Monday, October 5, 2009 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.

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