Firm Valuation
Schulz is considering purchase of Arras. Arras is a supplier for Schulz
and the acquisition will allow Schulz to better control its material
supply. Current CF from assets for Arras is $7.5 million. The CFs are
expected to grow at 8% for the next five years before levelling off to
4% for the indefinite future. The cost of capital for Schulz and Arras is
12% and 10% respectively. Arras has 3 million shares outstanding and
$25 million in debt outstanding. What is the maximum price per share
Schulz should pay for Arras?

PV of CFs = PV of annuity + PV of terminal value = Firm value at

10% cost of capital

Market value of equity = Firm Value – Market value of debt

Price per share = Market Value of equity/Shares outstanding

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