Cost of Capital
...f rd can be obtained by looking at yields on publicly traded debt of similar firms. However rd is not equal to the company’s cost of debt because, since interest payments are deductible, the government in effect pays part of the total cost. As a result, the cost of debt to the firm is: After-tax component cost of debt = rd (1-T) Where T is the firm’s marginal tax rate. The component cost of preferred stock rps, is the preferred dividend, Dps, divided by the net issuing price, Pn, which is the price the firm receives after deducting flotation costs: Component cost of preferred stock = rps = Dps / Pn Companies can raise common equity in two ways, by issuing new shares and indirectly, by retained earnings, rs . Since less than 2 percent of all new corporate funds come from the external equity market this paper will focus on the calculation of the cost of retained earnings. The cost of retained earnings is an opportunity cost – the firm should earn on its reinvested earnings, at least as much as its stockholders themselves could earn on alternative investments of equivalent risk, if not, it should pass those earnings on to its stockholders and let them invest the money themselves in assets that do provide rs. Whereas debt and preferred stock are contractual obligations that have easily determined costs, it is more difficult to estimate rs. Three methods are typically used: (1) CAPM, (2) DCF and (3) the bond-yield-risk-premium approach. Since recent surveys found that the CAPM approach is by far the most widely used (74% in one survey, 85% in another (Brigham 310) this paper will focus on the cost of equity through CAPM. The CAPM equation states that: rs = rrf + (RPM)bi. Where rrf = the risk free rate. RPM = current expected market risk premium = expected return minus the risk free rate. bi = the stocks beta coefficient. There is really no such thing as a riskless asset, therefore in estimating the risk free rate the return on long term treasury bonds is used, essentially free of default risk. The market risk premium can be estimated on the basis of historical data or forward-looking data. The logic behind using historical data to estimate the market risk premium is the simple assumption that the future will resemble the past. However, it is not at all clear that the future will resemble the past. For example, the choice of the beginning and ending periods can have a major effect on the calculated risk premiums. In fact using data for the past 30-40 years, the arithmetic average market risk premium has ranged from 5-6%, quite different than the 7.0% over the last 75 years. Note too that using periods as short as 5-10 years can lead to bizarre results. E.g. negative risk premiums, which would lead to the conclusion that treasury securities have a higher required rate of return than common stocks – contrary to both financial theory and common sense. All this suggests historical risk premiums should be approached with caution. Forward-looking risk premiums??? ‘The risk premium is primarily driven primarily by investors attitudes towards risk, and there are good reasons to believe that investors are less risk averse today than years ago… The bottom line is that there is no way to prove that a particular risk premium is either right or wrong, although we would be suspicious of an estimate market premium that is much less than 3% or greater than 6%. One of the major uses of the COC is in project appraisal. The fundamental assumption made in corporate finance is that of shareholder value maximisation. Creating shareholder value entails investing in projects that generate a return in excess of the COC. Net Present Value (NPV) and The Internal Rate of Return (IRR), two widely used project appraisal techniques attempt to select projects that create value for shareholders. They are described as Discounted Cash Flow (DCF) techniques: NPV uses the COC as a discount factor and the IRR uses it as a hurdle rate – the rate of return a project must exceed to be accepted. ‘An investment proposals NPV is derived by disc...