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Corporate Finance
MLI28C060
Capital structure II: Cost of capital
and its implications for capital raising
Lecture 6
Monday 17 October 2016
Capital structure III: Cost of capital and its
implications for capital raising
Structure:
- Introduction to the cost of equity
- Introduction to the cost of debt
- Weighted average cost of capital, or WACC.
- Implications of capital raising domestic versus international
Reading:
Brealey & Myers: Chapter 9
- Introduction to the cost of equity
Cost of Capital in Segmented vs.
Integrated Markets
• The cost of equity capital (Ke) of a firm is the
expected return on the firm’s stock that
investors require.
• This return is frequently estimated using the
Capital Asset Pricing Model (CAPM):
Ri = Rf + bi(RM – Rf)
where bi=
Cov(Ri , RM)
Var(RM)
Cost of Capital in Segmented vs.
Integrated Markets
If capital markets are segmented, then investors can only
invest domestically. This means that the market portfolio
(M) in the CAPM formula would be the domestic
portfolio instead of the world portfolio.
Ri = Rf + bi U.S.(RU.S. – Rf)
versus
Ri = Rf + bi W(RW – Rf)
Clearly integration or segmentation of international financial
markets has major implications for determining the cost of
capital.
Cost of Equity and Debt
• Cost of equity is calculated using the Capital Asset Pricing Model (CAPM)
k e  k rf  b (k m  k rf )
Where
ke
krf
km
β
= expected rate of return on equity
= risk free rate on bonds
= expected rate of return on the market
= coefficient of firm’s systematic risk
• The normal calculation for cost of debt is analyzing the various
proportions of debt and their associated interest rates for the firm
and calculating a before and after tax weighted average cost of debt
Worked Example: Trident’s WACC
• Maria Gonzales, Trident’s CFO, believes that Carlton has access to global
capital markets and because it is headquartered in the US, that the US should
serve as its base for market risk and equity risk calculations
k WACC  17.00%(0.60) 8.00%(1  0.35)(0.40)
k WACC  12.28%
Where
kWACC = weighted average cost of capital
ke
= Carlton’s cost of equity is 17.0%
kd
= Carlton’s before tax cost of debt is 8.0%
t
= tax rate of 35.0%
E/V = equity to value ratio of Carlton is 60.0%
D/V = debt to value ratio of Carlton is 40.0%
Nestlé: An Application of the International
CAPM
• The process of calculating an international WACC differs from
a domestic WACC in the selection of the appropriate market
portfolio and beta
• Stulz (1995) suggests using a global portfolio of securities
available to investors rather than the world portfolio of all
securities (some of which may not be available to investors)
when calculating a firm’s international cost of equity
• The next slide shows the domestic and international risk-free
rates, market portfolios, and betas for Nestlé used to calculate
required rates of return for equity
• In this example the domestic required return for Nestlé of
9.4065% differs slightly from Nestlé’s global required return of
9.3840%
Figure 3: Estimating the Global Cost of
Equity for Nestlé (Switzerland)
Calculating Equity Risk Premia in Practice
• Using CAPM, there is rising debate over what
numerical values should be used in its
application, especially the equity risk premium
– The equity risk premium is the expected average
annual return on the market above riskless debt
– Typically, the market’s return is calculated on a
historical basis yet others feel that the number
should be forward looking since it is being used to
calculate expected returns
Calculating Equity Risk Premia in Practice
• The field of finance does agree that a cost of
equity calculation should be forward-looking,
meaning that the inputs to the equation
should represent what is expected to happen
over the relevant future time horizon
• As is typically the case, however, practitioners
use historical evidence as the basis for their
forward-looking projections
Market Segmentation
• Capital market segmentation is a financial market
imperfection caused mainly by government
constraints, institutional practices, and investor
perceptions
• Other imperfections are
–
–
–
–
–
–
–
Asymmetric information
Lack of transparency
High securities transaction costs
Foreign exchange risks
Political risks
Corporate governance differences
Regulatory barriers
Introduction to the cost of debt
Estimating the Cost of Debt
• For developed countries, the target’s local or the acquirer’s home country
cost of debt.
• For emerging countries, the cost of debt (k d ) is as follows:
k d  R f  CRP  FRP
where
Rf = Local risk free rate or U.S. treasury bond rate converted to a local nominal
rate if cash flows are in the local currency; if cash flows in dollars, the U.S.
treasury rate
CRP = Specific country risk premium expressed as difference between the local
country’s (or a similar country’s) government bond rate and the U.S. treasury
bond rate of the same maturity
FRP = Firm’s default risk premium (i.e., additional premium for similar firms
rated by credit rating agencies or estimated by comparing interest coverage
ratios used by rating agencies to the firm’s interest coverage ratios to
determine how they would rate the firm.)
Standard & Poor's ratings
Sample mapping of default probabilities to
ratings
Weighted average cost of capital, or WACC
Weighted Average Cost of Capital
k WACC
E
D
 k e  k d (1  t)
V
V
Where
kWACC = weighted average cost of capital
ke
= risk adjusted cost of equity
kd
= before tax cost of debt
t
= tax rate
E
= market value of equity
D
= market value of debt
V
= market value of firm (D+E)
Worked Example: Carlton’s WACC
• Carlton’s CFO, believes that Carlton has access to global capital markets and
because it is headquartered in the US, that the US should serve as its base
for market risk and equity risk calculations
k WACC  17.00%(0.60) 8.00%(1  0.35)(0.40)
k WACC  12.28%
Where
kWACC = weighted average cost of capital
ke
= Carlton’s cost of equity is 17.0%
kd
= Carlton’s before tax cost of debt is 8.0%
t
= tax rate of 35.0%
E/V = equity to value ratio of Carlton is 60.0%
D/V = debt to value ratio of Carlton is 40.0%
Figure 2: Calculation of Trident’s Weighted
Average Cost of Capital