Corp.finance 2: Cost of capital (Chi phí vốn)

* Definition

• Cost of capital: 
• the rate of return required by capital suppliers: bondholders, stockholders (owners)
• the opportunity cost of funds for the suppliers of capital
• Component of capital: firm has several alternatives for raising capital: bonds, stocks, preferred stock => each source of capital becomes a component of the firm's funding & has a COST => called: component of capital
• Weighted average cost of capital: WACC
• Wd*rd*(1-T) + Wp*rp + We*re
• Wd, Wp, We: the portion of debt, preferred stock, equity, respectively, in total capital (notes: capital, in capital budgeting, NOT includes short-term capital)
• rd, rp, re (or Kd, Kp, Ke): the cost of debt, preferred stock, equity, respectively
• T: tax rate
  

* More detailed

• Taxes: 'cos debt expenses are deductible => the tax saving is subtracted cost of debt
• Weights
• target capital structure
• current capital structure, @ market value
• average (industry) data
  
• Marginal cost of capital (MCC) & Investment opportunity schedule (IOS)
• Flotation cost: add to expenses of the year <=> cash out flow; NO add to cost of capital
  

Now, let's talk 'bout cost of each type of capital
1. Cost of debt:

• YTM
• Debt-rating approach
• Some features could makes rd higher or lower, depends on the benefit it creates, belongs to whom

2. Cost of preferred stock

rp = D1/P0

3. Cost of equity

• CAPM approach: Ke = E(r) = Rf + beta*(Rm - Rf)
  
• DDM approach: Ke = D1/P0 + g
• g = growth rate = (1 - D/EPS)*ROE = b*ROE
• b = company's earning retention rate = 1 - D/EPS
• Bond yield plus risk premium approach: E(r) = bond yield + risk premium (notes: bond yield NO deducting tax)
  
• Adjust for country risk
• country equity premium = sovereign yield spread * (annualized standard deviation of equity index/ annualized standard deviation of the sovereign bond market in terms of the developed market currency) 
• Or, in short: Rc = delta Rf * SDe/SDd
• affection to E(r) in CAPM: E(r) = Rf + beta * [(Rm - Rf) + Rc]
• Estimating beta?
• beta equity (or beta levered) ### beta asset (or beta unlevered)
• beta asset = beta equity / [1+ ((1-t)*D/E)]
• beta equity = beta asset* [1 + (1-t)*D/E]
  
• Estimating a beta using the pure-play method
1. select the comparable: determine comparable company or companies operating in similar business risk
2. estimate those comparable companies' equity beta
3. unlever the equity beta at (2) => beta asset
4. lever the beta asset at (3) (for the financial risk of the considering company/project) => equity beta of the considering company/project
   

* Reality: CAPM is popular: larger co., public co., knowledge CEO/CFOs => use CAPM more.